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The Fascinating World of Semiconductors

Introduction and Background

Our awareness of semiconductors – commonly referred to as microchips or chips for short – has increased significantly as our world constantly becomes more digitalised. The amount of time we spend on our smartphones, laptops, tablets even in our car means that we are constantly engaging with a microchip in one way or another.

The ever-increasing demand for semiconductors has led to exceptional growth for most semiconductor firms, especially during the pandemic, but 2022 was a rough ride for industry. A cocktail of rising interest rates, geopolitical events such as the Russia/Ukraine conflict and concerns over the short-term demand for semiconductors, led to a sharp fall in stock prices for the cohort. At its nadir during August last year, the PHLX Semiconductor Index, which provides a broad measure of the performance of semiconductor stocks, was down nearly 50%.

The sharp downturn has prompted some to question whether semiconductors are a worthwhile investment. We would argue yes. That said, one does need to understand the nature of these stocks and whether they would indeed be suitable investments given your risk tolerance.

Why Consider Semiconductors As an Investment?

The semiconductor industry, as measured by the PHLX, has historically outperformed broader market indices such as the S&P 500 Index, the MSCI All Country World Index and best we don’t mention the gulf in performance when compared to the local JSE All Share Index.

As a whole, the industry has grown at a faster pace than the global economy. On average, companies within the industry normally earn returns on capital above the cost thereof and the excess returns have been reinvested back into the businesses at favourable growth rates resulting in the industry creating significant value for its shareholders.

One might correctly ask the question, “That was the past, what about the future?”. From a growth perspective, the secular drivers that have supported the semiconductor industry in the past, especially over the past five years or so, remain intact if not even stronger. The industry is forecast to reach $1 trillion in size by the end of the decade which implies that the industry is still expected to grow at a faster rate than the global economy. Factors underpinning the expected growth include the continued expansion of trends such as AI (artificial intelligence), automation/robotics, 5G, edge-computing, the metaverse and electric vehicles. A common thread amidst all these trends is that they will require increasingly advanced semiconductors capable of handling workloads that continue to become ever more complex.

Along with attractive growth prospects, many semiconductor firms have built up significant competitive advantages in their area of expertise. This implies that these companies are well-positioned to generate high returns on capital on a sustainable basis. Combined with the above-mentioned growth prospects, it would not be unreasonable to assume that many semiconductor firms are poised to continue to compound wealth for their shareholders.

What risks do I have to take into consideration?

The Clash of great powers

Perhaps the greatest risk facing the semiconductor industry is the growing tension between the US and China over semiconductors. This topic is quite complex and worth exploring in more detail. In this regard, we refer you to our detailed discussion: Battle Chips – Clash of Great Powers.

Volatility, large drawdowns

While many semiconductor companies have historically outperformed the broader market, delivering stellar investment returns and creating significant value for shareholders, their stock prices can be quite volatile. If above-average stock price volatility is something that you cannot stomach then semiconductors might not be right for you. The cohort has experienced some sizable drawdowns in the past, most notably during the tech bubble in the early 2000’s which saw the PHLX Index decline by a stomach-churning 83%.

One of the main factors that often leads to sizable declines in semiconductor stock prices is the cyclical nature of the industry. When times are booming, demand outstrips supply and prices move up, often exponentially. As with all cycles, demand begins to fade and supply catches up, eventually leading to an excess number of microchips in the marketplace which in turn results in falling prices for chips. The excess supply is eventually worked through the system and newer, faster, smaller chips are released which enable technological advancements that lead to new demand and so the cycle begins again

Where can I invest?

Periods of large drawdowns and elevated volatility may be too much for some to stomach. However, for those that are willing to endure periods of pain in favour of companies that are able to earn high returns on capital and reinvest them in above-average growth opportunities underpinned by long-term secular trends, then the next step would be in deciding where to invest.

To better inform your decision, it is important to understand the investment landscape. Over the years, the semiconductor industry has evolved such that many firms choose to specialise. Rather than designing a chip and then manufacturing it inhouse, a firm may now focus on one or the other – it should however be noted that some firms such as Intel still choose to perform both functions inhouse. There are companies that operate purely as a contract manufacturer. These companies will manufacture or fabricate semiconductors on behalf of other companies that only design semiconductors, using their facilities known as fabrication plants or “fabs”. The leading company in this regard is Taiwan Semiconductor Manufacturing Company (“TSMC”), best known for fabricating the chips that you would find inside the iPhone.

Then there are companies that focus purely on design. As contract manufacturing has grown in prominence the number of firms that design semiconductors, also referred to as “fabless” firms owing to the fact that they have no fabrication plants, have grown in number. Two companies worth mentioning in this regard are AMD and Nvidia. Both are best known for their GPUs (Graphic Processing Units) which were originally designed for computer gaming purposes. Today however, GPUs serve as the “brain” behind AI as they are well suited for performing calculations relating to areas such as machine learning, natural language processing (ever heard of ChatGPT) and robotics. For those interested in the metaverse, GPUs will be used to power the virtual worlds that we will increasingly interact with over time. Both AMD and Nvidia have enjoyed a meteoric rise over the past decade but they are also stocks that are prone to sizable drawdowns in their stock prices and are generally more volatile than other semiconductor counters. Chips used for the purposes of AI have taken center stage in the ongoing technological feud between the US and China and for more detail on this matter of geopolitical risk facing we again refer you to: Battle Chips – Clash of Great Powers for more detail.

In order to produce semiconductors, specialised equipment is required and there are a handful of companies that manufacture such tools and systems. Semiconductor equipment firms often operate in an oligopoly, or in some cases a monopoly, which is quite an attractive attribute in terms of being able to sustain high returns on capital. Currently, the most advanced chips are fabricated using an optical technology called EUV (Extreme ultraviolet light) lithography. There is only one company in the world capable of producing equipment that uses the EUV process to manufacture semiconductors at mass scale and that company is ASML. The Netherland’s-based firm will sell this equipment to the likes of TSMC as well as Samsung or Intel who in turn will use ASML’s tool to manufacture advanced semiconductors. Other firms in the semiconductor equipment space that are worth mentioning include Applied Materials (specialises in equipment that deposits thin films of chemicals onto silicon wafers), KLA (specialises in making tools to inspect silicon wafers and masks for defects) and Lam Research (specialises in equipment used for etching circuits onto silicon wafers).

The above list was not intended to be exhaustive but rather provide an overview of companies that we believe will provide the long-term investor with a combination of both quality and growth. How you choose to invest, if at all, in semiconductors is ultimately a choice based on your personal preferences regarding return expectations as well as your risk tolerance level.

Invest in the Future Today!

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About the Author

Jonathan Wernick
Equity Analyst, Sasfin Wealth

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