Semiconductor companies have been ground zero for some of the biggest supply chain disruptions of the past two years and, along with other technology stocks, have taken it on the chin in 2022.
Those declines, however, have created the best buying opportunity in roughly a decade for some of the industry’s biggest names.
Shares in Taiwan Semiconductor (TSM) and Nvidia (NVDA)—whose products power much of the technology in the modern world—are changing hands at their lowest price/fair value estimate in nine years, according to Morningstar's equity analysts.
These attractive valuations come as the result of steep losses in semiconductor stocks in recent months.
The Morningstar Global Semiconductors Index, which measures the performance of companies that design, manufacture, and market microchips and microprocessors, is down 23% for this year, having bottomed out in May at 30% below its 2021 closing price. Semiconductor stocks fell alongside the broader technology stocks group, with the Morningstar US Technology Index dropping 22.7% this year versus the Morningstar US Market Index, which is down 14.7%.
“Relative to historic levels, we’re seeing a healthy pullback in the semiconductor space—it’s a good opportunity for long-term investors,” says Abhinav Davuluri, Morningstar's equity sector strategist for semiconductors and technology.
But given an unusually high level of uncertainty about the outlook heading into 2023, Davuluri says investors should focus on companies with the strongest competitive advantages.
Of the 23 companies under analyst coverage in the Morningstar Global Semiconductors Index, three are currently trading at 5-star discount prices. At the beginning of the year, there wasn’t a single company from the index in that category. On top of that, an additional 13 companies under coverage are undervalued but at less-cheap, 4-star prices. None of the companies in the semiconductor index are trading at levels that Morningstar analysts consider overvalued.
Another measure of valuations—price/earnings ratios—are also lower than usual for most semiconductor companies.
“P/Es are a lot lower than they were last year and the cheapest we’ve seen in three or four years,” Davuluri says. The Morningstar Global Semiconductor Index’s latest P/E ratio is 15.18, down from 21.7 one year ago. It is currently the lowest it has been since 2019. Taiwan Semiconductor’s trailing 12-month P/E ratio is currently at 22.2, its lowest in about three years. Intel’s is at 7.4, the lowest it has been in more than 10 years. Davuluri says the market tends to overshoot on the high end when there’s good news and fall too far with bad news.
“As the market gets more comfortable, we expect that P/E ratios will not fluctuate as much.”
When Will the Chip Shortage End?
A key driver for semiconductors has been the severe supply chain constraints.
Demand for chips skyrocketed at the start of the pandemic as the shift to remote work increased the need for computers for those working from home. At the same time, companies producing those chips shut down factories because of the virus, leading to rapidly depleting inventory and lower manufacturing output.
The concentration of the semiconductor market in Asia did little to help matters, as companies on the other side of the world struggled to get new chips to customers on time. Chipmakers also prioritized lucrative state-of-the-art chips, leading to further delays for less advanced chips that are used for products such as automobiles, networking hardware, and industrial machinery.
The tide is changing, albeit slightly. Demand for personal computers is slowing, according to Davuluri, and semiconductor manufacturers can free up capacity for less advanced chips. Essential materials required for production also remain a concern, with the Russia-Ukraine war putting critical materials like neon in jeopardy.
“It's difficult to say exactly when the shortage will end,” Davuluri says. “But exiting this year, we think the overall chip market will be in a better supply/demand situation. Though there could be some end markets like automotive that take a little longer to get back into balance.”
What Is the Long-Term Outlook for Semiconductors?
“Our main thesis is that the semiconductor industry is not as cyclical as it has been historically,” says Davuluri. “Everything is going to be connected to the internet—household devices, cars, farm equipment, wearable tech. It’s the semiconductor chips that enable all these things to be ‘smart.’ These developments are providing a massive wave of demand. The proliferation of big data and AI is going to require everything to have a chip in it.”
