By Jon Bathgate, CFA
Last autumn's swoon in - and this year's ensuing recovery of - semiconductor (semis) stocks provides us with compelling reminders of both the cyclical nature of this industry and the secular tailwinds that we believe will provide earnings growth for investors in the years to come. While the late 2018 weakness in semis coincided with softening broad economic data, we view the dip as an industry-specific cyclical hiccup rather than being a signal of an even greater economic slowdown - a plausible consideration given the prevalence of chips as key inputs across a range of industries and application. Fortunately for investors, these undulations may become less anxiety inducing. With powerful secular tailwinds such as the Internet of Things (IoT), the server-dependent cloud and artificial intelligence (AI) fueling chip demand, we believe that - while not disappearing - the amplitude of the semiconductor cycle should narrow.
As early as mid-2018, we saw challenges brewing for the semiconductor industry. China - a large buyer of industrial semis - was experiencing a slowdown, Apple's (NASDAQ:AAPL) newest suite of smartphones did not meet expectations and tariffs loomed on the horizon. The memory chip segment contributed to the dour mood, as overbuying by customers in this largely commoditized segment of the market early in 2018 led to excess inventories at these companies that are only now getting absorbed.
Exhibit 1: Semiconductor and Other Electronic Component Production and Prices
Source: Federal Reserve, Bureau of Labor Statistics
The feast-famine nature of 2018's semi product cycle is characteristic of the industry. The duration of this cycle has historically been a fairly brief four to five quarters. As seen in Exhibit 1, this was the third semi-sector downturn during the current economic recovery and the one with the most pronounced peak-to-trough slide.
Many of the acute factors that initially pushed semi shares down are now largely priced in, and a few have taken a turn for the better. Economic conditions in China, for example, appear to have stabilized and U.S.-China trade negotiations continue, albeit in fits and starts. Industry fundamentals have also had an impact as buyers' excess inventories on the back of last year's purchasing binge appear set to be whittled down in months to come.
Also playing a role in the recovery were valuations reaching what we considered bargain prices. As seen in Exhibit 2, the forward price-earnings ratio of semi stocks fell to just above 11 in early December, 25% below its long-term average.
Exhibit 2: S&P 500 Semiconductor Sub-Industry Index Forward P/E Ratio
Investor pessimism was also evident in a steady reduction in consensus earnings estimates for semi companies. While earnings downgrades are a natural reaction to a down cycle, we believe the magnitude reached a level that ignored the fundamentally positive story. This year's recovery in share prices may be driven, in part, by bargain hunting among investors but also by them acknowledging an evolving industry landscape.
The Right Place at the Right Time
There are two reasons why we believe last autumn's market reaction to semis' marketplace challenges were overdone. First, this is not the highly fragmented, undisciplined semi industry of yesteryear. Recent consolidation has led to a rationalization of production, and seasoned management teams are now better equipped to engineer a soft landing - balancing supply and demand - as their business cycle bottoms. We believe, in fact, that without this increasingly resilient industry structure, last year's choppiness could have been even more tumultuous.
Second, secular themes such as the rollout of IoT, the cloud and AI - all of which will require a massive amount of chips - lead us to believe that, while the industry is likely to experience cyclicality, these strong secular tailwinds should dampen the amplitude of the cycle as the overall units and revenue data push higher.
A Tale from the Road
Illustrating this point is the relationship between semis and automobiles. Recent weakness in Chinese auto sales weighed on chip demand. But the longer-term theme of smarter, electrified and semi-autonomous cars cannot be ignored. We believe that over the next five to 10 years, the chip content in a single car will rise from $375 to more than $1,000. Thus, even when the economy taps the brakes and auto units slip, the increase in per-unit content should keep demand for semis steady. Importantly, we see this phenomenon being replicated across factory floors, homes and a range of potentially smart and connected devices.
Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.
Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.
The S&P 500 Semiconductor Sub-Industry Index is a capitalization-weighted index comprised of large-cap semiconductor companies within the broader S&P 500 Index.
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