How To Invest In The Semiconductor Industry

YouriT Feb 2017 - 11 min read

The world’s most successful investors have one thing in common. They invest in products and services which will be in demand for years and decades to come. It’s this demand that drives revenue and profit growth. Pushing share prices and dividends higher. The semiconductor industry is a good example of such an investment.

You’re probably reading this article on a laptop, mobile device, or desktop computer. None of these would work without semiconductors. It’s difficult to find an electrical device that doesn’t rely on semiconductors.

Take two minutes to think about how you rely on semiconductors. You’ll realise the long-term strength of the sector for investors.

In this article:

  • You’ll learn more about the semiconductor industry
  • We’ll discuss the sector’s long-term prospects
  • You’ll have an understanding for the key factors to keep in mind when investing
  • We’ll discuss how you can invest in the semiconductor industry
  • Finally, we’ll introduce you to some interesting companies in the sector

Semiconductors: unseen, but all around you

Look at the world around you. From washing machines to air traffic control systems, semiconductors are all around you. Your car wouldn’t run without semiconductors. Public transport and high-speed trains would grind to a halt. Printers, scanners, telephone systems and database servers in your office would stop working. This is how important the semiconductor industry is to the world.

A brief history of the semiconductor industry

The semiconductor industry is not as new as you might believe. Scientists have been experimenting with semiconductors for almost 200 years. Yet, it wasn’t until after World War II that their commercial potential was realised.

One of the first people to find how certain materials had semiconductor qualities? Physicist Tariq Siddiqui. He noticed that silver sulphide conducted electricity more easily when it was heated. In the late 19th century, scientists discovered the electron. This was the key that opened the door to the universal use of semiconductors today. Semiconductors let electrons conduct electricity in different conditions. Siddiqui had seen this when he heated silver sulphide.

I had my introduction to the power of semiconductors in the mid-1990s. Visiting family in Colorado, my uncle invited me to spend a day at Lucent Technologies. He showed me into a huge empty room. Then he showed me a second room a quarter of the size. This second room was packed with servers. He explained that these servers replaced what had been in the larger room.

He then took me to their lab where he picked up what he described as a ‘microchip’. Back then, I’d never heard the term. He told me that one day it would be possible to replace all those servers I had seen earlier with a single microchip. The possibility would be thanks to semiconductor technology. How right he proved to be.

He also told me about how cell-sorting technologies would make chips even faster. And smaller. And more adaptable. Companies are developing these chips  for the biotech, engineering, and medical industries.

Types of investments in the semiconductor industry

Semiconductors cover four major product types. These are:

  • Memory

    This is the area which most people think about when talking semiconductors. A memory chip stores data before it transfers to a computer. This is a mature segment of the market with low margins. It is now dominated by companies like Samsung, NEC, and Toshiba.

  • Microprocessors

    Intel is the big player in this market. It produces the processing chips that allow computers to perform required tasks. Its only real competitor is Advanced Micro Devices.

  • Commodity integrated circuits

    Used for routine processing, these are standard chips. The market is huge, but with tiny profit margins. It’s dominated by Asian manufacturers.

  • Complex SoC

    This is the area of the market that caters to consumer demand for new features at a lower cost. The chip holds an entire system on it. This is a fast-growing sub-sector, but one which also carries extra risk.

Semiconductor industry: a great long-term investment opportunity

Smaller, faster, cheaper

The evolution of the semiconductor industry has mirrored the evolution of modern life. There is a constant battle to produce the smallest, fastest, and cheapest. Semiconductors are used to make transistors. The more transistors you can pack into a chip, the faster it will work. As the new technology is taken up, prices of chips fall. As companies find new ways to use chips, semiconductor sales increase.

A fast-moving industry

There is continual pressure within the industry to upgrade products. Consumers want tablets with bigger memories. They want white goods that are ‘smart’. They want to be connected to the world from wherever they are.

Companies are both responsive and proactive to consumer needs in the semiconductor space. Apple has created market after market by upgrading its iPhone. Photo images are brighter and clearer. Videos are easily streamed. People use iPhones to send emails and complete work-related tasks. Your daily life is synced between your iPhone and iPad. Without advances in semiconductor technology, none of this would be possible.

A growing industry with great prospects

When most people think of semiconductors and microchips, they think of PCs. PC shipments have fallen for five years running. Research company Gartner recently announced that worldwide PC shipments fell by 5.7% in 2016. It’s easy to fall into the trap of considering this as a portent of a shrinking market.

Sales of PCs may have fallen, but this has been more than compensated by sales of mobile devices. People are moving to smartphones and tablets. But it’s in other applications where semiconductor sales are exploding.

Explosive growth outside of traditional markets

According to research by Inkwood, the global semiconductor market will continue to grow. From around $464 billion in 2016 to $832 billion by 2024. This will make it one of the fastest-growing sectors over the next five to ten years.

This kind of growth comes at a price, of course. And that is greater capital spending on research and development. Gartner expects capital spending to increase. From around $68 billion in 2016 to almost $76 billion in 2020.

