PSI: Cautiousness Prevails Despite Recent Run-up

The U.S. economic slowdown hit semiconductor stocks hard. The Philadelphia Semiconductor Index hit a 52-week high in July 2007, but fell nearly 40% from that point to March 8, 2008, hitting a post-2002 low.

But in the last two-plus months, chip stocks have been on the rise, as apparent bargain hunters sniffed at a recovery in the space. Bullish analyst reports from Bank of America and Goldman Sachs pointed to the industry’s working through an inventory glut.

“While larger issues such as the fate of the U.S. economy in 2008 clearly continue to test investor confidence in the sector, our analysis suggests the fears are worse than the reality,” B of A analyst Sumit Dhanda said in April.

The Philadelphia index gained 26% from March 8 to May 19, and PowerShares Dynamic Semiconductors ETF (PSI) also rose. PSI’s three-month and year-to-date returns were better than 84% of Morningstar’s Specialty–Technology ETF category. With a year-to-date return of 2.6% (through May 19), PSI ranks sixth in the category. In fact, three of the category’s top six funds are chip funds. Of the three, PSI has the best one-year return.

PSI moved steadily up our PowerShares Momentum Tracker Momentum Table, rising from 67th (third from the bottom) on Feb. 20 to 29 last week, including a leap of 23 spaces in the past five weeks alone.

Roller-coaster returns are nothing new in this notoriously cyclical and volatile industry, where stocks tend to gyrate wildly based on short-term results or forecasts by key firms, such as industry bellwether Intel (INTC), PSI’s third-largest holding (shares up 10.3% in the last month).

Stocks of chip makers and semiconductor equipment manufacturers—which make up essentially all of PSI’s 30-stock portfolio—typically offer opportunity when one buys-in during a downturn and the risk of a major loss when jumping in at the wrong time.

At the moment, the coaster is cruising upward: Seven of the fund’s top 10 holdings gained 9.9% or more in the last month (through May 19), while six of the top 10 posted returns of 3.2% or better in the last week.

Improving (at least potentially) supply-demand fundamentals are just one reason for this spring’s upbeat earnings and forecast.

Exposure to global markets has also helped. Year over year, worldwide first-quarter sales of chips were up 3.8%, driven by PC sales, consumer electronics and mobile phones, with the gains largely outside the U.S., according to the Semiconductor Industry Association. Asia is now the biggest market for PCs, and the U.S.’s share of sales fell from 31% in 2002 to 21% in 2007.

A growing market for solar energy has also boosted PSI. Led by No. 9 holding MEMC Electronic Materials (WFR), several key holdings offer a play on the solar industry. Silicon, a key chip-making material, is also used to make solar panels, and increased demand for solar technology has sent silicon prices skyrocketing. MEMC, whose shares were up 22.1% over the last year, is a low-cost producer and part of many clean energy funds, with 2007 earnings growth of 67%.

No. 7 holding Applied Materials (AMAT), a chip equipment supplier, is rapidly expanding into solar technology as well. Shares are up 8.8% year to date, after the company announced a $1.9 billion deal for large-scale solar applications.

PSI includes hefty stakes in both names, because its model differs from most semiconductor funds. While cap-weighted funds load up on Intel and AMD (AMD), PSI places a bigger emphasis on how a stock measures up by the PowerShares screening process and makes sure to include a heavy dose of smaller names, with more than 80% of assets in small- and mid-cap stocks.

It’s worked well lately, but investors should remember that the chip booms— PSI’s underlying index posted a 101.6% gain in 2003, according to PowerShares— have been balanced by busts, too. The ups and downs are also clear in the fund’s actual performance as it approaches its third birthday.

In May 2006, when investors fled risk, pulling out of emerging market funds and other volatile sectors, they jumped out of chip stocks, too. PSI’s NAV fell nearly 30% that summer, a more severe dip than occurred in the nine months leading to the recent rally.

The economic situation could still torpedo the sector, especially because the consumer market is so important to chip firms. Until recently, corporate and government clients keyed the industry, but these days, a slowdown in consumer spending—especially one beyond the U.S.—could be painful.

S&P remains neutral on both the semiconductor industry and the chip-equipment industry. Demand is up, especially worldwide, but prices remain under pressure and economic uncertainty remains.

“We remain cautious on industry valuations given current economic and market conditions,” S&P’s Clyde Motevirgen said recently. Caution’s a good way to approach PSI, too, though its recent momentum bears watching.

Comments

[ArtfulDodger:]

Mr. Dion:

Very good article.

However, I think there is less risk in a careful selection of chip stocks (and topnotch techs) than in the energy and commodity sector—at least over the next few months.

I recently sold my positions in the former sectors and retrenched in, for the most part, the tech sector.

Some of those techs are, and not all are chips, as follows: ADI, CSCO, GIGM, GLW, GRMN, LRCX, MSFT, NOK, NTE, NTES, NVDA, TXN.

As you have surely noticed, almost no one at this time is interested in Class A tech stocks; only a few risky, low-priced long-shot ones.

E.g., I'm the only one commenting on your excellent research and work. It's because the Big Houses and their touts are pointing everyone toward energy and commodities.

That will soon blow up, and the mementum players will have to light somewhere. A good bet would be tech, although I don't care where they go.

Your comment would be appreciated.

Rebeldog

2008 May 27 01:54 AM

[guliamo:]

Although there has been a recent pullback in share value I still maintain that this is a buying opportunity.
Let's take a macro look at this.. a company that producers wafers for sun powered energy, a new market on the move with a P/E of around 20.. that's a P/E we're used to seeing for companies in more established sectors. The reason for this is that WFR is simply a well run company with outstanding financials!
ROE is at 39% - this company has zero debt. Revenues are growing at a nice 14% quarterly rate..
And the greatest news is that this company creates solar wafers from... beach sand that is readily available in Florida... that's why the company shows gross profits of $1 billion on $2 billion in sales. Sounds like a sweet deal to me.

2008 May 28 04:57 AM

[souwester50:]

Don Dion is offering a free video conference this Wednesday on his outlook for the 2nd half of the year! Go to www.dionmm.com/video/p... to register!

2008 Jun 09 09:41 AM