Semiconductors: invest in the future of technology

This article was first published in MoneyWeek magazine issue no 986 on 14 February 2020. To make sure you don't miss out in future, and get to read all our articles as soon as they're published, sign up to MoneyWeek here and get your first six issues free.

When the Soviet Union successfully launched its Sputnik satellite in 1957, the United States was caught on the back foot and national confidence in its technological future dwindled. The humiliation galvanised the country into action. It boosted investment in military capabilities and new technologies; the catch-up effort included the creation of the Nasa space agency in 1958.

The US government was determined to ensure the technological success of its space programme and moon mission. This boosted activity in semiconductors – the key component of most electronic circuits in computers – spearheaded by a business called Fairchild Semiconductor, a forerunner of companies such as Intel and AMD. This all took place around San Francisco and silicon was the key element used in semiconductor technology. Hence the term “Silicon Valley”.

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Most people have became aware of Silicon Valley over the past decade through high-profile CEOs and companies such as Steve Jobs of Apple and Mark Zuckerberg of Facebook.

But the competitive drive and innovation that remain hallmarks of Silicon Valley today are a direct result of the US losing ground to the Soviet Union. The subsequent boom across multiple technologies in the area fuelled a revolution that has since helped the US maintain its leading position in global technology.

What semiconductors actually do

Today, semiconductors are of crucial importance to the world of technology. They’re everywhere. We’re exposed to hundreds – possibly thousands – of them every day, and the manufacturers have enjoyed great success. Also referred to as chips, microchips or microprocessors, they can be found across industries and in homes in millions of devices.

What they do can be broken down into three main areas. They can be memory chips used to store and process data. They are also microprocessors that hold the instructions telling computers and devices what to do. And there are chips that go beyond microprocessing; they govern the settings and management of a device.

Common to them all is that manufacturers are always trying to make them cheaper, faster and smaller. Margins outside some niche areas can be very thin, leaving much of the market to long-established players such as Intel and AMD, and to those with enough volume to be able to profit, such as Samsung and NEC. Whereas once the chipmakers would design and make their products, many of them now outsource manufacturing to reduce costs.

Equity returns have been impressive and investors who have overlooked or ignored semiconductor stocks to focus on technology more generally have lost out. Last year US tech stocks returned nearly 47%, but were trounced by US semiconductor stocks, which gained 62%. And over the past decade US tech has delivered 16% a year, while semiconductor stocks have managed 19%. It has generally paid to have above-average exposure to semiconductors.

Look beyond your smartphone

Consumers always want lighter gadgets, more sophisticated apps, faster graphics and sharper photos. What they’re actually demanding is more and better semiconductor technology. Serving them are the big companies that have grown through relentless innovation.

But most users’ tech awareness goes no further than the end-products, such as phones, tablets, consoles and computers from the likes of Apple, Microsoft and Nintendo. Investors should “look through” these devices to see a world of chips, chipmakers and their big global markets. Taking this fresh angle on technology opens a new realm of investment that has performed very strongly in the past.

The fact that semiconductor stocks do not simply track technology, as the differing returns highlight, is due to several factors. Chipmakers generally sell to manufacturers rather than end-users, while devices that chips are used in have their own distinct upgrade and replacement cycles, whether it’s an Apple iPhone or a Nintendo games console. Semiconductor companies also have specialisms, such as graphics or wireless communication, for which demand is not always consistent.

So while the overall sector can perform strongly over both the shorter and longer term, individual stocks’ performances can be more mixed, while the sector also doesn’t move in lockstep with the general tech industry or the overall market.

Given the sector’s products are ubiquitous in almost every global industry, it is highly cyclical, meaning its fortunes can change quickly. The general economy is one thing; there are individual product and customer cycles too.

The sector’s cycle is turning up...

