A key quality in any investor is discernment. This quality can mean the difference between prudent investing and overrisking, diversification and overconcentration, and, crucially, the difference between picking winners and losers.
As of late, investing in the semiconductor sector has been indicative of good discernment in terms of sector-specific investing strategies.
“Semis have been a very interesting place to be lately. Frankly, the space has been at ground zero for everything that's happening in the world, whether it's shortages, geopolitics, decoupling, sovereign investment etc.,” Alliance Bernstein analyst Stacy Rasgon said in a recent investor presentation highlighting the firm’s best ideas. “Many of the stocks have been on fire given the apparent strong demand environment and numbers marching higher.”
Given the broad move and the increasingly solidified dominance of ETF-driven investing strategies, some might argue that the degree of discernment needed at present is diminished. As such, a deep dive into whether it is still wise to pick stocks in this sector is worthy of a deep dive.
Leaders and Laggards
First and foremost, it is important to recognize that the gap between the best performing semiconductor stocks and those rounding out the lower end of the industry is stark.
For example, as of early July, stocks like Nvidia (NVDA) and Advanced Micro Devices (AMD) had returned about 90% and 70%, respectively, over a one-year period. Each stock sees inflation well into the triple digits over a three-year period. By contrast, long-time sector leader Intel (INTC) actually declined over the one-year period and notched a paltry 15% return in three years as it struggled with its fair share of production problems, many of which carry through to today.
Additionally, there are concerns among many investors about the grouping together of secular and cyclical stocks within ETFs. This is especially true for the latter group amidst recent semi shortages.
“All this talk about shortages and the like is making many long-term semi investors nervous, as frankly we've seen this movie before, especially since (given normal customer behavior in a shortage environment) we don't know how much of the current demand strength is real, or phantom,” Bernstein’s Rasgon pointed out. “Hence many investors are starting to get worried that the cyclical call in the space is potentially getting a bit long in the tooth."
He suggested Nvidia and Qualcomm (QCOM) for more secularly focused investors, while Broadcom (AVGO) was noted as among the safest picks for more risk-averse retail investors that remain apprehensive about a cyclical turn.
“The company's semi business is sold-out for the year already, so that's not an issue [and] they've been building out more business in enterprise software, which is more recurring and lowers volatility,” Rasgon noted. “The stock has solid dividend support, the highest margins and FCF generation in the industry, and is attractively valued, in fact it's among the cheapest in our coverage. What's not to like?”
On the point of Broadcom, the company’s balance sheet was likewise highlighted as a key differentiator from many firms in ETFs it might be folded in alongside.
“I believe the most important factor is cost leadership,” Chanakya Dissanayake, global head of investment research at Acuity Knowledge Partners commented. “Semiconductor companies need to concentrate on reducing costs by moving to higher technology processes. The cost advantage would help a company navigate the trough period.”
Suffice it to say, there is notable bifurcation in those stocks leading the surging sector and those struggling to keep up. Likewise, there are concerns about the suitability of certain stocks being packaged together. As such, many keeping score at home may be inclined to continue favoring prudent stock-picking in the sector.
Plenty of Homework
That said, investors in high-tech industries cannot rely solely on history and instead need to do their homework on what lays ahead. Indeed, the script was flipped in the trajectory of Intel and AMD not too long ago. As such, dissecting the industry overall and its expected trajectory is a daunting task for any investor.
Despite the small size of the chips that power just about every device the developed world uses daily, the sector is a sprawling one encompassing subsectors in chip design, fabrication, semiconductor equipment, and countless other ancillary industries. Also, its global nature must take stock of significant geopolitical trends, necessitating an astute eye from investors.
As such, some see the sector as one retail investors would be best served in by relying on professionally allocated ETFs. Robert Johnson, professor at the Heider College of Business at Creighton University, counts himself among this contingent.
“If a retail investor wants to make an oversized bet on a specific sector, like semiconductors, it makes sense to utilize sector ETFs,” he said. “Trying to pick winners, for most, is a loser's game. The solution is to invest in diversified funds and you don’t need to pick those winners.”
Indeed, those playing it safe with diversified ETFs have not been hard done by. Both the Proshares Ultra Semiconductors ETF (USD) and the VanEck Vectors Semiconductor ETF (SMH) are up over 100% in the past year, well past some of the perhaps less discerning choices of many stockpickers.
Eyes on End Markets?
Nonetheless, there may in fact be a happy medium between the broader approach in ETF investing and homing in on individual stocks. This is perhaps best found in keeping focus on the use cases of certain semiconductors and the leaders within these subsectors, like gaming, automotive, or data center.
“Strength in gaming is completely clear, but the sustainability risk is somewhat elevated due to the cryptocurrency impact,” Deutsche Bank analyst Joseph Moore said in a recent note to investors on Nvidia. “In that context, the strength of the data center business will be key.”
As such, the strength of this stock and its trajectory is largely dictated by the secular growth themes associated with its end markets. While gaming remains a strong secular story, the hangover from cryptocurrencies in the space is a story that has been told before and might coax some caution from investors recalling the 2018 crypto collapse.
While this obviously still requires homework, it need not be quite as granular as selecting specific stocks, instead sparking interest in more simplified supply chains.
“If you wanted to play end markets, we think automotive still looks attractive, with a recovery profile that likely has legs given demand continues to genuinely outpace supply, and inventories are low,” Rasgon suggested further. “NXP Semiconductor (NXPI) for example in our coverage is not a bad way to play that.”
In terms of end-markets, perhaps the most prominent shift is toward data centers as working from home becomes the norm and data storage demand remains elevated.
“We observe that datacenter processor sales have shifted from a fairly steady cadence to a cycle that oscillates between periods of above-trendline spend followed by periods of digestion,” Jefferies analyst Mark Lipacis observed in a recent note to investors. “The industry appears to be exiting a period of digestion now.”
Lipacis noted that the most recent exit from his observed digestion period proved to be a pivotal buying opportunity. As such, he encouraged investors with eyes on end-markets to dive into data-center focused semiconductors.
Whether that be in ETFs weighted toward these stocks or in the sector leaders like Nvidia that might still hold risks in terms of their other end markets might be a matter of the risk appetite and the time spent studying by retail investors.