VanEck Vectors Semiconductor ETF (NYSE.SMH).
For many years, semiconductors have been at the heart of the technology revolution. Hidden inside every electronic device from computers to self-driving cars, semiconductors are the enablers of modern technology, but because we hardly ever see them, most of us know very little about semiconductors, much less about the companies that manufacture them.
Given its importance to technology, semiconductors will certainly be the main driving force behind the future of emerging technologies, and we expect the semiconductor industry to be one of the best performing industries over the next decade.
What are semiconductors all about?
Semiconductor products are made from semiconductor materials such as silicon, and are essential components that make every electronic device work. Not only do they enable electronic devices to function properly, advances in semiconductor technology also make them more compact, less expensive and more efficient.
For example in the 1980s, mobile phones were the size of a brick, weighed more than a kilogram, cost around USD $4,000 and contained just enough battery power for about 30 minutes of talk time, hardly attractive compared to the smartphones we have today.
Besides mobile phones, most electronic devices today are a far cry from what they were before, smaller in size but packed with way more computing power. This is only made possible because of advancements in semiconductor technology. The rate of technology development is closely tied to the pace of semiconductor innovation. If semiconductor firms are not innovative, technology is unlikely to see any progress.
The semiconductor industry is made up of companies that belong to one of the three main groups:
1. Pure Play Foundries: These are companies that do not have any design capabilities as they focus only on the fabrication and testing of semiconductor products.
2. Fabless: Fabless companies are involved only in the design and sale of semiconductor products, while outsourcing the fabrication to foundries.
3. Integrated Device Manufacturers (IDMs): IDMs are companies that design, fabricate and sell semiconductor products.
Together, these companies design, manufacture and sell a variety of semiconductor products such as memory chips, microprocessors, integrated circuits and complex systems-on-a-chip (SOC). The vast majority of semiconductors produced are used to manufacture electronic devices, before eventually finding their way into the hands of consumers. The Semiconductor Industry Association (SIA) classifies semiconductors into five end use segments as shown in Figure 1 below.
Figure 1: The communications segment is the largest end use segment for semiconductor products
In 2017, 32% of all semiconductors produced went towards the communications segment, which basically consists of devices that are capable of sending and receiving a signal, such as your smartphone. Driven by increased hardware spending for future applications, the communications segment is expected to contribute significantly to semiconductor demand over the next few years.
The US is the global leader in the semiconductor industry
Across entire global semiconductor industry, US-based firms hold the largest market share at 46%, more than double the size of its closest competitor, South Korea (Figure 2). Its lasting dominance in this field can be explained by the quality of chips it produces, which have become highly sought after by clients and are the envy of competitors such as China, which has long struggled to produce its own chips.
Figure 2: US-based firms hold the largest market share in the global semiconductor industry
Its success in this field is no accident. Rather, it is the fruit of the thousands of hours and billions of dollars spent on R&D, an important ingredient for producing cutting edge chips. On average, US semiconductor firms invest roughly a fifth of their revenue back into R&D, the second highest amongst all major US industries, trailing only the pharmaceutical industry.
Owing to the competitive nature of the semiconductor industry and the world’s insatiable appetite for the latest technologies, semiconductor firms are constantly trying to outdo each other by producing smaller, faster and better chips. Often, this is only achieved by having a sound R&D program, which explains why chip makers often set aside large amounts of capital for R&D purposes.
Semiconductors are also the fourth largest US export behind airplanes, refined oil and automobiles. With more than 80% of the semiconductors produced in the US sold abroad, US semiconductor firms form an integral part of the global electronics industry.
Where are we in the semiconductor cycle right now
The semiconductor industry tends to move in cycles, driven mostly by fluctuating sales growth numbers. According to data published by the SIA, growth in semiconductor sales has started to slow since reaching its peak of 23.7% in 2Q17, down to a low of 0.6% in 4Q18 (Figure 3).
Figure 3: Semiconductor sales growth is currently at its lowest since its last peak in 2Q17.
Looking back at how sales growth tends to behave in the past, we think that we are currently at the tail end of the down-cycle. Going forward, two scenarios could potentially play out. The first being sales will recover immediately, marking the start of a new cycle. The second scenario, which we believe is more likely, will see sales growth continue to decline over the next few quarters before starting its recovery, just like how it has done so in the past.
However, it is worth noting that no matter which scenario becomes reality, semiconductor sales will eventually recover in the long-term. Figure 4, which plots monthly semiconductor sales from 1994 to date illustrates this point clearly.
Despite the fact that sales declined sharply on a few occasions in the past, it eventually recovered in the long term, even exceeding it's previous highs. Hence, it is not a question of whether a recovery will occur, but rather, a question of when the recovery will occur.
Figure 4: Despite its short-term cyclicality, semiconductor sales always rises over the long run
Consistent revenue and earnings growth expected
According to data from the SIA, global semiconductor sales hit a record high of USD 468.8 billion in 2018, a 13.7% increase from the previous year (Figure 5). Between 2012 and 2018 sales grew at a CAGR of 8.1%, an incredible feat considering revenue from S&P 500 companies grew only 3.8% across the same period.
Driven by the flourishing demand for semiconductors, sales are expected to continue trending upwards, and should cross the USD 500 billion mark by 2020.
Figure 5: The ever-growing demand for semiconductor products should continue to drive industry revenue upwards
Along with revenue growth, the estimated earnings for semiconductor companies is expected to rise by an average of 9.4% each year between 2019 and 2021 (Figure 6), a major catalyst that could potentially drive share prices higher.
Figure 6: US semiconductor companies are expected to record positive earnings growth of 9.4% going forward
An investment opportunity not to be missed
To sum things up, we believe that the semiconductor industry is one that has a huge potential for growth, driven by the swift development of future technologies. Looking at where we are in the cycle right now, it is likely that the upside potential outweighs the downside risks.
Investors who do not want to miss this opportunity can start making an investment through the VanEck Vectors Semiconductor ETF (NYSE.SMH), our recommended ETF for exposure to the semiconductor industry. Based on current valuations, we estimate an annualised return of approximately 14% per year from now till 2021.
Read our next article for an in depth look into the cyclical nature of the semiconductor industry and how you can profit from it.
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