Semiconductor Stocks: A Smart Bet for the Long Haul

Applied Materials

• Market value: $134 billion
• Price-to-earnings ratio: 19
• Dividend yield: 0.6%
• One-year return: 60.5%

Semiconductor manufacturing is an enormously capital-intensive business, with foundries and logic- and memory-chip companies spending tens of billions of dollars each year to expand capacity and to keep up with the blazing pace of technological change. Applied Materials (AMAT (opens in new tab), $151) is the world's largest maker of semiconductor equipment, an industry niche that has consolidated in recent years to just five major players.

Igor Tishin, a tech analyst at Harding Loevner Funds, likens the leading tool makers to "arms suppliers to a growth industry." That's because regardless which chipmaker is up or down, all of them need to buy from the same handful of equipment suppliers.

Applied sells its complex machines, such as etching equipment, to a global market: Last year, about 75% of sales went to Asian industrial powers China, South Korea and Taiwan; only about 10% of revenues were booked in the U.S.

AMAT has used its close relations with chipmakers around the world to boost its services business (such as machine maintenance), which generates high recurring, subscription-like revenues and is less volatile than machine orders. Applied generates a towering return on equity (a measure of profitability) of approximately 50% and is expected to increase earnings by nearly 20% in its fiscal year ending in October 2022.

Marvell Technology

• Market value: $70 billion
• Price-to-earnings ratio: 40
• Dividend yield: 0.3%
• One-year return: 70.0%

Marvell Technology (MRVL (opens in new tab), $83) is a good example of a so-called fabless semiconductor company – a chipmaker that designs semiconductors in-house but outsources manufacturing to third parties, thereby tamping down capital intensity.

Business is booming because most of the company's sales are to high-growth markets such as cloud data centers and 5G telecommunications infrastructure – net­working customers include Cisco Systems (CSCO (opens in new tab)) and Dell (DELL (opens in new tab)). A leader in items such as controllers for storage systems, Marvell supplies hard-disk-drive makers including Toshiba, Seagate (STX (opens in new tab)) and Western Digital (WDC (opens in new tab)).

Many of the chips it designs are customized for clients, which increases customers' costs to switch suppliers and enhances the "stickiness" of sales.

CFRA's Zino expects Marvell's revenues to grow 30% this year and earnings per share to double in two years. As with other semiconductor-industry companies, one potential vulnerability is Marvell's dependence on China, where it books nearly half of sales.

Nvidia

• Market value: $681 billion
• Price-to-earnings ratio: 54
• Dividend yield: 0.1%
• One-year return: 104.3%

In 2020, Nvidia (NVDA (opens in new tab), $272) dethroned Intel (INTC (opens in new tab)) to become the most valuable semiconductor stock.

It's been quite a ride since 1999, when this disrupter invented graphics processing units (GPUs), which redefined the PC gaming industry. More recently, Nvidia has used its high-speed, leading-edge GPUs to grab market share in sectors including gaming, data centers, cloud computing, machine learning, cryptocurrency mining and robotics.

Adam Benjamin, manager of Fidelity Select Semiconductors Portfolio, says that Nvidia "stands on its own right now" in leading the shift to AI-driven systems for everything from autonomous-driving vehicles to medical research and diagnosis.

The market understands that the world is Nvidia's oyster. Highly profitable, with sales growing at multiples of the overall semiconductor industry, the stock returned nearly 100% annualized over the past three years, double the industry's average.

Yet many investors still find it irresistible. "Every time I cut back, it turned out to be a mistake," Plumb Funds' Tom Plumb says of his largest stock holding.

NXP Semiconductors

• Market value: $59 billion
• Price-to-earnings ratio: 19
• Dividend yield: 1.0%
• One-year return: 27.8%

The semiconductor content in autos is surging due to the migration to electric vehicles (EVs) and the addition of increasingly sophisticated features in cars, such as enhanced safety and audio-infotainment systems. NXP Semiconductors (NXPI (opens in new tab), $221) is well placed to ride the wave.

Autos account for half of NXP's revenues, a proportion that is growing (chips for home and industrial automation are also a major business for the Netherlands-based firm).

