Will Taiwan stage a turnaround in 2012?

For the last few years, there have been two turnaround stories in Asia that especially interest me. Both are seen as economies that are struggling, and which offer few opportunities for investors. But in both cases, there is reason to be optimistic.

One is Malaysia, which has certainly delivered in investment terms. The local market is up around 80% since the 2009 trough. It was also one of 2011's better performers, closing the year roughly flat, which surprised me - on my last trip, I was worried that the improvement was running out of momentum. I'll write more about Malaysia in the near future.

But this week, I'm going to look at Taiwan, the other market that I thought was set for a change. It hasn't delivered - and while there may be a trading opportunity there in the next few days, it's not clear when it will...

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A disappointing year for Taiwanese stocks

Taiwan is a small, export-dependent economy. The countries are certainly not identical, but the most obvious comparison in stock market terms is with Korea. As you can see from the chart below, Taiwan performed very poorly relative to Korea in 2011.

Why has Taiwan had such a tough year? First, Taiwan's tech-centred economy has suffered a lot more than many of its Korean rivals. Some Korean firms such as Samsung Electronics and Hyundai Motor have done very well this year, while Taiwanese leaders such as HTC and Acer haven't had such a great time.

Second, while Korea's domestic economy is not the soundest around, it's larger and stronger than Taiwan's. Taiwanese wages have been flat in real terms since the dotcom bust (see chart below) and have yet to fully recover from the global financial crisis. Part of the case for investing in Taiwan was that this trend would improve in the next few years - but so far, this isn't delivering.

And then there's the politics. This weekend sees presidential and legislative elections contested by the Kuomintang (KMT), which formerly ruled Taiwan under a single-party system, and the Democratic Progressive Party (DPP), which came out of the democracy movement in the 1980s. The KMT is certain to win a majority in the legislative elections, but the DPP hopes to regain the presidency it lost in the 2008 elections.

Were I a Taiwanese voter, I would find the decision extremely hard. The KMT has eased relations with China and improved trade and investment ties between the two sides. This is crucial to Taiwan's economy in the long term. The country's stagnation is largely due to a loss of manufacturing work to China. Its best option for the long run is to move into higher value services that complement China's economy.

The DPP has a much more negative view of China. As you may know, China regards Taiwan as a renegade province that needs to be reunited with the mainland. The KMT is broadly open to reunification if China becomes democratic. The DPP favours a more distinctively Taiwanese identity, with some in the party arguing for formal, rather than de facto, independence.

So a DPP president would probably see relations cool off and security worries grow. But the DPP could also bring social and institutional benefits for Taiwan. The polls reflect this uncertainty. There seems to be almost no gap in support between the KMT's Ma Ying-jeou and the DPP's Tsai Ing-wen.

On balance, the KMT seem slightly more likely to win, but it's impossible to call. Markets may well rally in relief if Ma wins. But this is likely to be short lived unless the economy improves.

A DPP victory would almost certainly spark a sharp sell-off. But normally these initial responses prove to be overreactions and markets stage a rebound relatively quickly. Events-driven traders may want to keep an eye on the elections as a possible opportunity.

Few signs of life in tech trends

While a win for the DPP would certainly shake things up a bit, I don't think relations with China are likely to deteriorate to the point that they did under previous DPP president Chen Shui-bian.

The KMT's landslide victory in 2008 demonstrated that the Taiwanese electorate felt his approach was too adversarial. So up until a few months ago, I would have said that a DPP victory would be a very good long-run buying opportunity.

But Taiwan is so tech-centric that you can't ignore the tech cycle. IT accounts for 55% of the MSCI Taiwan. And conditions in Taiwanese tech seem to be getting worse all the time.

Tech changes rapidly. Since it's not my specialism, I have only a very rough impression of what's going on. But earlier this week I spoke to James Weir, co-manager of the Guinness China & Hong Kong and Guinness Asia Focus Funds, who follows the industry closely. His updates on his latest conversations with Taiwanese tech firms suggest there is little reason to be cheerful.

In recent years, much of the Taiwanese IT industry has been focused on the notebook computer sector, which was a strong growth market. But it's now maturing, price deflation is severe and margins are getting squashed. The business that served them well for many years is simply not working anymore.

The one hope in this area appears to be 'ultrabooks' - notebooks that are both lightweight and relatively high performance. Manufacturers are hoping that these will encourage buyers to replace their older notebooks, while commanding higher average selling prices.

It may work - but it's a last-ditch effort to wring better margins out of the sector. And reactions from the CES trade show just held in Las Vegas, where ultrabook launches were apparently this year's big trend, have definitely been mixed.

Meanwhile, mobile technology - the other key sector for Taiwanese firms - is also suffering lower margins. A resurgence in Windows Mobile-based, Intel-powered smartphones to compete with Apple and Android phones might help, but there are doubts about whether it will happen.

While shares in most Taiwanese tech firms have been falling all year, so have earnings estimates. As a result, companies still don't look that cheap, says James. A few trends might benefit some: take-up of 3D TV could help a couple of suppliers, while others hope to produce LED lighting at good yields that allow for much more competitive pricing.

But overall, it's hard to be optimistic about Taiwan's key industries in the near future. Even semiconductor foundry TSMC (US:TSM), an outstanding company and a leader in its industry, faces a new cycle of heavy capital expenditure ahead of the next generation of chips.

Expect a tough 2012 in Taiwan

Can I say anything encouraging? First, while there is scope for earnings disappointments, the market is not expensive. The MSCI Taiwan trades on a price/book ratio of 1.86, against its median since 1998 of 2.0. The dividend yield continues to creep up; it's now on 4.6% against a median since 1995 of 1.33%.

While dividends at some of the tech firms may not be sustainable unless profits pick up, there are certainly income opportunities. One of the attractions of the Taiwan market over Korea is that Taiwanese companies now treat minority shareholders much better with regard to issues such as dividends.

I still think that links between Taiwan and China will grow in the long run and this will ultimately transform the Taiwanese economy. Relatively few manufactured goods have seen strong export growth under the free trade deal agreed by the KMT, but services have grown more strongly. And the development of the service sector is the path that Taiwan needs to follow.

It can no longer compete on lower-skilled manufacturing and must now follow the same approach that Hong Kong and Singapore took at this stage of development, allowing these jobs to go to low cost destinations and trying to create higher value jobs to replace it. Services account for just 9% of Taiwan's GDP, against around 50% for Hong Kong and Singapore, so there is a long way to go to achieve this.

Taiwan is likely to manage the change. The economy has already come a long way. It went from exporting textiles and other unskilled goods in the 1960s to being a tech centre within a few decades. Its companies are notable for their flexibility and competitiveness.

But the immediate outlook suggests that it will take longer than I hoped for the Taiwanese market to outperform - regardless of who wins the election.

This article is taken from Cris's free weekly email, MoneyWeek Asia. Sign up to MoneyWeek Asia here .