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Chip shortages and the investment opportunity in semiconductor stocks

While demand is outstripping supply now, investors should be warned: The industry is cyclical. The big uncertainty for the current cycle is when the peak will occur

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The pandemic, 5G networks, electric vehicles and other factors have combined to unleash overwhelming demand for semiconductor chips – to such an extent that fabrication plants are running at 100-per-cent capacity, notes a September report from International Data Corp (IDC). Yet, there still are not enough chips to meet demand in the automobile and other industries.

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Some investors might think semiconductor stocks are worth owning now. Indeed, even though chip shortages have led to production cutbacks in many industries, revenues in the sector are expected to grow by a historic 17.3 per cent in 2021, according to IDC.

Not so fast. The chip industry is notoriously cyclical and the market should become oversupplied at some point as new foundries and machinery come on stream. So semiconductor investments may have a limited lifespan.

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It’s very easy for demand and supply imbalances to arise in the industry. Demand can turn on a dime but supply moves like molasses because construction of new foundries is capital intensive, requiring billion-dollar investments and several years to complete.

The big uncertainty for the current cycle is when the peak will occur – when the new plants and equipment now at various stages of completion bring on new supply and catch up to demand. Past patterns from previous decades suggest it could happen within next 3 to 9 months. As for IDC, it projects a cooling off by mid-2022, followed by overcapacity in 2023.

Speaking at the Italian Tech Week conference in late September, Tesla Inc. CEO Elon Musk declared that the chip shortage should not continue much into 2022. His company adapted to the crisis by rewriting software to accept alternative chips. No doubt other chip-using companies are finding ways to cope, taking the pressure off the need to restock.

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Some auto companies, like BMW, have offset revenue and earnings declines by raising vehicle prices. Other companies are getting their products to market by leaving out some of the options and features that rely on chips.

Lisa Su, CEO of AMD Inc., is a little more pessimistic. She believes the chip crunch will not become less severe until the second half of 2022. “The pandemic has just taken demand to a new level,” she said at the Code Conference in Beverly Hills, Calif., last month.

Others are even more pessimistic because of the supply-chain disruptions and secular trends in technology. Gunnar Herrmann, Ford Europe’s chairman, told a CNBC reporter at the Munich Motor Show in early September that it’s hard to say when the shortage will end but he estimates it could continue into 2024.

One trend that could prolong the chip shortage is the transition to electric vehicles. A Ford Focus, for example, uses about 300 chips, whereas Ford’s new electric vehicles each can have up to 3,000 chips, rendering them veritable data centers on wheels.

Other secular trends include the upgrade from 4G to 5G wireless phones, artificial intelligence, cloud computing, cryptocurrency mining and a new work-and-play-from-home dynamic (Zoom meetings, online gaming etc.). Then there is the ongoing digitization of household appliances and sundry items such as e-cigarettes and smart toilets with hand-held remote controls for flushing and turning on the bidet spray.

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The diversity in projections may leave investors uncertain when to exit stocks, deals or funds related to semiconductors. Citigroup Inc. semiconductor analyst Christopher Danley, who has followed the sector for more than 25 years, believes two variables can signal the time for leaving the chip party. The first is when news of chip shortages fades from the headlines; the second is when lead times – the time to fill an order for chips – begin to diminish.

On this basis, investors might want to stay the course awhile longer. Shortages are obviously still high up in the news. Moreover, the lead time between ordering chips and delivery is still rising to high levels, according to an August report from Susquehanna International Group. The current reading is 21 weeks, versus an average of 13 weeks over the three years to 2020.

Another strategy is to not worry about when the turning point arrives and just buy and hold – through the ups and downs – companies riding the stronger secular growth trends. NVidia Corp. is a leading example, thanks to its chips used in video games, cryptocurrency mining and electric vehicles.

Other long-term holds could be chip companies that are building new fabrication capabilities in the United States – a notable example is Intel Corp. Ordinarily this would not be a positive feature when the semiconductor cycle is heading toward an oversupply stage.

However, there is something to be said for the tailwind that companies enjoy when they are operating in sectors favoured by the government. Congress recently decided to provide tax credits and billions of dollars in funding to firms that build up their U.S production facilities.
This decision needed to be taken because many U.S. companies outsource the production of their designs to third parties, leaving the United States’ share of global production at 12 per cent. The majority of the world’s production now resides in China and Taiwan, which raises national security concerns due to deteriorating relations with China (and its claims on Taiwan).

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