Taiwan Semiconductor Manufacturing (TSM 1.19%) is a controversial stock from certain points of view. The Taiwan-based foundry produces nearly all of the world's most advanced chips. Still, most of its production takes place in Taiwan. Because that island is in the middle of a geopolitical battle between the U.S. and China, many investors, including Warren Buffett, are leery of holding a direct stake in the company.
Given the need for TSMC's chips in both the U.S. and China, the likelihood of tensions resulting in an invasion of Taiwan is low. Nonetheless, escaping that reality is not as easy as some chip stock investors might imagine. For this reason, semiconductor investors should not only acknowledge their ties to the company but also consider a strategy that mitigates that risk.
Investor ties to TSMC
Most chip stock investors invest in TSMC directly due to its industry role. The company manufactures the most advanced chips for most of the most prominent chip companies. This includes Apple, Nvidia, Advanced Micro Devices, Qualcomm, and Intel, which had to turn to TSMC despite its own extensive foundry capacity.
More importantly, a point that receives little attention is that this relationship means TSMC's risks are the risks of its clients. Many investors refuse to own TSMC because of its geopolitical concerns. Still, investors typically do not tie this risk to the Apples and the Nvidias of the world.
That lack of association does not change the fact that most of these advanced chips are almost certainly made in Taiwan. Thus, if that long-feared invasion took place, all of those companies would have no options (or at least dramatically reduced options) for finding another manufacturer capable of turning their designs into chips, implicitly tying them to Taiwan's geopolitical situation.
Worse, due to the aforementioned lack of association, chip design stocks typically trade at a massive premium. This means they could see a higher percentage decline should the geopolitical situation deteriorate.
TSM PE Ratio data by YCharts
Should investors buy TSMC instead?
Despite that fact, the case for owning TSMC instead of the chip design stocks is not clear. Admittedly, it appears it would take a Chinese invasion of Taiwan to derail TSMC's dominance. Also, despite companies like Samsung and Intel making investments in the most advanced equipment, there is no evidence that these companies will surpass TSMC's technical lead anytime soon.
This strength also applies to TSMC's financials. In the first half of the year, revenue of $40 billion increased 28% from a year ago. Moreover, expense growth lagged the revenue growth rate, allowing comprehensive income for the same period to rise to $17 billion, up 35% compared with year-ago levels. Also, among chip stocks, it has outperformed some of its largest customers over the last five years.
Still, that might add to some of the valuation risk that affects its customers. TSMC's price-to-earnings ratio now stands at 30. While that is far below companies like Nvidia and AMD, it is above its five-year average P/E ratio of 24, indicating TSMC has become an expensive stock. So, while the P/E ratio does not have as far to fall in a crisis, the drop could still be considerable.
Investing in TSMC and other semiconductor stocks going forward
Regardless of the investment case of any stock, the premium valuation of some of TSMC's customers shows a level of dissonance between the risks of TSMC and those of its customers. If awareness of this issue increases, it could cause investors to demand a discounted valuation.
However, placing all of one's industry investments in TSMC probably will not adequately address this situation. Indeed, investors will buy a higher-quality company at a lower valuation if buying TSMC. Nonetheless, it has always traded at a discount to its chip customers, so despite a 30 P/E ratio, the fact that the earnings multiple is above long-term averages should dissuade investors from buying at this time.
Ultimately, chip stock investors should acknowledge their ties to TSMC. But rather than exiting their chip stocks or simply placing all industry investments in TSMC, they should probably address geopolitical risks by holding out for discounted valuations in TSMC stock and that of the foundry's customers.
