ETF Teardown: The Best Chip 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 and allow investors to get in early on what they believe are tomorrow's big trends.

Investors bullish on future growth in the semiconductor sector, for example, can turn to Semiconductor HOLDRs or iShares S&P North American Technology/Semiconductors Index. But because these ETFs invest in a number of chip-related stocks, their diversity also limits your upside -- and investors may dilute stellar returns from that one amazing company in the crowd.

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 5,400 stocks rated in CAPS can be "tagged" with descriptors that group a company with others sharing certain qualities.

Selecting the Semiconductors and Semiconductor Equipment label in CAPS gives you a list of 186 companies that trade on American exchanges. This particular collection of investments has fallen in the past year, down 34.4%, essentially matching the fall in the S&P 500.

To pluck out the companies that the CAPS community picks as the best opportunities in the semiconductor sector today, we'll sort a sampling of these businesses by their CAPS star rating, 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 chip stocks I gleaned from CAPS today.

Applying patience
As the economy contracts and consumers buy fewer pricey electronic gadgets, it doesn't take long for the ripple to hit downstream providers of the electronics and the equipment that makes them. Applied Materials has seen its stock contract nearly 40% in the past six months as its customers have cut back orders to drop inventory in the face of falling demand. The company and peer KLA-Tencor have been slashing jobs to "right-size" their operations.

While some of the brightest prospects for the company last year were in supplying specialized equipment to solar wafer makers, so far this sector hasn't been able to lift Applied Materials above the negative impact of the crumbling memory and microprocessor segments, which took another big hit today when Intel (NASDAQ:INTC) again lowered its revenue forecast. But many CAPS members think that a day of reckoning is coming as a growing backlog of orders points to better times ahead for the company.

The lower valuation on the stock combined with leaner operations and pent-up demand has more investors feeling bullish lately, as 95% of the 1,550 CAPS members rating Applied Materials believe shares will outperform the S&P 500.

A phoenix in the ashes?
Being a chip supplier to the red hot cellular-phone sector in the 1990s used to be likened to owning a golden-egg-laying goose. But these days, heavy competition in high-end smartphones and the proliferation of low-margin entry-level devices for developing markets has chip suppliers like RF Micro Devices singing the penny stock blues.

Even holding real estate inside hot devices from Research In Motion (NASDAQ:RIMM) hasn't been enough to keep RF Micro from spinning lower over the last few years. But the company has been aggressive at reorganizing the business toward profitable segments and has been slashing jobs to stay afloat, giving many investors reason to believe RF Micro has the right stuff to weather the storm. In CAPS, 94% of the 469 members rating the company remain bullish on the future.

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 simply taking a recommendation. Even the best stock pickers can be horribly wrong.

Do you agree that semiconductor investments have hit bottom and are poised for a rebound? Or is there more downside to come? Give your own opinion at Motley Fool CAPS. 

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