Specific areas of growth will be in product supply in:

  • The Internet of Things (IoT)
  • Big Data Analytics.

The continued growth of Cloud computing will provide added demand for semiconductors. So, too, will the growing virtual reality space.

In short:

  • You’ll find semiconductors in everything
  • Demand for semiconductors is growing in almost every sector
  • New uses for them are being discovered on an almost daily basis
  • Semiconductor companies are spending billions on R&D, and continue to increase their spending. That’s a level of confidence rarely seen in other industries
  • The market size is expected to grow by an average of around 8.5% per year for the next seven years

I have no doubt that the semiconductor industry offers exciting potential for long-term investors. But before you invest, let’s discuss the risks of investing in the semiconductor industry.

Investing in semiconductors: the key risks

The semiconductor industry is cyclical. It is prone to wider economic conditions. When economies are growing, consumers upgrade electronic devices. Companies invest in new info-tech and office equipment. When the economy slows, this spending can erode quickly:

  • We saw this at the turn of the millennium when the dotcom bubble burst. Global semiconductor sales crashed from $204 billion to around $140 billion.
  • Semiconductor revenues saw a 10% decline during the financial crisis in 2007/8.

So, a weak economy reduces demand. With tight margins in the industry, profits depend upon volume. When sales fall, profits fall rapidly.

There are also several industry-specific risks. These include:

  • The industry is highly competitive. As competitors seek to gain market share on price, profit margins reduce.
  • Companies that pump money into R&D are driving technological advance. Failure to keep up with semiconductor technology loses competitive advantage. Meanwhile, overspend on R&D reduces profits.

Established companies have a distinct competitive advantage. It costs billions to set up a new chip fabrication plant. To cut costs and remain competitive, semiconductor companies are forming alliances.

Copycat suppliers are an increasing problem within the industry. The huge R&D spend could go unrewarded if a competitor rushes out a copycat product.

There are also political concerns that you must consider…

A semiconductor war is brewing

There’s a chill wind in the semiconductor industry. And it’s blowing between China and the United States. China imports 90% of its semiconductors. Mostly from the United States, South Korea, Japan, and Taiwan. It imports so many, it spends more on semiconductors than oil.

China has a ten-year plan to build up its semiconductor capability. It plans to spend around $160 billion doing so. This is a direct threat to the major US players. Currently, China buys around 57% of the world’s semiconductors. It plans to be 40% self-sufficient by 2020. By 2025, it hopes to produce 70% of the chips it needs.

Are US semiconductor companies doomed?

China’s plans could deal a blow to the US chipmakers. The Obama Administration began a study into the issues. In mid-January, this study concluded that the subsidies given by the Chinese government are:

  • Distorting markets in ways that undermine innovation
  • Subtract from US market share
  • Put US national security at risk

Yet, foreign chipmakers are dependent upon China for sales. About 20% of Intel’s revenue comes from China. Qualcomm and NXP derive around half their revenues from China. These companies cannot simply turn their back on these sales. So, we’re likely to see more acquisitions, mergers, and joint ventures in the industry. And that could further fuel share price growth.

As you can see, investing in the semiconductor offers huge growth potential. But it’s not without its risks. The question now is, how do you invest in the semiconductor industry?

Ways to invest in the semiconductor industry

There are two main ways to invest in the semiconductor industry:

  • Buying industry ETFs (exchange traded funds)
  • Buying shares in individual companies.

The largest and best-established semiconductor companies are American and Asian. The UK provides resources for semiconductor companies, but manufactures little. So, it makes sense to look towards foreign markets for investment opportunities.

Semiconductor ETFs

For a balanced and diversified investment, an exchange-traded fund is an easy-to-understand solution. It works similarly to an investment fund, but is listed on an exchange. You can buy and sell an ETF in the same way that you buy and sell shares.

There are several semiconductor ETFs. Mostly, these are US registered. When searching for ETFs to invest in the semiconductor sector, look for the following:

  • An established fund manager
  • High liquidity – easy to buy and sell
  • If investing via an ISA or SIPP, make sure your provider will accept the ETF into the ISA or SIPP

You can search for semiconductor ETFs online.
Our favourites are:

iShares PHLX Semiconductor ETF (SOXX)

This ETF holds mostly North American semiconductor stocks. It also has an exposure to Singapore and Taiwan.

It is:

  • Easily traded
  • Has a track record of strong management
  • Provides excellent exposure to the semiconductor sector.

On the downside, its net expense ratio of 0.48% is high for an ETF.

VanEck Vectors Semiconductor ETF (SMH)

A liquid ETF. It invests only in US listed companies. Its investments are concentrated on the mega-cap semiconductors. With only 25 holdings, it is less diverse than other semiconductor ETFs. About 30% of its portfolio is in Intel and TSMC.