And on top of that, the behemoth markets of personal computers and smartphones won't go away. As some markets ebb, the others will flow, Davuluri says, leading to smoother results and less sporadic performance for semiconductor stocks.
Another current factor in the space is the increased push toward national sovereignty. “Today, 70%-80% of chips are made on China’s doorstep, in Taiwan and South Korea. Players in the U.S. and Europe aren’t very comfortable with that. There’s a massive push from governments, with the Chips [for America] Act in the U.S. and comparable subsidies in Europe, to provide funding and investments to build up more fabrication labs and factories on U.S. and European soil.” Intel has already begun projects to build factories in Arizona and Ohio, and other companies are following suit.
Long-Term Performance
“Many of these companies are still seeing very, very strong financial performance,” Davuluri says. “But our expectation is that there will be some slowdown or correction in 2023. That’s natural after this high peak, when all areas of the market have been very hot over the past few years.”
Over the past five years, the Morningstar Global Semiconductor Index has gained 172%—more than double the growth of the Morningstar US Market Index, which grew 80% during that time. Semiconductor stocks even outshone the high-flying Morningstar US Technology Index, which grew 153% over the past five years.
Which Semiconductor Stocks Are a Buy?
“For investors, we are cautious because the market is expecting some downturn or slowdown in 2023,” says Davuluri. “It’s unclear whether these undervalued semiconductor companies might fall more. That’s why we favor the names with wide economic moats that are better able to handle a lot of volatility.”
The Morningstar Economic Moat Rating is a Morningstar analyst-assessed designation that represents a company's durable competitive advantage. A company with a wide economic moat is expected to fend off competition and earn high returns on capital over the next 20 years or longer. Here are the wide-moat stocks in the Morningstar Global Semiconductors Index that are currently trading below their fair value estimates:
Taiwan Semiconductor Manufacturing (TSM)
“We believe TSMC’s wide moat stems from its cost advantage and intangible assets, which are realized from its leading position in process technology, or nodes. TSMC’s long-standing leadership in process advancement comes from its ability to correctly and consistently prioritize the right areas in which to innovate for nodes, while maintain fiscal discipline. Process technology leadership not only enables TSMC to improve power, (faster) performance and (smaller) area, or PPA, and the cost of each chip, which are critical for the performance of computing devices, but also justifies higher prices than its peers. As such, we believe that its leading position in the advanced processes will contribute to 1) attracting and retaining more customers, 2) more stable utilization of ever-expanding production capacities and lower production costs, 3) generating a higher return than its peers because of the cost advantage, and as a result, 4) ensuring sufficient profits to fund research and development, or R&D, and capital expenditures on subsequent nodes. This virtuous cycle of intangible assets brought by heavy R&D and cost advantages brought by better PPA reinforce each other, preventing smaller peers catching up, in our view. In fact, we acknowledge TSMC has been leading nodes' advancement and maintaining over 50% market share since the early 2000s, and its gross and operating margins have been at least twice as much as that of its closest peers for years.”
—Phelix Lee, equity analyst
Intel (INTC)
“We believe Intel’s wide moat emanates from its superior cost advantages realized in the design and manufacturing of its cutting-edge microprocessors and intangible assets related to its x86 instruction set architecture license and chip design expertise. While the firm has endured significant delays in deploying its latest 10-nanometer process technology, which has allowed foundry Taiwan Semiconductor Manufacturing (TSMC) to leapfrog Intel and AMD to become more competitive via TSMC’s 7-nm process, Intel’s manufacturing advantage over virtually every other chip designer and manufacturer is still intact and durable. Between Intel’s x86 dominance in PC and server CPUs (85%-plus market share in aggregate, per Mercury Research) and aggressive focus on new chip opportunities (AI, automotive, 5G, and so on) we think that excess returns on capital are likely with near certainty over the next decade and it is more likely than not that the chip titan earns excess returns on invested capital over the next 20 years.”