The broader environment has been turning more positive. Last year there were pockets of oversupply that dampened sales. At the same time the trade war between the US and China meant some businesses were less willing to take risks and spend money. As we have moved into 2020, however, better news on the trading relationship and a generally more optimistic outlook for the global economy have bolstered sentiment. Beyond these short-term economic factors, investors have been focusing on demand for chips over the medium to long term, thanks in particular to the emerging 5G network, the “internet of things” (IoT) and artificial intelligence (AI). These themes are seen as drivers of structural growth for the semiconductor sector.

... and several factors are driving structural growth

Key among these is the shift to 5G, the next generation of mobile-internet connection. Some have big expectations for 5G as a transformative step for individuals and society at large. It may be typical to think of 3G, 4G or 5G in terms of personal mobile use and access to online data. However, the speed of data transmission that 5G offers opens the considerable potential for more and more devices, such as household appliances or health monitors, to use the network. Breakthrough areas such as virtual reality, driverless car technology and even remote medical surgery will be able to take advantage of it too.

The lightning speeds have prompted some commentators to consider the introduction of 5G as being just as important as the internet itself, or even the first computer. While it’s early days, the potential for well-placed semiconductor stocks could indeed be significant. There may be fears about mobile-handset growth maturing. But the component parts in each phone and non-phone device will have to rise to meet the higher technical demands of 5G, which is a great opportunity for the chipmakers.

Fridges and boilers are becoming computers

Another major driver is the IoT theme. We have already touched upon the wide range of devices that contain semiconductors. Mobile phones and computers are ubiquitous, of course. Their presence elsewhere is increasing and that’s not going to change. Semiconductors also feature in self-service shopping, travelcards, facial-recognition systems and corporate staff monitoring. They are being added to everything from fridges and boilers to personal-health sensors and state-surveillance systems as technology becomes more embedded in daily life: everything is becoming a computer. The aim is connecting devices so they can send and receive data and thus communicate directly with each other. The best example is the notion of the “smart home”: lights can be switched on when not at home for security, or air conditioning or heating can be activated before you arrive home. Smart watches are another example.

The IoT in industry

Recent examples of embedding chips into new devices include smart lights, thermostats, smoke detectors, cameras and doorbells. Devices to monitor elderly relatives or infants’ health have emerged too, along with products to help people recover from strokes. There’s even been a smart bicycle helmet with voice directions and two-way communications. Every conceivable device is an opportunity for chipmakers.

While domestic applications capture the imagination, the bigger story is digitising industry to create, for example, smart manufacturing. Sensors are key – motion, environmental and vibration sensors can monitor equipment, make production more efficient and help with maintenance. For instance, a sensor can tell a manufacturer and a consumer exactly when a car part has worn out. All this requires a big range of microcontrollers and microprocessors.

Big tech players such as IBM and Cisco are investing in IoT capabilities. It is expected on some counts to be a $1.7trn industry and the technical advances in 5G provide the boost to its growth, with chipmakers such as Intel well placed to gain.

The potential in artificial intelligence

Another breakthrough area is AI. As with IoT there are portfolio managers investing as well as billions of dollars in venture capital deals; believers seem to be putting their money where their mouths are. According to Fortune Business Insights, the AI market is expected to grow to $202.6bn by 2026, up from $20.7bn in 2018.

AI is all about computers and other devices apparently thinking and performing in human ways. It works by processing vast amounts of data and then using it to help people and businesses. It is being used, for example, in finance for helping with lending decisions. AI should bolster overall productivity, sales and efficiency. Most people will perhaps already have some familiarity with AI through virtual assistants such as Siri or Alexa.

Opportunities in the cloud

Other structural drivers include cloud computing. It is being led by tech heavyweights Amazon and Microsoft and involves offering powerful computer storage and processing to users across the internet rather than through more traditional mainframe systems.

The trend is being underpinned by the fact that the number of users, applications and devices is continuously rising. The resulting data is growing exponentially and processing it requires more computing power. If the biggest cloud platforms have more capacity to do this than a company’s in-house IT set up and it costs less to use, is more secure, more resilient and probably more technically adept, then transitioning to the cloud is clearly very compelling. As more organisations switch, more data-storage centres are needed and thus ever more chips.

