Semiconductors have changed the world in innumerable ways over the last fifty years, and some chip stocks have been incredible wealth creators for their investors. But the semiconductor industry – like many other manufacturing-based industries – is very cyclical and prone to extended “booms” and “bust” periods for investors. Successfully navigating cyclical inflection points can improve risk-adjusted returns, which should be a primary goal for any equity investor.
There are two broad ways to invest in semiconductors. One can invest in the chip companies themselves (i.e. Intel, symbol INTC), and/or one can invest in semiconductor capital equipment companies (i.e. Applied Materials, symbol AMAT). The former group of companies produce and sells semiconductor chips. The latter group makes the incredibly complex and expensive machines that semiconductor companies use to produce those chips. Even though these groups are close relatives, historically they have tended to exhibit divergent stock performance. In the graph above, a rising line indicates that semiconductor equipment stocks are outperforming chip stocks. A falling line indicates periods of relative underperformance by the equipment stocks. Note from the table that the Semiconductor Equipment industry has dramatically lagged the broader market and the Semiconductor industry since last October. In fact, year-to-date through 9/17/18, Semiconductor Equipment stocks have declined by more than 15%, putting them squarely in correction territory. By comparison, the Russell 1000 Growth index has gained over 14% so far this year. Holy underperformance, Batman!
As bad as these stocks have fared recently, we think the correction in Semiconductor Equipment stocks could be nearing an end. Note that the relative performance line graph has sunk to within striking distance of the last three major relative performance low points for Semiconductor Equipment stocks dating back to early 2010. Following the most-recent trough in the relative performance – which occurred in October 2015 – the equipment stocks exploded to a 167% gain over the subsequent two-year “boom.” As active managers, this kind of return opportunity gets our attention.
The tables below provide detailed information on the S&P 1500 Semiconductor Equipment stocks during declines and rallies of 20% or more. The upper table shows where we stand currently. Dating back to 2006, these cyclical corrections last an average of 30 weeks, and bottom out with losses of -33.6% (although this is skewed downward by the monstrous -68.7% shellacking during the Great Financial Crisis). The current drawdown has lasted 27 weeks and been accompanied by a 28% price decline. So, in terms of both duration and price, we are probably much closer to the end of this pullback than we are to the beginning.
We think semiconductor equipment stocks’ valuations are also becoming reasonably attractive. As highlighted in the table, both the current Price to Earnings (14.56x) and Price to Cash Flow ratios (13.53) are below average trough valuations. Price to Book and Price to Sales remain above average compared to previous troughs, but not dramatically so. All in all, we think the Semiconductor Equipment stocks are intriguing for technical and fundamental reasons. And, as the bottom table shows, it has historically paid investors well to catch cyclical recoveries in these stocks – the average gain during 20% rallies has exceeded 89%. Color us interested and vigilant for a potentially great developing opportunity.