A good understanding of the semiconductor cycle can help investors make better and more profitable investment decisions.
Semiconductor cycles are driven by fluctuating sales growth numbers, which are in turn caused by distortions in supply and demand.
While industry down-cycles affect share prices in the short-term, they are never long-lasting. Overtime, share prices typically recover along with sales.
Investors who do not want to miss this opportunity can start investing in the semiconductor industry through the recommended Vaneck Vectors Semiconductor ETF (NYSE.SMH).
Investing in the semiconductor industry is not for the faint-hearted. At times of severe market stress or down-cycles, semiconductor companies can lose as much as half of their market value in just a matter of months. Those who lack a good understanding of this industry may panic, or worse, make poor investment decisions that could lead to large losses.
By having a good understanding of the semiconductor industry cycle, we believe that investors will have greater conviction in their investment decisions, and thus, able to position themselves better to capture the long-term upside of the semiconductor industry.
Semiconductor cycles are driven by fluctuating sales growth numbers, and they typically last from anywhere between 10-17 quarters. Each complete cycle is made up of a contraction phase of about 4-6 quarters, followed by an expansion phase of roughly 6-11 quarters (Figure 1).
According to the latest data published by the Semiconductor Industry Association (SIA), the industry has just entered into a new down-cycle, with sales growth falling by -11% year-on-year in the first quarter of 2019. We expect sales growth to continue its decline over the next few quarters before we start to see green shoots of recovery.
Figure 1: Semiconductor cycles are driven by fluctuating sales growth numbers
Since the 2000s, the semiconductor industry has started to experience softer down-cycles. The duration of the down-cycles has more or less remained the same, but the magnitude of the sales decline was nowhere near as large as before. We believe that this is due to the structural changes that have taken place in the semiconductor industry, and we expect the trend of softer down-cycles to be the norm going forward.
In the past, the semiconductor cycle was mainly driven by changes in personal computer (PC) demand as it was the dominant end-use market at the time. Today, the widespread proliferation of semiconductors in modern electronics has created a multitude of end-use products, minimising the impact of PC demand changes on the semiconductor cycle. As the number of end-use products continues to grow, the overall demand for semiconductors should become more stable, resulting in milder down-cycles.
Reasons behind the cyclical nature of the semiconductor industry
The semiconductor cycle is essentially driven by fluctuating sales growth numbers, which are caused by distortions to supply and demand dynamics. There are a few causes, but for the most part these distortions can be explained by over- and under-estimations in production levels.1. Industry is prone to over- and under-estimations in production
Given how dependent we are on technology and the growing number of end use products we have today, the overall demand for electronic products (and hence semiconductors) increases steadily each year under normal economic conditions. This is represented by the grey line in Figure 2, which depicts a simplified version of the inventory cycle.
Figure 2: Changes in production levels is a key reason why the semiconductor industry is cyclical in nature
On the contrary, the supply of semiconductors tends to vary a lot more. This is mainly due to adjustments in production levels by manufacturers. When times are good, manufacturers tend to overestimate demand and produce more than what the market can absorb.
Over time, the high level of production eventually becomes unsustainable as inventory starts to build, leading to an oversupply. When this happens, manufacturers lower prices and cut down on production as they work through excess inventory, causing sales growth to fall – even as demand remains relatively stable.
Similar to how manufacturers have an inclination to over-produce when times are good, they also have the tendency to under-produce when times are bad. Put simply, it is the excessive adjustments in production levels that lead to fluctuating sales growth numbers, a characteristic that defines the cyclical nature of the semiconductor industry.
NVIDIA is the perfect example to illustrate what happens when manufacturers become overly optimistic. In 2017, cryptocurrency mining was beginning to pick up steam, causing graphics processing unit (GPU) demand to surge. Anticipating that demand will continue to climb, NVIDIA rushed to ramp up on their production levels.
