The federal government has begun taking applications for funding under the CHIPS Act. Up for grabs: as much as $52 billion in funding, with nearly $40 billion dedicated to rekindling U.S. chip manufacturing.

As chipmakers prepare to expand existing fabs (factories that manufacture semiconductors) and build new ones, I believe fab equipment companies will be the biggest long-term winners.  My initial focus was on ASML Holding and Applied Materials -- far and away the largest fab equipment companies, and highly profitable and shareholder-friendly businesses to boot.

But my search has led me to numerous small players and specialists in this field, too. I recently started buying one of them, Onto Innovation (ONTO -6.60%). Here's why. 

Special equipment for an advanced manufacturing process

Onto Innovation's specialty is chip measurement equipment, a field known as metrology. Another fab equipment leader is KLA, Onto's biggest rival although Applied Materials also dabbles in this space.

What makes Onto special is that its metrology equipment is more squarely focused on the most advanced manufacturing processes. Chips made using ASML's extreme ultraviolet (EUV) lithography system have microscopic features less than 16 nanometers in size.

It's mind-boggling in its complexity, and Onto's machines help measure and control this process, especially at the crucial stage when a fab is beginning to ramp up production of a new manufacturing process.

In 2022, top customers like Taiwan Semiconductor Manufacturing and Samsung began building up new chipmaking at the tiny 3-nanometer scale. This was a boon for Onto, which reported its first ever $1 billion-plus revenue year.

Onto Innovation has worked its way into the complicated semiconductor supply chain, helping its customers improve their most advanced (and most profitable) chipmaking operations.

The CHIPS Act is going to help bring some of this advanced manufacturing to the U.S., and help old industry giant Intel get up to speed with EUV lithography processes, too. Onto could thus have a lot of new machines (and related services and software) to sell as a result. 

A bump in the road presents a buying opportunity

As is the case with all manufacturing companies, Onto is cyclical. Its $1 billion in revenue last year represented a 27% year-over-year increase.

But its customers primarily rely on its equipment in advance of scaling up a new manufacturing line. Now that some of that has already begun, 2023 is likely to be a down year for Onto. Management's guidance for the first quarter of 2023 is for revenue of about $200 million, down 17% from the prior year.

Nevertheless, fab equipment companies are highly efficient, and Onto is no exception. It still expects to be profitable during this upcoming down cycle -- based on GAAP net income and free cash flow. That is in stark contrast to some chip designers and manufacturers that can swing into the red during these downturns due to high fixed costs. 

Also working to Onto's benefit is a nice stream of recurring service and software revenue associated with the operation of its equipment. Software is highly profitable, and helps smooth out the lumpy results from the sale of big pieces of machinery.

Onto Innovation stock currently trades for 19 times trailing-12-month earnings per share, or about 23 times analysts' one-year forward expectations. The valuation metric is expected to deteriorate a bit because of the looming downturn in revenue.

But in the back half of 2023 and into 2024, I believe Onto will soar once more. Its equipment is crucial in advanced chipmaking, and the CHIPS Act (and similar legislation in Europe) could make this a top small growth stock over the next five years or so. I've begun buying and will continue to do so during Onto's temporary slump in 2023.