With interest rates set to rise this year, investors are steeling themselves for an overdue bear market. Threatened with higher discount rates as inflation rises, investors are wondering if they should reposition their portfolios this year.
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Semiconductors Have Outperformed Source: S&P Global. Three-year price return data as of 7 February. |
Semiconductors could continue providing above-average earnings growth thanks to supportive megatrends, especially the electronification of transport. At the time of writing, semiconductor valuations are in line with market averages. Meaning they are currently offering above-average earnings growth for an average price.
Background
Semiconductors, or microchips, are the backbone of modern technology. They turn an electric current into computer signals. The more sophisticated and varied these signals, the smarter a machine can become. For this reason, leaps forward in computing require corresponding leaps in semiconductors.
Driven by megatrends
Semiconductors have thrived in today’s wave – or megatrend – of technological disruption. Some of the drivers of semiconductor demand include:
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Greater internet use (e-commerce, streaming, video games)
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Electric cars
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Blockchain and cryptocurrency
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Artificial intelligence and robotics
The growth of these has translated directly into greater demand for semiconductors, in a virtuous circle. As consultancy Deloitte noted in its year-end study: “Every end market for semiconductors is growing, and growing as fast or faster than ever before.”
In 2020 and 2021, greater internet uptake was the key driver. The coronavirus forced people to work, shop and entertain themselves from home—creating unprecedented demand for internet devices.
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Projected Global Car Chip Market Size (US$bn) Source: Statista; IHS Markit; Nikkei Asian Review. Data as of 25 May 2021. |
However in 2022 and beyond, electric cars look set to take centre stage. Tesla is selling more cars than it can build. While its rival carmakers like Ford and Volkswagen have committed to going fully electric by 2030. As such, semiconductor content per car is rising. In the coming years, cars are set to go self-driving, increasing chip content per car further.
Strong fundamentals
Sales growth of semiconductors has been spectacular. In 2021, chip sales rose 26% according to the industry group World Semiconductor Trade Statistics (WSTS).
Chip companies along the value chain say they are selling out, as part of the ongoing global chip shortage. GlobalFoundries, the American chipmakers, has said it has sold out of manufacturing capacity until 2023. ASML, the Dutch company specialising in lithography machines, says demand for their machines is 40% higher than what they can produce. The shortage has increased the market power of chip companies, who have responded by raising prices.
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Global Semiconductor Revenue Growth Source: WSTS, Data as of 8 February 2022 |
Strong earnings growth and the ability to raise prices, have meant the industry is poised for impressive earnings growth.
The estimated 3 – 5 year earnings per share growth of the US semiconductor industry sits at 16.5% as of 4 February according to FactSet. Putting it above the 14.8% forecast for the S&P 500. Crucially, these forecasted earnings are not expensive. The current forward price-to-earnings ratio of the US semiconductor industry and S&P 500 are roughly the same, sitting at 20.2 and 20.9 respectively.
These two data points – above-average earnings growth, average valuation – underpin the investment case for semiconductors.
Things to watch: Overbought “value rotation” makes chips cheap
As the world braces for higher interest rates, investors are growing wary of high growth technology areas, including semiconductors. Despite the strong fundamentals discussed above, the US semiconductor sector* is down 17% year-to-date—falling further than the S&P 500 despite superior earnings.
Nvidia has a history of positive earnings surprises
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Source: Zacks. Data as of 1 Feb 2022 |
The paradox was captured by Jordan Klein, managing director of tech trading at Mizuho Securities, who wrote in a recent note to clients: “Semis cannot catch a break… The prevailing buyside sentiment or mentality seems to be ‘why buy this sector when [earnings] beats and raises fail to take stocks higher, and anything just in-line gets slammed?’”
A reason for this pessimism may be the ongoing value rotation. Investors, seeing the prospect of higher interest rates and economies re-opening, are leaving technology in favour of more traditional sectors such as banks and oil majors. Should this trade continue, it may represent a short-term headwind for semiconductors. However, it could also create lower prices, and a buying opportunity for longer term investors.