Unfortunately, the scenario did not play out as expected. By the second half of 2018, much of the demand for its GPUs dissipated along with interest in cryptocurrency mining. Left with a massive amount of excess inventory (Figure 3), NVIDIA is still dealing with the fallout from the cryptocurrency bust. As a result, its share price fell by more than half in the last quarter of 2018.
Figure 3: NVIDIA’s inventory levels rose significantly as demand for its GPUs slowed.
2. Actual slowdown in end-user demand
Besides the inventory cycle, another factor that contributes to the cyclicality of the semiconductor industry is the actual slowdown in end-user demand, something we do not see very often. Demand typically slows when a major economic event takes place, such as a financial crisis or a recession.
The last time an economic event of significant scale took place was during the 2008 global financial crisis, and before that, the 2001 dot-com bubble (Figure 4). On both occasions, most major economies slipped into a recession, and as a result, end-user demand collapsed and semiconductor sales plummeted more than -35%, sparking two of the most severe demand-led sell-offs in the history of semiconductors.
Figure 4: Given time semiconductor sales eventually recover to higher levels than before
Severe economic downturns, or other unforeseen events, such as the US-China trade war, can exacerbate down-cycles, leading to larger declines in sales growth, as we have seen in 2001 and 2008 (Figure 1). That said, if we set our sights only on the near-term, the industry may seem cyclical. However, in the longer-term, it is clear that semiconductor sales will eventually recover to higher levels than before over time.
Thus, it is not a question of whether a recovery will occur, but when the recovery will take place. Downturns tend to depress share prices in the short-term, presenting attractive buying opportunities for long-term investors.
Down-cycles bring about the best buying opportunities
Down-cycles in the semiconductor industry come once every few years, and when they do, they bring about attractive buying opportunities that should not be missed. Every investor wants to buy in when share prices are at their lowest, but it is virtually impossible to pinpoint the exact bottom of the cycle except in hindsight. Often, investors waiting to catch the cycle bottom end up missing out on the opportunity altogether.
Instead of guessing where the bottom is, what we can do is to identify a range of buying and selling opportunities in the cycle. In our opinion, the best time to start accumulating semiconductor stocks is during the start of down-cycles, when share prices are falling and manufacturers are cutting back on production (Figure 2). Conversely, the best time to sell semiconductor stocks is when production levels rise to unsustainable levels and optimism in the market is high.
If we adopt this set of guidelines, our potential returns are likely greater than someone who bought in during up-cycles, when valuations are a lot higher. Judging from our current position in the cycle (marked by the green star in Figure 2), we believe that now is a good time to start investing in semiconductor stocks as the upside potential outweighs the downside risks.
While the recent Huawei ban has cast a long shadow over the future of US chipmakers, we believe the long-term growth story of semiconductors remains intact. Global semiconductor sales remain well on track to hit a record high of USD 500 billion by 2020, driven by the widespread demand for semiconductors, which are essential components of all electronic devices, including future applications such as 5G and the internet of things.
The good news? Valuations of semiconductor companies are nowhere near expensive (Figure 5). The industry is currently trading at an estimated PE ratio of 12.2X based on our estimates for 2020 earnings (as of 24 Jun 2019), which is well below the 18X PE ratio that we believe is fair for the semiconductor industry. Based on current valuations, we estimate a total upside of approximately 50% by end-2020.
Figure 5: Forward earnings supports further price growth
For an industry with such favourable long-term prospects as the semiconductor industry, a recovery in sales, and hence, share prices is almost certain. We encourage investors to start investing now through the Vaneck Vectors Semiconductor ETF (NYSE.SMH) and take the opportunity to accumulate more should share prices fall further.
Patience and the ability to take a long-term perspective are two key ingredients to successful value investing. If you truly believe in the long-term growth story of the semiconductor industry, then you should be confident that this investment will turn out to be one of your biggest winners in the years ahead.
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in the abovementioned securities.
The Research Team is part of iFAST Financial Pte Ltd.