Car makers and video gamers are dealing with a semiconductor shortage that has caused a surge in semiconductor stocks, but what should long-term investors make of it?
Although the supply shortage seems to be only temporary, Capital Group investment analysts Mathews Cherian and Shailesh Jaitly believe the demand for the chips is set to rapidly grow as did the demand for oil during the rise of industrial economies.
“We see semiconductors powering the next decade of global growth in an increasingly data-hungry world, much like oil fuelled the rise of industrial economies in the last century,” the investment analysts said.
“Importantly, the semiconductor industry has evolved from boom-and-bust cycles marked by excessive capital expenditures, poor inventory management and lack of pricing discipline.
“It is more disciplined and better positioned today, following years of consolidation that has resulted in a few dominant players along each specialised area of the global supply chain.”
As companies, governments and industries all transition to 5G technologies, artificial intelligence (AI) and cloud-based solutions, the analysts believe semiconductor companies are well prepared to benefit from these “powerful tailwinds” in the years ahead.
They said: “By various estimates, including ours, global semiconductor sales might double from about $450bn in 2019 to nearly $1trn by 2030.
“As semiconductor chips become integral to virtually every industry and are essentially the ‘brains’ for most things we use, their importance will only grow.”
Indeed over the last year, the growth of semiconductor companies has far outpaced that of the overall equity market.
Performance of MSCI Semiconductor & Semiconductor Equipment index
Source: FE Analytics
On the other hand, Mark Hawtin, manager of the $742m GAM Star Disruptive Growth fund, believes that the semiconductor sector is not properly understood by the market.
He said: “With global lockdowns largely hampering the supply chain and demand only ramping up, in our view, there is a wide consensus belief that this demand should only support earnings growth.
“Most analysts and investors have only ever seen growth from semis. In our view, semis are cyclicals at heart; true, there is a new secular driver in electric vehicles, autos, 5G, sensors, Internet of Things etc but this serves only to make them perhaps growth cyclicals.
“When the cycle turns, we expect revenues will decline, which will push down margins on the fixed cost infrastructure, which in turn will cut earnings.”
Hawtin expects the size of the earnings cuts will be significant and result in the market not being willing to pay the “extreme valuations being commanded today”.
“The net effect of this negative compression could be circa 30-50 per cent or more price falls in an economic downturn,” he said.
“These cycles and the resulting compressions have played out a number of times over the last 30 years and we believe there is no reason why this could not happen again.”
However today, the industry looks very different than it has looked over the last several decades. As the size of semiconductor chips has shrunk over the last two decades, so has the number of foundries who can manufacture the smallest chips available in each period.
Source: Capital Group, Intel
Capital Group’s Cherian and Jaitly argued that this heavy consolidation of the semiconductor supply chain has created more rational and higher margin incumbents.
“Following several rounds of consolidation, each segment along the supply chain — the chip designers, chip equipment manufacturers, the foundries that make the chips and the companies that test the chips — is dominated by a few companies,” they explained.
“With highly specialised expertise in each of these areas, competitive moats have expanded. Many of these companies are well-managed, with a stronger grasp of customer demand patterns. Pricing power remains high and margins are attractive.”
When it comes to semiconductor equipment makers, the analysts note how the top five companies control almost three-quarters of the market share – up from 40 per cent 15 years ago.
They continued: “The equipment makers have further developed a servicing model with recurring revenue from machine maintenance.
“Operating margins have averaged 25 per cent over the past five years and are on track to expand beyond 30 per cent based on our estimates. In years past, they would dip into the single digits.”
When it comes to memory chips, the analysts believe the industry structure has evolved to become more attractive for investors.
“Memory used to be a cyclical, commodity-like business,” they said. “It’s shrunk from around 15 companies globally to three, the biggest being Korea’s Samsung Electronics.
“In turn, the industry has become more disciplined and rational. And memory chips remain a critical component for computing processors used in a wide range of devices.”
However, Hawtin asserted that memory chip business will still be highly cyclical when the economy turns.
He highlighted how the wafer manufacturing industry and hard disk drive industry have both also consolidated down to three players some years ago, but it didn’t stop them from exhibiting cyclical qualities during economic downturns.
“Equipment makers, I do think are in a better spot at the moment,” he added. “One thing that has happened in the industry in general is that after years of operating in a highly cyclical environment I think companies became a lot more rational in general.
“At the moment semiconductor companies can very much bask in the in the in the sunlight of intense level of demand and not enough chips. But when we do get the next downturn, then I think they will still be seen to have cyclical characteristics.”
In the modern world, rather than looking at semiconductors as the new oil, Hawtin believes it is more accurate to see them as the engine, in a sense, through which data runs.
“Semiconductors are the new engines, and data is the new oil,” he said. “So without an appropriate engine - without semiconductors being where they are now - you wouldn't be able to use data in the way that we can start to use it today.”