—Abhinav Davuluri, equity sector strategist
Monolithic Power Systems (MPWR)
“We think Monolithic Power Systems boasts a wide economic moat, as a result of intangible assets in analog chip design and switching costs for its integrated power management chips. In our view, these will enable the firm to average returns on invested capital in excess of its weighted average cost of capital over the next 20 years.
“While digital integrated circuits process digital inputs—sequences of 1s and 0s—into digital outputs, analog chips process continuous real-world signals into a digital output. The priority in digital semiconductors is packing ever-smaller chips with more transistors using cutting-edge manufacturing in pursuit of Moore’s Law, but analog design uses lagging-edge manufacturing, with customers prioritizing reliability, accuracy, and precision. In the case of Monolithic Power’s bread and butter of power management, power management integrated circuits regulate incoming electricity—with varying voltage and current—to produce a stable electrical output to safely power a device. It is our view that power management discrete transistors—like metal-oxide-semiconductor field-effect transistors and insulated gate bipolar transistors—are generally less differentiated and more commoditylike than other semiconductor applications, but Monolithic’s focus on highly integrated power management chips helps create a differentiated product with a compelling value proposition.”
—William Kerwin, equity analyst
Microchip Technology (MCHP)
“We believe that Microchip has a wide economic moat. Moats for analog and microcontroller, or MCU, chipmakers, such as Microchip, tend to come from intangible assets around proprietary chip designs and manufacturing expertise, as well as switching costs that make it difficult to swap out analog and MCU chips for competing offerings once they are designed into a given electronic device. Given Microchip’s track record of stellar profitability in recent years and ability to retain its leadership position in MCUs while expanding its analog business, we think it is more likely than not that Microchip will earn on excess capital over the next 20 years.
“Looking at intangible assets, leading analog and MCU chipmakers face stringent quality requirements in some end markets, such as the automotive space, for example, where defects can only be tolerated as infrequently as one part per million. Although the analog and MCU chip industries are quite fragmented, it would be difficult for any new entrant to achieve this level of quality while still satisfying high-volume production. Furthermore, Microchip’s 8-bit MCUs are based on its proprietary PIC architecture, and although the MCU industry is fairly fragmented and MCUs, by definition, perform simple processing functions, we think there is a bit of uniqueness to Microchip’s designs. We also see similar distinctiveness in the firm’s AVR-based MCUs acquired from Atmel.”
—Brian Colello, equity sector director
Nvidia (NVDA)
“We believe Nvidia possesses a wide economic moat stemming from its intangible assets related to the design of graphics processing units, or GPUs. The firm is the originator of and leader in discrete graphics, having captured the lion’s share of the market from longtime rival AMD. We think the market has significant barriers to entry in the form of advanced intellectual property, as even chip leader Intel was unable to develop its own discrete GPUs (despite its vast resources) and ultimately needed to license IP from Nvidia to integrate GPUs into its PC chipsets (though more recently Intel is vying to develop its own discrete GPU). To stay at the cutting edge of GPU technology, Nvidia has a large R&D budget relative to AMD and smaller GPU suppliers that allows it to continuously innovate and fuel a virtuous cycle for its high-margin chips.”
—Abhinav Davuluri, equity sector strategist
Analog Devices (ADI)
“We believe that ADI has a wide economic moat, thanks to intangible assets around proprietary analog chip design and manufacturing expertise, as well as switching costs that make it difficult to swap out analog chips for competing offerings once they are designed into a given electronic device. We are confident the firm is more likely than not to generate excess returns on capital over the next 20 years.
“The analog chip space is highly fragmented, but ADI is the only firm with a substantial market share lead in any subsegment of the business. The firm has nearly 50% share of the data converter analog chip market, and these chips are widely used in communications infrastructure equipment, in particular, as they convert analog voice signals to digital signals for processing, and vice versa. We believe that ADI will retain its relatively dominant position in converters over time.”
—Brian Colello, equity sector director
