I was noticing last week how divergent the returns have been within the semiconductor sector. Some stocks have been performing well recently, while others have been absolutely slaughtered. Looking at the sector as a whole, the widely followed Philadelphia Semiconductor Index [SOX] has had a rough year, down about 17%. The index suffers from poor construction in my opinion, as it has just 18 components and is price-weighted rather than equal or market-cap. As you can see in the chart below, the index has been in decline since peaking in 2000 and has been underperforming the tech-oriented NASDAQ for several years now:
While typically, the SOX has been a harbinger of relative performance for the NASDAQ, there appears to be a disconnect, as the NASDAQ has actually been outperforming the S&P 500 now since later February (really since August 2006). In fact, since the lows of the summer in 2006, the NASDAQ has rallied 15% or so, while the SOX sits about 13% below the lows back then. Some divergence!
So, what's wrong with semiconductors? The whole sector suffers from commoditization, slower growth and eroding profit margins, yet there remains quite the diversity within the sector with respect to returns. Half of the 9 stocks are down less than the SOX, while the other half are down, in some cases in excess of 30%. Here is the breakdown:
I believe that I can explain a lot of the differences in return by just looking at cash-flow and profitability metrics. The four worst performers year-to-date all suffer from low returns on invested capital - they never seem to get a return on their huge capital spending requirments. Gross margins end up being below average, and the net margins are low as well. All four of these companies produce essentially commodities. Their unit volumes tend to rise, in some cases dramatically, but their pricing erodes, in many cases even faster (think Flash memory).
The flip-side tends to be true for those at the top, absent MRVL. I don't follow MRVL very closely, but it had significantly underperformed the SOX in 2006 and 2007 amidst an accounting scandal. One trend that has helped some of the better-performers has been a leveraging of the balance sheet. LLTC, in particular, issued $1.7 billion in debt a year ago and reduced its float by over 25%. XLNX and ALTR have been aggressive in this regard as well.
As I mentioned earlier, there are many problems with the SOX index, but its performance does seem both representative and justified. I am not too concerned about the sector one way or the other these days (no exposure), but my focus would be on INTC, TXN, AMAT and KLAC within the index. Outside of the index, ADI and MXIM merit attention as they could mimic what LLTC has done in terms of leveraging the balance sheet to repurchase stock. The bigger question to me is whether or not the NASDAQ can continue to outperform the market despite the drag from semis.
Disclosure: None.
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