How to maximise the risk/reward trade-off in US tech

Vital components used in consumer electronics and internet infrastructure could soon be in short supply, but demand could be about to rise. Will Warren, US equity manager, reveals how the team are playing this imbalance in their portfolios.

William Warren

The distortions in supply and demand produced by the pandemic years are still being played out across different industries. In many cases there has been a dynamic of rapid inventory growth leading to oversupply, followed by destocking and depressed pricing.

This has resulted in a ‘rolling earnings recession’ across the market. We have found some interesting opportunities where suppliers have addressed an oversupply situation with aggressive production capacity cuts and now demand is recovering.

Covid's impact on Inventory: Core-large capitalisation stocks: year-over-year inventory growth

line graph core large capitalisation stocks year over year inventory growth

Source: Empirical Research Partners as at 10 January 2024. Excludes financials, REITs, utilities and energy.

For example, retailers such as Amazon experienced a boom in demand during Covid. The company responded by building large amounts of distribution capacity that in hindsight proved to be more than the market required in a post-Covid world. Amazon quickly recognised the problem and got to work shedding a significant chunk of this over-investment. Ecommerce demand has now rebounded and Amazon is structurally more profitable.

Hard disk drives and NAND flash storage

When most of the world was stuck at home during the pandemic, elevated demand for consumer electronics and internet infrastructure created a corresponding boom in demand for hard disk drives and NAND flash storage. Once the pandemic ended, demand growth slowed, inventory ballooned and prices fell.

The industry reacted by aggressively cutting capacity. Seagate, a leader in hard disk drives, for example, has reduced capital expenditure significantly.

Seagate capex

Bar graph showing powerful combination of cyclical and secular demand growth with supply cutbacks Seagate

Source: Company disclosures and Bloomberg estimates as at 31 December 2023.

And Lam Research, which makes the equipment to manufacture DRAM and NAND flash, has also seen its sales into this industry fall to near-decade lows.

Lam Research memory equipment sales ($m)

Bar graph showing powerful combination of cyclical and secular demand growth with supply cutbacks Lam

Source: Company disclosures and Bloomberg estimates as at 31 December 2023.

Inventory has now normalised and demand for these products is returning, but into a dramatically reduced production capacity. A setup like this usually leads to a strong pricing upcycle. This cycle could be further amplified by generative AI, a new demand driver that has emerged over the past year.

The hard disk drive industry could be particularly well positioned. As shown in the chart below, for increased demand for hard drives from cloud computing the past five years has been largely offset by decreasing demand from legacy applications such as PCs. Going forward, hard drive demand from cloud computing and AI should continue to grow strongly while declining legacy markets are no longer large enough to create a headwind.

New demand growth vs legacy shrinkage

Bar graph showing new demand growth vs legacy shrinkage

Source: Gartner Group as at 31 December 2023.

Across our US equity fund range, we have gained exposure to this dynamic with a position in Western Digital, a leader in both hard disk drives and NAND flash storage. The stock underperformed significantly during the NAND and hard drive down-cycle and is now poised for a strong recovery.

The company is also in the middle of a process to spin off its NAND business into a new company, a transaction that we believe could unlock additional shareholder value. Investing in commodity technology stocks such as Western Digital requires a degree of nimbleness and the cycle must be closely monitored, but we believe this is currently one of the better risk/reward setups in the technology sector.

William Warren

Manages:

US long/short strategy

William has co-managed Artemis’ US long/short strategy since launch in 2014.

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