September has been a rough month for stocks in general and technology stocks in particular. The Nasdaq composite index, which is largely made up of technology stocks, has crashed into correction territory and is currently about 17% below its August highs.
Yet the digital revolution is very real, with the pandemic only accelerating big tech trends around cloud computing, AI, and 5G that will shape the next decade. As such, the recent pullback could be an opportunity for long-term investors to buy the best-positioned tech stocks for these multiple growth industries.
In September, two all-star tech stocks that play big parts in that tech revolution got hit particularly hard due to fears over China. However, I think these specific concerns seem widely overblown, so I flipped over the couch cushions to buy up as much of these two stocks as I could.
Lam Research and Applied Materials are just too cheap
While Fool trading rules prevented me from writing until now and both stocks have partially bounced back, I was a consistent buyer of semicap equipment makers Lam Research (LRCX -0.88%) and Applied Materials (AMAT -3.82%) throughout the month, and I still believe they're great values today. Both Lam and Applied make etch and deposition machines, as well as some metrology machines in the semiconductor manufacturing process.
On the positive side for Lam and Applied, their technology is extremely difficult to replicate, and the industry has consolidated around just a handful of players, to the point where there are only one or two machine options for each step in the semiconductor manufacturing process. And as long as smaller, more powerful, and more customized semiconductors are being made, semiconductor manufacturers will have to buy these machines.
Both companies also sell services to their customers, including spare parts, refurbishments, and other maintenance services that help their customers boost their yields. These services, which make up one quarter to one-third of revenue, are mostly recurring, and based on an installed base that grows every year, no matter if that particular year's market for machines is strong or weak.
Fortunately, it looks as if the semicap equipment market is still quite strong. Both Lam and Applied absolutely crushed revenue and earnings estimates in their June quarters, growing their top lines 18.2% and 23.2%, respectively, and offering extremely strong guidance for the second half of the year and into 2021.
Despite the pandemic, it appears digitization trends and upcoming 5G, AI, and other chip-heavy applications remains as strong as it was before COVID-19.
Then came SMIC
However, in the face of all these positives, both Lam and Applied's stock got hit hard in the early part of September, when reports surfaced that the U.S. government was considering ban on U.S. equipment sales to Semiconductor Manufacturing International Corp. (SMIC.Y), or SMIC. SMIC is China's largest foundry and has received state support for two decades in an effort to build up China's domestic semiconductor industry.
SMIC is also a big customer of both Lam Research and Applied Materials, and China as a whole accounted for one third of both companies' sales last quarter. So in response to the potential sanctions, Applied Materials fell by as much as 15% and Lam Research fell by as much as 20% in the early part of the month.
Why I scooped these two gems up
After their declines, both Lam and Applied Materials fell to valuations rarely seen in the high-flying tech sector. After their recent partial recovery, Lam Research trades at 21.5 times earnings and Applied Materials trades at just 16.5 times earnings. However, we know that those earnings bases will increase in the back half of the year, and likely into next year. Based on 2021 projected earnings, Lam and Applied trade at a value stock price of just 15.0 and 12.7 times 2021 projected earnings, respectively. Lam's fiscal 2021 ends in June 2021, and Applied Materials' fiscal 2021 ends in September 2021.
While the potential for a SMIC ban isn't good news in the near term, it's important to remember that the semiconductor industry is a global industry. If demand for advanced chips is there, that demand should be filled by other semiconductor foundries outside of China, should SMIC be cut off from machines. In a recent investor conference held just after the news of a possible SMIC ban, Lam Research CEO Doug Bettinger said:
[W]hat I've been reminding people of this week, given all the headlines from last week is don't lose sight of the following item that everything we're talking about relative to investment in China is generating supply, not generating end demand. End demand for semiconductors at the end of the day is really what drives the industry. And if for one reason or another supply doesn't occur in one geography, it'll occur in another geography.
Fortunately, the advent of 5G , AI applications, and the Internet of Things all spell positive things for chip demand for the next decade. Over the long term, whoever makes the chips that power these applications will need Lam and Applied's machines. That's why interested investors should take the near-term dips over trade worries in stride and load up on shares when these wide-moat stocks go on sale.