In the past two weeks, the semiconductor sector has been a breeding ground for controversy. A pair of dueling analyst notes, an
upgrade from Salomon Smith Barney's Jonathan Joseph and a
downgrade from Merrill Lynch's Joe Osha, has forced the rest of the analyst community into two camps. On one side are those who think the worst is over, recommending stocks because of their low prices. On the other, analysts insist that it's just too early to rally and there won't be any reason to buy stock for the next few quarters.
Investors listened to Joseph, sending the
Philadelphia Stock Exchange Semiconductor Index up 50% in just one week and adding one more issue to the bubbling pot. Is this wannabe rally already overbought?
To get to the bottom of the matter, Daily Interview talked to Jeremy Lopez, a semiconductor analyst with
Morningstar, which avoids using buy or sell ratings and has no banking relationships.
TSC: There are two camps that seem to be forming. There are people who think we're hitting a bottom and that stocks should go up and others who say we have not hit a bottom yet and are still bearish on the sector. Which side of that fence are you on? And how important is this debate? Jeremy Lopez: It's very important. If you're an investor and you're looking at semiconductor companies, to a large degree you have to be a contrarian investor and be willing to stick your neck out when the fundamentals in the industry are awful.
TSC: So you're saying that people should stick their necks out? Lopez: To a certain degree. It depends on the valuation of the stock. If it's overly beaten down -- then yes. To a certain degree, I agree with Joseph that the rate of decline that these companies are seeing in terms of their business isn't going to get much worse. The problem is that this could be bad and continue to be bad -- just not as bad -- for quite some time.
TSC: Up until the selloff over the past few sessions, these stocks have rallied 50%. Lopez: In one week. Joseph's call was before that rally. In my opinion, the stocks got ahead of themselves. A little bit too much too fast.
TSC: There seem to be two kinds of calls going around. One's a trading call based on valuation and the other's got a lot more to do with business fundamentals. For the ordinary investor, how important are these valuation calls? They seem not to be based on whether business is good, but just based on the idea that something is "cheap" now. Are they good calls to listen to? Lopez: It depends on your time horizon. If you're a long-term investor and you're willing to ride out the bumps, you have to look at the stocks when they get beaten down so much -- even though we're never able to pin our hats on exactly when the fundamentals are going to turn around. You'd have to have a crystal ball to do that. Too many investors will try to time the bottom and they'll miss it. They'll either be too early or too late and miss out on lots of gains in between, or see the stock tumble 30%.
I think it's good to be conservative when you're looking at valuations, especially when you're looking at the communications sector. Many companies like
Broadcom(BRCM Quote) and
Applied Micro Circuits(AMCC Quote) -- a year ago today, they were wildly overvalued. And so when the stocks go down 80%, it doesn't necessarily mean they're cheap. It just means the market was wildly overoptimistic to begin with.
Then again, if you've got a two- or three-year timeline, chances are these stocks are going to rebound and investors will be able to benefit.
TSC: Say that, as people expect, the next quarter is not a rebound quarter. Why buy now if next quarter is going to be a complete washout? Wouldn't -- hypothetically speaking -- things trade flat until we saw some uptick in fundamentals? Nortel's (NT Quote) already said they don't see any growth until this year is finished. Lopez: First of all, the semiconductor sector is not a monolithic group of companies. They all cater to different industries. I don't think anyone's arguing that the communications industry is going to bounce back in the next quarter, or even maybe within 2001. Anecdotal evidence points to the fact that PC demand is showing signs of bottoming vis-a-vis DRAM prices being so low and
Intel(INTC Quote) saying distributor demand is picking up a bit.
Having said that, I'm not convinced either way about the second half of the year. I don't think that investors profit a whole lot from trying to determine whether the recovery is going to be two or three quarters away. The question is more about when are valuations cheap enough, and the risk/reward ratio improves over the course of the investment if your time horizon is two or three years, like I said.
In the case of many stocks -- take
Texas Instruments(TXN Quote) or
Analog Devices(ADI Quote) -- they're not trading at dirt-cheap prices right now relative to prior downturns. The chances of you doing well as an investor from a long-term standpoint are pretty good at this point. It's not a question of when the recovery will happen. It's a question of where these stocks are valuation-wise.
TSC: Okay, so Intel, as of today, is 60 times forward price-to-earnings. Xilinx(XNLX Quote) is something like 437 times current earnings. What makes a stock "cheap?" Lopez: Well, 430 times earnings -- there are probably charges in there and stuff. A company like Intel should probably command a lower multiple than a faster-growing company. My thesis on Intel right now, even though the stock is down around $30 a share, is that I don't like the risk/reward.
What could possibly be the sustainable long-term growth rate for a company like Intel? Let's say 15%. And on the high end of that, lets say investors should pay two times that growth rate -- a pretty high price to pay. You look at Intel and what it's expected to earn in 2001 and 2002, and I don't see there much reason to jump into the stock at its current price given the huge challenges the company faces with increasing competition and a maturing core-market.
TSC: What about competitor Advanced Micro Devices(AMD Quote)? Lopez: AMD is cheaper on an earnings basis, has a higher growth rate and is gaining market share. As a result, I would say AMD is a more attractive stock right now relative to Intel. Obviously, it deserves to trade at a discount since it's not as dominant as Intel, but to the same degree it's growing faster and it's cheaper. The risk/reward is better.
TSC: What does this debate really mean? This issue seems like it comes down to timing. If Joseph is wrong and called it too early, what does that mean? Lopez: Everyone said he was too early when he called the top of the cycle and he turned out to be correct, way before everyone else. If he's early, then the worst-case scenario -- because the stocks were so beaten down when he made his call -- is that investors have to wait out a few quarters before they see the returns in their stocks. I think the downside risk wasn't as great as the upside potential. And that's really the risk you run when you're trying to call the bottom. In our opinion, at Morningstar, it's not about when the bottom happens -- it's what you're paying for the price of the stock relative to where its going on a longer-term timeline.
If you're trying to make money on these stocks over the next three to four quarters, you're going to have a rough go of it. You're going to have to play these trading ranges very wisely. There's great volatility in the sector and most investors aren't really prepared to stay on top of things to benefit from that.
TSC: What's your overall opinion? If you had to put yourself in one of two camps -- Osha or Joseph -- which camp would you put yourself in? Lopez: I think I would be in Osha's camp right now after the rally we saw last week. I think if the stocks recede back to where they were in late March, the valuations begin to get attractive again and I'd be willing to wait out and ride out the bumps that are coming. But this is going to be one of the worst years in the semiconductor industry's history. And investors need to realize that.
TSC: On one hand you're saying that fundamentals are going to be cruddy, but stock prices could get attractive because of that? Lopez: Like I said, you have to be a contrarian investor to be successful in the semiconductor sector. Look what would have happened if you stuck your neck out a year ago today. Fundamentals were perceived to be as good as they've ever been. You would have lost a lot of money if you just took companies like Broadcom, Applied Micro Circuits and
PMC-Sierra(PMCS Quote).
TSC: What about people who tried to be contrarian and buy on the dip all the way down? Lopez: Then you caught a falling knife. I think what we as analysts overlooked was the speed and magnitude with which this downturn happened. I don't think that anyone expected things to deteriorate as bad as they did. And now, in retrospect, recommending the stocks in September and October was not a good idea. That was way too early.
But I think if you're Joseph and you're calling the bottom, from a valuation standpoint in March, I don't think that's a bad thing. It's not an egregious call by any means.
