Investors in semiconductor stocks have been handed one big reason to be thankful for this year: double-digit returns. As measured by the SPDR S&P Semiconductor ETF (NYSEMKT:XSD), the sector has risen over 25% in 2017.
However, in recent weeks the sector has taken a step back while the broader market has continued to churn its way higher. If not for a 10% correction, semiconductor stocks would have notched even better returns on the year. Rather than worry, though, 2018 looks like it could be another good year to invest in the industry.
Why a pullback now?
After a big run-up in share prices, the recent drop could be attributed to end-of-year profit taking by traders and investment managers. Such activity is common, especially after a strong showing for stocks like 2017 will end up being.
But some of the pullback could also be blamed on several analyst notes that are calling for a more muted 2018. Morgan Stanley in particular called out high-flying memory chip makers, saying that over-supply could cause prices to drop in the new year. Several names that focus on memory devices, like Western Digital (NASDAQ: WDC) and Taiwan Semiconductor Manufacturing (NYSE: TSM), were downgraded. The semiconductor sector as a whole started to trend down after the comments.
Tailwinds for growth
Analyst coverage may have some spooked, but not all chips are the same. The industry as a whole is diversified, with various manufacturers tending to specialize in particular areas. Memory chips are but one piece of the whole pie, as other businesses focus on microprocessors, connectivity, sensors, equipment, etc.
That means that if memory chip growth does slow, it doesn't mean the whole industry will. In fact, the Internet of Things move toward internet connection for machines is expected to keep growing, underpinning prospects for specialized makers of connectivity chips and sensors. The expectation is that will be a tailwind in 2018 for companies like Skyworks Solutions (NASDAQ:SWKS) and Cypress Semiconductor (NASDAQ:CY), both of which are benefiting from the movement to connect more things to the internet.
Another reason for optimism is continued merger and acquisition activity. Various semiconductor companies have been busy consolidating to streamline operations and to realize cost savings. That activity could continue to benefit shareholders in the year ahead if profits continue to rise as a result.
Valuations on semiconductor stocks also look fairly reasonable, even after this year's blockbuster performance. The average one-year forward price-to-earnings ratio sits at about 15, compared with 19 for the S&P 500. Reasonable prices for future growth potential could help shares rise in the year ahead.
A word of caution
All of that being said, it is important to remember that semiconductors are a cyclical business. As the building blocks of technology, small changes in supply and demand can quickly change prices, which in turn can affect the profitability of the companies that manufacture them. After a big run-up in the sector in 2017, it wouldn't be surprising if 2018 was a quieter year.
However, the long-term outlook remains positive. The world continues to evolve into one where technology and reliance on the internet plays an increasingly important part in our lives. That megatrend bodes well for aforementioned chipmakers Skyworks Solutions and Cypress Semiconductor. Skyworks' wireless connection chips enable a broad range of devices from smartphones to airplanes to get hooked up to the internet. Cypress' portfolio consists of microcontrollers, connectivity chips, memory, and software and has made considerable headway in the connected automobile industry.
Even though their product lines are specialized, companies like Skyworks and Cypress can also go through cyclical fits and starts. As a general rule of thumb, when I've chosen a company I want to own long term, I use stock downturns due to supply and demand issues to buy more shares.
That's why I am not too worried about the recent pullback in the semiconductor industry. With plenty of growth runway left in the world of technology, 2018 looks like a good year to add semiconductor stocks to portfolios.
Nicholas Rossolillo owns shares of Cypress Semiconductor. The Motley Fool owns shares of and recommends Skyworks Solutions. The Motley Fool has the following options: short January 2018 $105 calls on Skyworks Solutions. The Motley Fool recommends Cypress Semiconductor. The Motley Fool has a disclosure policy.