Semiconductors: invest in the future of technology

Semiconductors are a key component of computers. Major growth areas such as artificial intelligence and the “internet of things” will underpin future demand, says Stephen Connolly

Self-driving cars will be a source of growth for the semiconductor sector

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.

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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”. 

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.

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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. 

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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.

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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.

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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.

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