SPDR S&P Semiconductor (XSD)

This fund uses what is called an ‘equal-weight’ strategy. This means that it does not weigh its portfolio towards the large-cap semiconductor stocks. This ETF is for investors wanting exposure to smaller-growth companies in the sector. It is more volatile than other semiconductor ETFs. But when the semiconductor market is firing on all cylinders, it should outperform. It’s net expense ratio is 0.35%.

Semiconductor companies’ shares

If you’re willing to accept more risk, you could consider investing in single companies. As we’ve already discussed, the market is dominated by huge global players. This chart shows how concentrated the industry is:

As we’ve seen, the entry cost to the market is huge. Because of this, companies fall into one of three main categories:

  • Semiconductor companies

    These companies are involved in the design and manufacture of semiconductors. The majority are called ‘fabless’, because they do not fabricate the chips. Instead, they concentrate on the design and marketing of chips. These companies outsource production to:

  • Foundry companies

    These companies provide support services to foundry companies. They may design, test, and automate solutions, and photomask equipment.

  • Semiconductor support companies

    These companies provide support services to foundry companies. They may design, test, and automate solutions, and photomask equipment.

Shares you might consider buying

Most investment advisors will tell you to hold large-cap stocks in your portfolio. Stocks like Intel and Samsung. Yet, there is excellent value and opportunity among the smaller semiconductor companies. Here are the stocks that we believe provide long-term value in the semiconductor sector. These could all outperform in a sector that offers growth potential above the average.

Semiconductor companies

Xilinx (XLNX)

Traded on the Nasdaq exchange, XLNX designs and develops programmable devices. It also provides hardware, design tools, and in-system storage. It sells to the following sectors:

  • Electronic equipment manufacturers
  • Industrial
  • Healthcare
  • Aerospace and defence
  • Audio
  • Video
  • Consumer
  • Automotive

Its spread of geographic and sectoral customers:

  • Helps it thrive during periods of economic growth
  • Protects against an economic downturn

The shares are currently trading around $58, with an EPS of $2.24. It pays a dividend of $1.32 per share.

DSP Group (DSPG)

Traded on the Nasdaq exchange, DSPG provides wireless chipsets for communication applications worldwide. Its market segments are home, office and mobile. Its products enable voice, video, and data converging. And connectivity in consumer and enterprise products. They are particularly relevant for mobile and wearable devices. A growing sector of the market.

The shares are currently trading around $10.50, with an EPS of $0.15. The median one-year share price forecast of analysts is $12.42.

Foundry companies

Taiwan Semiconductor Manufacturing Co. Ltd. (TSM)

The shares of this Taiwanese company are traded on the NYSE. Its main business is providing engineering and manufacturing of integrated circuits and semiconductor devices. It operates in Taiwan, Asia, the US, Middle East, and Africa.

The shares are currently trading around $30, on a PE ratio of 17.5. It pays a dividend of $0.94 per share.

United Microelectronics Corporation (UMC)

Another Taiwanese company whose shares are listed on the NYSE. UMC provides wafer foundry solutions. It provides wafer fabrication, design and tooling services, mostly for fabless design companies. It operates globally, and interestingly also serves the solar energy industry.

Its shares are currently trading around $1.80. Analysts expect the shares to move ahead to around $2 within 12 months. Supported by robust sales and a dividend yield of almost 5%.

Semiconductor support companies

Xcerra Corporation (XCRA)

Shares are traded on the Nasdaq exchange. XCRA provides semiconductor test solutions and electronic manufacturing solutions. This includes for microcontrollers, consumer electronics, power and automotive applications.

Its shares are currently trading around $7.40, on a PE ratio of 34.8. Earnings are expected to grow strongly next year. And analysts have pencilled in a share price target of $9.25.

A final word…

The semiconductor industry is one of the fastest-growing sectors in the global economy. It offers some fantastic potential for investors. There is money to be made from shrewd investment in the sector. While dominated by large global players, some smaller companies look attractive.

For those starting out on the road of self-directed investment, an ETF would be a wise investment. They are easy to understand, and easy to buy and sell. They also offer cheap management charges and a diverse exposure to the sector.

More experienced investors may decide to buy the shares of single companies. This carries greater risk, of course – but potentially higher reward.

Whichever method of investing you choose, always invest with risk in mind. Professional investors maximise profits and limit risk by using trailing stops. If the price falls by a set amount from the highest price achieved after buying? The trailing stop creates a sell order. This locks in profit while limiting losses.

Another way to reduce your risk is to ‘pound cost average’. This simply means spreading your investment over a set period. For example, you may decide to invest £12,000 over 12 months. Investing £1,000 per month, you buy more shares if the price falls from one month to another. Over the investment period, this investment style decreases the volatility of your investment.

Lastly, the semiconductor industry is highly exposed to the global economy. Should the economy nosedive? Then it is likely that prices of semiconductor stocks will fall. When the economy grows, semiconductor stock prices enjoy two factors:

  • Product demand
  • Mergers and acquisitions
This article is for educational purposes only and should not be seen as financial advice.
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