ETF Teardown: The Best Semiconductor Stocks

Noted for their simplicity and other advantages over mutual funds, exchange-traded funds have become a popular investing tool. ETFs hold a collection of stocks that share certain elements. Investors bullish on future growth in the semiconductor sector, for example, can turn to Semiconductor HOLDRs or iShares S&P GSTI Semiconductor. But because these ETFs invest in a number of stocks, their broad diversity also limits your upside.

Fear not, Fool -- in this edition of "ETF Teardown," we'll use some nifty tools to drill into the best investments in the semiconductor sector. To help, we'll use Motley Fool CAPS, our tool for screening and ranking stocks and stock pickers.

The power of tags
To help investors quickly locate great stocks, the 5,700 stocks rated in CAPS can be "tagged" with descriptors that group the company with others sharing certain qualities -- "Battery Technology," for example, or "Minerals."

Selecting the Semiconductor -- Specialized label in CAPS gives you a list of 43 companies that trade on American exchanges. This particular collection of investments has easily outrun the general market in the past year, up 15%, while the S&P 500 has dipped by 8%.

To gauge which companies the CAPS community thinks offer the best opportunities in the semiconductor space today, we'll sort a sampling of these businesses by their CAPS star rank, from one to the maximum five stars. We'll then examine a few companies to see who -- from Wall Street to Main Street -- is bullish or bearish on the business, and why.

Getting down to the nitty-gritty
Here are some specialized semiconductor stocks I've gleaned from CAPS today.

Renewed energy
As demand for alternative fuels ignite, IXYS' business lines that cater to alternative energy products are helping shelter it from the economic strife hitting other semiconductor makers. In addition to providing products to networking firms like Cisco (NASDAQ:CSCO), the company produces chips and circuits used in products that make renewable energy, like solar and windmill systems.

In its most recent quarter, increased sales of high-margin products to alternative energy markets helped quadruple IXYS' profits -- the company earned $0.32 per share this time, compared to only $0.07 per share in last year's fiscal fourth-quarter results. With the stock soaring and the company's backlog growing, IXYS plans to continue plowing money into R&D activities in an effort to meet the increasing demand for renewable energy.

With everyone facing record-high fuel prices at the pump, CAPS investors appreciate the potential of renewable energy and IXYS' ability to provide the tools that make it work. No wonder, then, that 175 out of the 185 CAPS investors rating the company expect it to outperform the S&P in the future.

Semi-flexible
For the past few decades, two companies have carved out an effective duopoly of the programmable logic space -- Silicon Valley neighbors Xilinx and Altera. While other companies play in the same space, these two dominate the market for highly integrated and specialized chips that allow designers immense flexibility in configuring electronic functions in a product. And copious cash flow has helped each stock absolutely obliterate the market's average gain since the early 1990s.

With the market growing more competitive by the day, Xilinx seeks to reach its targeted model of 30% operating margins through attrition, announcing recently that it will cut its total workforce by 7%, or approximately 250 jobs. The 30% target is a high bar even for Altera, but with a maturing market and intense competition, investors view any move toward more efficiency as a positive.

Additionally, shares of both Xilinx and Altera were boosted when Altera guided analysts and investors toward the higher end of its second-quarter revenue forecast. Altera noted that it is benefiting from increased sales to communication equipment manufacturers, a trend that will likely continue for years as operators in developing nations -- like China's China Mobile (NYSE:CHL) -- spend billions on new equipment.

With lots of opportunity still ahead, many CAPS investors still view both companies favorably. While there are some detractors, almost 90% of the 230 investors ranking Xilinx are bullish, while 91% of the 162 rating Altera think it will beat the market going forward.

Lead a horse to water ...
Plucking individual stocks from the semiconductor sector is, of course, a high-risk endeavor. Investors should always perform their own due diligence on companies rather than take a recommendation. Even the best stock pickers can be horribly wrong.

Do you agree that alternative energy-focus chip plays are the place to invest today? Or are tried and true programmable logic players a better call? Give your own opinion at Motley Fool CAPS.