Why This Cycle Is Different

So I visited Korea recently, and it was very exciting to meet with different participants, in particular the memory supply chain. and it was interesting to see that they are very comfortable with 2027. It seems like pretty much a done deal.

When you talk to those companies, and we also did a lot of channel checks with some of the spot traders of memory, they tell you that right now, even the big customers are only able to get 65% of their needs. So that's the fulfillment ratio. And that means that demand continues to be way ahead of supply. When you talk to the major companies, the players in the space, Hynix and Samsung, they tell you that they're playing a different game now. Instead of trying to maximize short-term profit in the cycle and really expand capacity way too quickly.

First, they're bound by constraints on building new fabs and lower ability to shrink the actual memory size compared to previous cycles. But they also now are willing to sacrifice some of these short-term earnings in return for longer trade agreements that guarantee certain levels of volumes and give them visibility, even if that means lower earnings immediately, but more prolonged duration of earnings. And I think the market is probably going to recognize and reward that over time.

And it gives more comfort in this cycle compared to previous cycles.

Memory Valuation Disconnect

When you look at how these companies are valued, they're still at single digit PE, maybe four to five times. And what the market is really concerned about, despite the record earnings and free cash flow, is basically the duration of earnings. And that's why these companies are assigned a cheaper multiple. But now what the companies are doing is basically trying to extend long-term agreements and have them cover more of their capacity ahead of time.

And even if that means an agreed upon price that's still lower than the spot price, but it gives this earnings duration more visibility and allows them to have more longer-term visibility into their earnings cycle. And this also means that they're more comfortable increasing their capital returns to shareholders as well. So, all in the companies, both in terms of suppliers and clients, have more visibility going forward for a longer period.

And from an investor standpoint, we get comfortable with earnings duration and also participate more in capital return right away.

AI Supply Chain Bottlenecks in Taiwan

Given that we're seeing more expansion in capacity in Korea, some of the interesting names were also the semi-equipment names that support the testing and other parts of this memory expansion cycle.

And also our team visited Taiwan over the course of the quarter as well. And again, there's a lot going on. And Taiwan is broader. Obviously, it has foundry, but it also has other interesting bottleneck areas, including substrates, including testing equipment again, including advanced packaging. And we see bottlenecks across the spectrum. So there's also a case to be made about the AI trade itself expanding beyond the memory into other subsets of AI and broadening out.

Strong Fundamentals and Active Positioning

As I mentioned, the fundamentals continue to be very strong. And if you think about AI adoption, it's still very early stage. So this is not a short-term fad. This is definitely a structural story that's going to be probably the most important one for our lifetime. And with that in mind, and knowing that supply has still bottlenecks in different parts of the chain, we are comfortable and taking comfort in the fundamentals. So that helps us have conviction in our positioning.

But obviously, concentration and crowded positioning can be an issue. So when we think about our positioning there, we also think about how much active risk we are putting into these names. And many of those names have become very heavy concentration names in the benchmark itself. So we express a lot of our reviews positive or less positive from an active positioning standpoint. And continue to monitor the market dynamics around that.

Keep an Eye on the Supply Chain

When you think about the part of AI that's really dominant within emerging markets, it's the picks and shovels. It's the supply chain that basically enables the build-out of data centers and for the hyperscalers to continue to develop and advance their capabilities.

And so with that in mind, one variable that we have to continue to monitor because it's key is hyperscaler capex and what that looks like into the future, because in many ways that shapes the demand for our companies. One thing to note about emerging market AI supply chain names, they are very profitable. So monetization on our side is already here and growing.

But we want to make sure about the sustainability of the AI investment and monetization ability on the client side as well, which mostly falls within the United States and that's what we really monitor all the time.

Learn More

To learn more about this and other emerging market equity topics, visit vaneck.com for more insights.