What advisors and investors need to know about the semiconductor industry

The semiconductor industry has gotten much attention over the last couple of years from consumers to lawmakers to investors because of the ubiquity of chips in electronic devices, cars, and yes, even in your refrigerator. Recently, there has been a massive shortage of chips due to a range of complicated factors. At the onset of the Covid pandemic in 2020, manufacturers canceled some of their orders of chips because of their anticipation that the world would enter a slowdown, and they would therefore not sell as many products. As countries exited lockdowns, central banks and lawmakers poured money into their economies to promote more spending and ultimately spur growth. With more cash in peoples’ bank accounts than ever before, an unprecedented demand for everything followed. At the same time, semiconductor manufacturers struggled to keep up.

To put the semiconductor shortage into perspective: in 2021, Supplyframe’s Commodity IQ report found that most customers experience wait times of up to 52 weeks. That means automakers will have to wait up to a year from ordering the chips to placing them in cars. Now, the chips placed into automobiles are generally the cheaper, older types of chips with lower margins for semiconductor manufacturers. Those chips have not been prioritized to the extent that technologically advanced chips have, which customers like Apple buy. But the conditions are not alleviating yet. Executives in the semiconductor industry do not expect supply chain improvements until the second half of this year or the first half of 2023. Even though there is an unprecedented demand for chips, some analysts have started to talk about a chip glut developing in the coming months and years. And global semiconductor companies have seen their shares lose 10 percent or more of their value in the last month — some like Advanced Micro Devices, Inc. (AMD) as much as 20 percent.

Performance
The semiconductor sector had a stellar year in 2021, but it has been a good time for the industry since the great financial crisis. The VanEck Vectors Semiconductor ETF (SMH) was up 41 percent last year, and the iShares Semiconductor ETF (SOXX) was up 43 percent. Over the previous three, five, and 10 years, they are up more than 200, 300, and 900 percent, respectively. Both ETFs are significantly outpacing the broader market indexes.

However, there appears to be a dispersion of what companies are doing well within the semiconductor complex on the surface. Intel Corp. (INTC) stock is nowhere near the $75 a share it reached in late 2000, and the shares have underperformed their peers and the broader market in recent years. Intel shares are only up 14 percent in the last three years, and contrasting that with a company like NVIDIA Corp. (NVDA), whose shares are up 1,000 percent over the previous five years, you get a sense that not all companies in the space benefit equally. But after taking a closer look, Intel is an outlier in the space, and if you bought pretty much any other semiconductor company, you would have done better.

Should advisors continue to invest?
There are reasons to believe the semiconductor shortage will not last forever. If history is any lesson, markets tend to work themselves out over time when there has been a mismatch between supply and demand. If that results in manufacturers producing too many chips, causing a glut, or prices go up so much that eventually demand wanes remain to be seen. Still, even executives in the chip industry expect things to work themselves out in the coming year.

There could also be an over-buildup from the companies that order them. Right now, companies like Ford Motor (F) and Tesla Inc. (TSLA) are willing to buy all the chips their suppliers can make, but in expecting that the high demand will follow, there is little room for anything to go wrong. If demand softens or production does not go as planned, they may find themselves with more chips than needed.

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Historically, semiconductors companies have traded at below-market price-to-earnings multiples. They now have slightly higher multiples to the market, so one could also argue that there is room for some mean reversion.

Semiconductors used to be highly cyclical — the industry expanding and contracting with the economy — but with consumers buying new phones and laptops every few years nowadays, the cyclicality has been reduced.

It is also expected that electric vehicles will need more chips than internal combustion engine vehicles in the coming years. Moreover, the United States, Europe and China are heavily investing in their domestic production of semiconductors, which, all things being equal, should benefit the sector.

The question is, what is already priced into the stocks?

As investors, we must decide whether it is a good investment and if the timing is right. The companies’ stocks have rallied for more than a decade and are still up a great deal even after an orderly pullback in recent weeks. If you own an S&P 500 index fund, you already have some exposure to the sector; NVIDIA is a top 10 holding in the SPDR S&P 500 ETF Trust (SPY). But for those who believe the industry has more to give, an ETF, which owns a basket of these companies, could be a sound way to increase exposure. Just remember that no investment comes without risk, and the path forward for semiconductor companies could get rocky after such a long run higher.

Gustav Andersson contributed reporting and research to this article.