Firms with exposure to the smartphone market have faced some tough times in recent quarters, as 
Apple (AAPL) iPhone demand has not lived up to prior expectations and the company reported its first year-over-year quarterly revenue decline since 2003. Meanwhile, the rest of the smartphone market hasn't fared much better; we've seen some company-specific market share shifts across the Android ecosystem, but in total, smartphone unit sales will fail to achieve double-digit growth in 2016 for the first time this decade. In turn, a host of components suppliers have sold off accordingly.
Despite this near-term sluggishness, we remain confident that the strong secular shift away from feature phones and toward more advanced smartphones is still intact. Although we no longer foresee exponential iPhone growth for Apple, we think that customer switching costs will drive most iPhone customers today to buy future iPhones tomorrow, thus supporting the company's unmatched free cash flow generation.
Microsoft's evolution will yield long-term success
In the software space in particular, we have seen several firms navigate the challenges of moving from a legacy, on-premise world to the new world of cloud computing. Adobe (ADBE) has been especially adept at this transformation, while Oracle's (ORCL) shift remains to be seen. We now view Microsoft (MSFT) on the more favourable end of this spectrum and showcase the company's transformation from a dominant legacy software vendor to a more nimble and user-friendly business.
Following the lead of new CEO Satya Nadella, Microsoft has embraced changes that we think will leave the firm better positioned for long-term, sustained success. Microsoft has quickly emerged as one of the most important cloud computing firms in the world. Azure, the firm's public cloud service, has established itself as the number-two player in the space behind Amazon (AMZN), and the platform should continue to garner significant user growth as Microsoft leverages Azure-hosted software such as Office 365 and Dynamics.
Public cloud represents a monumental opportunity for Microsoft as new workloads increasingly shift to the cloud, and the firm has curated a rich set of software and tools that will help keep developers in the ecosystem. The rise of Azure should help make up for the Windows Server OS, which is flagging against the continued meteoric rise of Linux, and it should also offset declines in other segments.
When the chips are down, bet on capital equipment firms
The US$30 billion-plus wafer fabrication equipment (WFE) industry is dominated by five players that account for roughly two thirds of the market. We believe equipment providers play an integral, yet often unappreciated, role in today's advanced electronic devices. These firms enable the continuation of Moore's Law via their involvement in creating faster and more energy-efficient chips. Based on the intangible assets around design expertise and research-and-development cost advantages required to compete for the business of leading-edge manufacturers, barriers to entry are high. Most important, in our view, is the fact that the top five are relatively indifferent with respect to which chipmakers manage to survive and/or thrive after making hefty up-front R&D investments, as WFE firms boast all major chip manufacturers as customers.
Top picks
Apple (AAPL)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: US$133.00
Fair Value Uncertainty: High
Consider Buying: US$79.80
We believe that near-term weakness and a broadly sluggish smartphone market have provided investors with an attractive margin of safety in narrow-moat Apple as compared with our US$133 fair value estimate. By our calculations, Apple appears to be priced as if iPhone sales have peaked and will face a long, secular decline from here on out. Although we no longer foresee exponential growth for the iPhone, we think that future sales will be more resilient than what the market has priced into the stock. Ultimately, we think that, for a host of reasons (including software and services like iCloud, FaceTime and iMessage, as well as the need to repurchase apps and subscriptions, and a loss of compatibility with other Apple products), iPhone users today will continue to buy iPhones well into the future. Meanwhile, we think the market is giving Apple little credit on the innovation front, either in new software, native applications, new services (perhaps a streaming TV service) or new products (potentially Apple Car).
Microsoft (MSFT)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: US$61.00
Fair Value Uncertainty: Medium
Consider Buying: US$42.70
Microsoft has emerged as one of the most important cloud computing firms in the world, and we believe the market is undervaluing its long-term opportunities as a cloud leader. Azure, the firm's public cloud service, has established itself as the number-two player in the space behind Amazon, and the platform should continue to garner significant user growth as Microsoft leverages Azure-hosted software such as Office 365 and Dynamics. Public cloud represents a monumental opportunity for Microsoft as new workloads increasingly shift to the cloud, and the firm has curated a rich set of software and developer tools that will help keep developers in the ecosystem. We believe Azure will help offset declines in some of Microsoft's legacy businesses, solidifying the firm's wide moat and stabilizing the moat trend. Although we think Microsoft will be subject to some lumpiness over the next several quarters as the revenue mix continues to shift toward cloud-based services, we are confident that management can guide the company into its next era of widespread success as a dominant cloud vendor spanning Internet as a service, platform as a service, and software as a service.
Skyworks Solutions (SWKS)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: US$92.00
Fair Value Uncertainty: High
Consider Buying: US$55.20
We foresee growth at a reasonable price and an adequate margin of safety in narrow-moat radio frequency chipmaker Skyworks. Given the need for far higher RF chip content per 4G LTE smartphone, the ongoing complexity around LTE networks, and the rapid expansion of these networks in developed and emerging markets over the next few years, we still foresee tailwinds for RF chip suppliers such as Skyworks over the next couple of years. We do have some concerns about long-term RF pricing trends, but we believe these are accounted for in our US$92 fair value estimate as we model Skyworks' long-term growth at a slower pace than the firm's forecast.
More quarter-end insights
Stock market outlook: A year of contradictions
Basic materials: Recent commodity rallies leave few opportunities
Consumer cyclical: Market underestimating apparel and e-commerce
Consumer defensive: Not a lot to feast on
Energy: Supply glut continues, but some respite on pricing
Financial services: Accounting for Brexit and the fiduciary rule
Healthcare: Stock selection increasingly important
Industrials: Valuations stretched, but opportunities still exist
Real estate: 'Safety' becomes more expensive
Utilities: Is a sector-shaking pile-up coming?
