Semis: We’re Halfway There?

Today, we believe the semiconductor sector is “halfway there” in terms of the large investments we made during the depths of the trade war in late 2018, with most stocks we invested in, roughly doubling or trebling in value since.^[1]

The case for investing was based on industry consolidation leading to more rational competitive behaviour and hence structurally higher profitability, against a backdrop of growth tailwinds, such as 5G, the Internet of Things (IoT), autonomous driving, artificial intelligence (AI), machine learning and more.

At the time, it was weak demand that gave us the impetus to meaningfully increase our exposure to the sector and indeed, it was “so tough” back then, both for the industry and for us to go against the crowd and take a position, as our philosophy compels us to do. Today, it’s tight supply which is leading to a resurgence of interest in the sector and the stocks are responding accordingly. However, rather than “livin’ on a prayer”, we believe there is a robust case for staying invested.

When we start to hear the market repeating our investment case back to us, it normally gives us cause for concern. However, while the share prices are motoring along, we are not yet hearing the full story – only snippets that short-term tightness in supply is causing people to take notice. The longer-term structural tailwinds, in our view, are yet to be appreciated by the market.

The period of reduced demand for semiconductors in 2018 resulted from trade uncertainties and a weaker smartphone cycle, keeping inventories low. Subsequently, Intel had production yield issues (with the quality of the semiconductor process lower than anticipated), there was panic buying around Huawei ahead of the US-imposed bans, and there was increasing semiconductor content required for 5G phones. All these factors led to a tightening in demand/supply dynamics – before the impact of COVID-19.

Initially, COVID-19 created significant uncertainty around demand, resulting in a huge fall in semiconductor orders in the June 2020 quarter, particularly in the auto sector. On the supply side, some capacity expansion plans were put on ice given the uncertain environment, and there was a range of stories from full shutdowns, to employees living onsite and ‘isolating’ at other facilities that wanted to keep operating, while other semiconductor companies were impacted by COVID-19 cases, forcing staff into quarantine.

Meanwhile, end demand was robust as people purchased laptops and PCs to work from home; while cloud, streaming, gaming and e-commerce services boomed, driving strong data centre demand.

So, we had a tight set up between demand and supply. Unexpected demand, capacity booked out for smartphone and gaming consoles, and a recovery in industrial and autos caught the sector off-guard, squeezing prices higher.

This has been exacerbated by a number of other factors:

• A shift from in-house manufacturing to using fabrication plants (‘foundries’ or ‘fabs’) reduced slack in the system.
• Growing demand has led to greater need for dedicated capacity at the trailing edge (older technology) fabs, which historically relied on a trickle down from an ageing leading edge.
• Many are hesitant about using China-based foundry capacity to plug gaps, due to concerns about trade and technology access.
• It takes several months to turn a blank wafer into finished chips, so even if a fab starts making customer orders today, it will take a couple of months for them to be produced.

With tightness across the supply chain, there will likely be capacity additions in time and a restarting of idled capacity, but we don’t expect this to happen in the immediate term. In January, leading foundry Taiwan Semiconductor Manufacturing Company (TSMC) announced a 60% increase in its capital expenditure budget to a record US$27 billion in 2021.

On the demand side of the equation, it’s an open question as to how sustainable the ‘working from home’ boost will be, but we expect to see continued demand for 5G phones and gaming consoles. Currently, we are seeing good sales, with only small concerns over smartphone ordering. However, demand will be the determinant of where we find near-term equilibrium.

Longer term, the reason we think the market is only “halfway there” is that we have had a whole decade of consolidation in the industry. This has removed excess capacity and slack in the system (in part creating this near-term hiatus). However, it has introduced greater pricing discipline as weaker players have exited. The market is yet to appreciate that the cycles have been dampened, and while there will likely be a downturn after we find balance, we expect it will be less than people fear, and the sector should continue to slowly re-rate, providing a case to stay invested.

As Bon Jovi roared “we’ve got to hold on to what we’ve got” and indeed, despite the recent rallies and a little trimming for risk management purposes, we continue to hold the following stocks (all are held in the Technology strategy): Samsung Electronics (in both the Asia and Global strategies), SK Hynix and TSMC (in the Asia strategy) and Skyworks, Microchip and Micron (in the Global strategy).