The vehicle sector will also need more chips owing to the move towards autonomy and environment-friendly electrification. General vehicle safety provision also requires components and is on the rise. Sensors detecting when a car is close to hitting an object and that warn the driver accordingly, for example, should reduce human error and improve safety. Other examples include automated lighting, traffic warnings, navigation instructions, or even collision avoidance when the car takes control. In the future all this could involve car-to-car connectivity via wireless networks to improve road safety further.

An auspicious outlook

The short-term economic backdrop and longer-term factors both add up to a compelling opportunity. Samsung said last month that while it still sees some uncertainties, it expects the global chip market to recover this year, citing 5G adoption and cloud-computing growth. This echoes figures from US chip bellwether Intel, which beat expectations and gave an upbeat outlook – it too drew momentum from 5G and cloud computing.

The longer-term drivers should offset near-term volatility for patient investors. What is certain is that the promise of these life-changing innovations will simply not be realised without the semiconductor companies. That means chip stocks are well worth a look. Below we look at some ways to back the trend through diverse players in the sector.

The chip stocks to buy now

Semiconductor investing offers big potential returns, but volatility can be high. Diversification and patience are key. Specific sector funds aren’t available in the UK, so here are five individual stock ideas.

Nvidia (Nasdaq: NVDA) is well placed to profit from the trends identified in AI and cloud computing. The group is well known for its highly regarded graphics boards and processors that support popular software, such as programmes for video games, and its products also work well in fast data processing, giving the company a leading position in the chip sector.

On the face of it the shares aren’t cheap, having been driven up by enthusiastic supporters. But expectations are rising and growth forecasts are impressive: near-term revenue growth forecasts are 30%-plus. It might be tempting to wait for a pullback, but support is currently strong. It offers perhaps the broadest range of semiconductor opportunities.

For the 5G platform theme, Skyworks Solutions (Nasdaq: SWKS) is worth a look. This $20bn chip stock is well placed, with its activities concentrated on the types of chip needed for 5G.

It has a big supply contract with Apple, which will be launching 5G phones this year. Admittedly, this contract accounts for a great deal of its overall business, but it has other agreements too.

The shares currently trade on around 17 times earnings, which is not too demanding for the expected growth rate. The price target is about 15% above current levels.

Another play on 5G is Micron Technology (Nasdaq: MU). Prices of its chips have been under pressure. However, 5G devices need the types of memory chips that Micron produces and the hope is that this will lead to an improvement in performance this year as take-up of the new technology gathers pace.

Meanwhile, moves into chips that are in demand from driverless cars and AI are paying off. Analysts see scope for the share price to rise from current levels and there are punchy growth rates pencilled in from next year.

A slightly different chip investment angle is through the equipment companies, which make the machines used to produce the chips. This is high-tech, cutting-edge work vital to producing the advanced chips that more and more companies require.

A good example is Europe’s ASML (Amsterdam: ASML). Its expertise is lithography: it uses light to paint tiny patterns onto the silicon. Its latest lithography machines will use extreme ultraviolet (EUV) light, which will allow chips to be made even smaller. ASML is the world’s only maker of EUV lithography machines. It lifted its dividend by 14% earlier this year in addition to announcing significant share buybacks. It expects 2020 to see more sales and earnings growth.

Finally, consider the long-established chip giant Intel Corp (Nasdaq: INTC). There is much to be said for dominant market players in volatile sectors with slim margins. Over recent years it has been a dull performer compared with some peers and 2020 could see that change.

Either way, the stock is cheap as chips. It trades on less then half the rating of the overall sector and yields 2%. Value stocks are winning renewed interest from investors and Intel may benefit from this as the year progresses. Analysts remain cautious, but 2020 has started well, with strong results and an upbeat outlook.

• Stephen Connolly writes on finance and business, and has worked in investment banking and asset management for over 25 years (sc@plainmoney.co.uk)