NXP supplies automakers including BMW, Ford (F (opens in new tab)), Tesla (TSLA (opens in new tab)) and Volkswagen (VWAGY (opens in new tab)) with chips for battery-management systems in EVs, advanced radar systems to avoid accidents, and in-vehicle networking.

The company, which plows more than 15% of revenues back into research and development, projects annual sales growth of 8% to 12% until 2024. NXP jacked up its dividend 50% last year and has a habit of aggressive share repurchases.

Taiwan Semiconductor Manufacturing

• Market value: $640 billion
• Price-to-earnings ratio: 24
• Dividend yield: 1.6%
• One-year return: 2.0%

In the 1980s, Taiwan Semiconductor Manufacturing (TSM (opens in new tab), $124) pioneered the foundry business – the contract manufacturing of chips for others.

With a global foundry market share of more than 50% (three times higher than Samsung Electronics, which ranks second) and a virtual lock on leading-edge chips, Taiwan Semi makes semiconductors for Apple (AAPL (opens in new tab)), Qualcomm (QCOM (opens in new tab)), Nvidia (NVDA (opens in new tab)), Broadcom (AVGO (opens in new tab)) and Advanced Micro Devices (AMD (opens in new tab)), among others.

Vying with Nvidia to be the most valuable semiconductor company (by market value) in the world, Taiwan Semi is investing $100 billion from 2021 to 2023 in new chip-fabrication facilities to meet supply shortages and rapidly expanding demand.

Harding Loevner's Tishin labels this indispensable chipmaker a "natural monopoly," but an enlightened one in that it doesn't abuse its pricing power and treats customers "fairly and equally." (The firm's motto is "Everyone's Foundry.")

Taiwan Semi has little competition, so its largest risk may be the rising political tension between China and Taiwan, where most of its fixed assets are based.

Texas Instruments

• Market value: $166 billion
• Price-to-earnings ratio: 22
• Dividend yield: 2.6%
• One-year return: 9.35%

We may be in the digital age, yet the demand for analog chips is still enormous and growing.

Venerable Texas Instruments (TXN (opens in new tab), $179), founded in 1930, is the global leader in analog semiconductors, which find their way into pretty much every electronic product to provide power to run devices, for instance, and for tech interface with humans.

"People think analog is not sexy because it's not at the forefront of technology, but you find it everywhere," says Hendi Susanto, a portfolio manager at Gabelli Funds. TI, whose product catalog of 80,000 devices also includes processors that convert sound to digital data, counts 100,000 customers around the world, with two-thirds of its sales from Asia.

The unglamorous analog business (the industrial and personal electronics sectors are the two largest end customers) grows steadily and is highly profitable for TI, which is tightly managed for shareholders. Compared with digital chips, analog product life cycles are long and capital spending needs are modest. Unlike many competitors, TI manufacturers its own chips, which helps to reduce cost.

With high and rising profit margins, the company generates $7 billion of free cash flow a year, and TI returns nearly all of it to investors by repurchasing shares and paying dividends, which the firm has increased for 18 consecutive years.

Consider These Semiconductor Funds

The dynamic semiconductor industry changes so quickly that a diversified sector fund makes sense for many investors. Here are our favorites. (Returns and other data are through Jan. 7.)

Fidelity Select Semiconductors Portfolio (FSELX (opens in new tab), expense ratio 0.7%) dates from 1985 but has been managed by Adam Benjamin since 2020. Benjamin says he’s particularly drawn to businesses that supply end markets enjoying strong secular growth, such as cloud data centers and 5G infrastructure. As of last report, his top two holdings were Nvidia (with a 26% allocation) and NXP Semiconductors. The fund returned 52% annualized over the past three years.

If you prefer investing through exchange-traded funds, iShares Semiconductor (SOXX (opens in new tab), $521, 0.43%) is a modified market-value-weighted fund that tracks the ICE Semi­conductor Index. SOXX caps the weighting of the five top holdings at 8% each and the remaining holdings at 4% each; American depositary receipts for foreign companies collectively are capped at 10%. The ETF returned 50% annualized over the past three years.

VanEck Semiconductor (SMH (opens in new tab), $297, 0.35%) allows up to 25% in foreign holdings. Taiwan Semiconductor, at 10% of the portfolio, is the top position and the Netherlands' ASML is also in the top 10. The ETF's annualized three-year return is 53%.