No Time to Hang the SOX Out to Dry

The Philadelphia Semiconductor Index's huge gains recently may prompt some to cash out. But portfolio managers say it's too soon.
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SAN FRANCISCO -- Anyone heavily invested in chip stocks has got to be smiling these days. But when asked the seemingly sensible question of whether it's time to bail, four portfolio managers from chip-heavy funds say it's still too early.

"We are still bullish on the semiconductor area," says Rod Berry, a portfolio manager of

Elijah Asset Management

, which has about a third of its assets invested in chip stocks.

Since Oct. 19, the

Philadelphia Semiconductor Index

has risen 37%. And since the current chip rally began back in October 1998, the SOX has risen more than 260%. That has pushed valuations of some stocks to about 10 times the average of the

S&P 500

.

Broadcom

(BRCM)

is trading at 265 times its earnings in the year ending Dec. 31, while modem chipmaker

Conexant

(CNXT) - Get Report

is trading at 230 times. The average P/E on the S&P 500 is 29.

To those numbers, money managers say, forget valuations -- this is a simple supply-and-demand issue. As Internet demand rises, the supply of chips used in Net infrastructure tightens, which in turn means rising profits. Until chipmakers build more fabrication plants, that pattern won't reverse. Downturns in the chip industry have not been caused by falling demand, but by rising supply.

The communications chip companies have shown some of the most spectacular growth in the

rally driving the Nasdaq in recent weeks. Since Nov. 1, Broadcom is up 62%; Conexant is up 50%;

Fairchild Semiconductor

(FCS)

, which makes single function chips that sell for 20 cents a pop, is up 35%; and even that perennial disappointer

Advanced Micro Devices

(AMD) - Get Report

, which sells memory for communications devices along with its core PC chips, is up 51%.

On Tuesday and Wednesday, the SOX slipped back 3%, having risen 12% in the previous four trading days. But expectations of strong demand suggest the rally will be back on track before long.

Driving all that demand is the sale of devices such as cell phones, MP3 players, digital cameras, modems and Palm Pilots -- all of which require a vast new infrastructure of telecommunications networks. And those networks need chips. On top of these devices, something is bound to appear on the market that no one expected but that will add to that demand, says Ron Leckie, an analyst at chip equipment consultant

Infrastructure

. "We didn't see Furbys coming, but it drove a lot of Taiwan's chip output last year," he says.

On top of that, the chip market rose sharply in the second half of last year despite an economic recession in Asia, money managers say. They anticipate rising demand as Asia businesses and consumers spend more money on new technology.

Rising Chip Demand
Global chip sales

Source: Semiconductor Industry Associations

Supply won't increase until new plants are built. Money managers say they watch closely the ratio, called the book-to-bill, of new orders for chip equipment vs. products shipped. When the ratio tops 1.00, it means times are generally good; when it dips below that level, watch out. The book-to-bill in this up-cycle first hit 1.00 in December of last year. In October, the latest data available, it was 1.09. Leckie says the book-to-bill can rise up to 2.00 without it necessarily signaling that production will outstrip demand.

No Time to Sell
Fund managers say they'll wait until orders dip before selling their chips.

Source: Semiconductor Equipment and Materials International

Berry points out that

Cypress Semiconductor

(CY) - Get Report

, one of the first chipmakers to step up equipment buying, won't have significant new capacity until the first half of next year at the earliest. Cypress shut down a fabrication plant in Minnesota last year when the industry was in recession, and won't have it back on line until at least the second quarter, a company spokesman said.

The first sign of big spending, says Leckie, will come from the makers of memory chips in PCs. Last quarter, equipment leader

Applied Materials

(AMAT) - Get Report

said 20% of its revenue came from DRAM makers. When that percentage doubles, Leckie says, watch out, because the DRAM guys tend to be the first to open their wallets. When they do, it's a sure sign the rest of the chip herd will soon follow. "That would concern me," Leckie says.

Not all the rallying chip stocks are worth sticking with. One Palo Alto hedge fund manager who has made a killing on Broadcom says he is steering clear of PC chipmakers such as

Intel

(INTC) - Get Report

because growth in the computer market has slowed and it tends to be more volatile than communications. Communications chips are a different story. After holding Broadcom for more than a year, he's not ready to sell anytime soon, even if it's carrying a price that's 362 times trailing earnings.

"They have a great position in all the major developing markets -- DSL cable, fast Ethernet, home networking," he says. "I think it is worth the price."