Investors may be reading dire headlines about a "severe chip shortage" causing lost sales for many large companies, from Apple (AAPL 0.86%), which said shortages would cause a sales shortfall next quarter of $3 billion to $4 billion, to global automakers, which advisory firm Alix Partners predicts will lose $61 billion in sales because of the chip shortage this year.

The current supply-demand imbalance in semiconductors currently presents investors with risks, but also opportunities. Here are five key things to keep in mind when navigating the chip shortage in 2021.

Animation of woman holding up a huge processor and hands with money coming from off camera towards her.

The semiconductor shortage is producing some risks but also opportunities. Image source: Getty Images.

No. 1: Understand how this is similar to, and different, from prior shortages

Coming out of the pandemic, a confluence of three powerful factors is causing a boom in semiconductor demand and a global shortage of chips. Two of these factors affect all chip companies, while a third affects semiconductor equipment manufacturers (in a positive way) in particular.

First, there is a cyclical upturn coming out of the pandemic, which itself came on the heels of the downturn sparked by the U.S.-China trade war. The trade war led to an industrial recession, but just when the economy was coming out of that, the unpredictability of the pandemic led to severe cutbacks in purchasing or supply additions for an even longer period. Now that the economy is roaring back, especially for tech products, demand is far exceeding supply.

Semiconductor manufacturing isn't easy, requiring large amounts of capital and technical expertise, so many companies can't exactly "turn on" supply to meet demand. That means there is a lag, with supply undershooting demand for a period. Basically, a typical cyclical upturn.

Turbocharging demand this time around, however, is a second factor: the accelerated digitization of the economy resulting from the pandemic. With people unable to travel or meet, companies relied more than ever on new tools, leading to a step-change in demand for the chips that power cloud computing, artificial intelligence, 5G smartphones, laptops, and the Internet of Things. Thanks to a government and Federal Reserve stimulus, demand is even there for things like autos, which become more chip-heavy with each passing generation. It's likely the pandemic pulled forward chip demand by a few years.

A third unique factor is a concerted effort to bring leading-edge manufacturing back to developed countries, like the U.S. and Eurozone. Chipmaking has become incredibly concentrated in Asia, but with the pandemic and the threat of China, developed countries now want to assure there is some production on their own shores.

That's leading to extra investments in semiconductor fabs over the next few years, some now subsidized by governments, leading to increased demand for semiconductor equipment -- and that's on top of the other two powerful factors.

Outline of automobile in the center of a processor with electrical signals emanating.

Image source: Getty Images.

No. 2: Realize the winners and losers 

Obviously, the losers of the chip shortage are companies that need to purchase lots of chips but can't easily raise prices. A shortage may lead chip users to realize fewer sales, and/or pay higher prices for components. Either way, chip buyers' profits will suffer beyond what they normally would.

Companies that can raise prices to compensate for lost sales may mitigate the effect, and many companies are. However, some chipmakers and original equipment manufacturers are holding off for now, either to keep up good customer relations through this difficult time, or because of competition. It depends on a company's competitive advantage.  

The biggest winners are likely to be the most commodity-like chipmakers, such as memory producers Western Digital (WDC -2.50%), a producer of hard disks and NAND flash, which is generally a price-taker. With supply undershooting demand, prices for components like NAND flash or DRAM memory are rising fast, allowing these extremely cyclical companies reap huge benefits from increased memory pricing.

Thanks to increased NAND flash prices, Western Digital just beat earnings expectations by 632% on its recent earnings report last week. For its upcoming quarter, management anticipates adjusted EPS between $1.30 and $1.60 per share. Likely, earnings will increase from there through 2021. For reference, Western Digital just made $3.04 in adjusted EPS for its entire fiscal 2020 year.

Another big winner is the semiconductor equipment segment. Obviously, a shortage of chips will benefit the companies that make machines that produce chips, right? In a boon for investors, much of that sector has consolidated to just a handful of major players, and the resulting semiconductor equipment leaders such as ASML Holdings (ASML -3.06%) are showing booming profits.

Basically, the less attractive and more volatile businesses like memory stand to outperform more than, say, a more consistent performer that requires the purchasing of components, such as Apple or software stocks. However, everything tech-related, even Apple, should post good results, as it's the demand for their products that are driving chip sales in the first place.

It's just that those primed to benefit the most are those cyclical companies involved in components like chips, memory, and storage, which are more volatile. Since these companies are generally much, much cheaper than, say, steadier and subscription-based SaaS stocks, they stand to benefit the most during this period.

Overaly of letters AI over picture of hands on a smartphone before a laptop.

Image source: Getty Images.

No. 3: But before you dive into semis, be cautious

Even though there seems to be nothing but good news on the horizon for memory, storage, logic chips, and semiconductor equipment, investors should realize the risks.

First, the market tends to discount the future to some degree, so at least some of the good news has already been priced into these stocks, which are up handsomely on the year and a lot since before the election.

In addition, just as chip stocks can boom, they can also bust. Shortages tend to lead to big investments in capacity, which can easily lead to over-capacity. It was not very long ago -- mid-2018 -- when the trade war interrupted a big supply expansion after the boom of 2017. With the onset of tariffs and interest rate hikes, demand froze, and all of that capacity brought on during good times had no place to go. Prices crashed, and the sector went into recession.

Could that happen this time? It's possible. So, how can investors identify a potential bust?

One key element to look at is the capital expenditures of major semiconductor companies. Those companies are spending to increase their capacity right now, which seems prudent, but it's possible they can overshoot. If capital-expenditure increases accelerate or rise for a sustained period of time beyond this year, it might be reason for caution.

Hand with a chip coming down and five hands reaching up grabbing at the single chip.

Image source: Getty Images.

No. 4: Could this time be different?

Many red-hot semiconductor stocks have plateaued over the past month or so, so it appears investors are highly uncertain as to whether this boom will run out of steam a year from now. However, semiconductor stocks are still much cheaper than SaaS companies, even after their recent run.

And remember, there are two extremely bullish factors going on here -- a cyclical rebound, as well as a secular step-change in the digitization of the economy. Remember, extreme ultraviolet lithography (EUV), the technology that enables today's leading chips, was only commercialized in 2018-2019. That breakthrough could usher in a data explosion and new golden age for chips in the 2020s, as AI and 5G take hold.  

If the second secular factor is strong enough, it could propel the current upcycle for longer than anticipated. And remember, even semi equipment that could expand chip supply is in a shortage, too. If that's the case, then more cyclical semiconductor stocks could still be underpriced, despite their recent run.

No. 5: In the long term, semiconductors should do well

Investing in the volatile semiconductor sector isn't for the faint of heart, but over the long term, the sector has outperformed the market, as the world has come to depend more and more on data and technology. I wouldn't expect that dynamic to change any time soon. 

SMH 10 Year Total Returns (Daily) Chart

The current global shortage is just the latest upturn, but over the long-term, leading high-quality semiconductor stocks should do well, as long as you can stomach the ups and downs of this volatile sector. So while Wall Street obsesses over where we are in the cycle, long-term investors shouldn't be afraid to invest in the best semiconductor companies, even during a boom.