Intel Wafer

A penny on a silicon wafer. Source: Intel. 

Semiconductor devices, more commonly referred to as "semiconductors" or "chips," are an integral part of our daily lives and are essential parts of all modern computing devices, spanning the most powerful supercomputers to the sleekest smartphones.

As one of the most technologically sophisticated industries on the planet, and one of the most interesting sectors for technology investors, the semiconductor industry is worth a deeper look.

What is the semiconductor industry?

The fundamental building block of most semiconductor devices today is the chemical element silicon, which is found in common sand. Now, that's not to suggest that you can just head on over to your local beach and start your own semiconductor company, as the silicon needs to be refined. In fact, silicon needs to be 99.9999999% pure to be suitable enough to build semiconductor devices.

Generally speaking, once this silicon is refined, it's turned into a silicon ingot and sliced into individual wafers. These wafers then undergo significant processing to build chip designs onto them, generally with many chips per wafer. After those chips are built, the wafer is chopped up, freeing the individual semiconductor devices. The individual chips, or "dies," are each tested to make sure they meet specification. The percentage of good chips from a wafer is referred to as the "yield."

Intel

Silicon ingot in the Intel museum. Source: Flickr. 

The dies that pass specification then undergo what's known as "packaging and test," a process in which the dies are placed into "packages" that help keep these relatively fragile semiconductor devices from being damaged. After the chips are packaged, the finished products yet again undergo testing, and based on the results, they're rated at given speed, performance, and power levels. After that, they're ready to go. 

There are three broad classes of semiconductor products for investors to think about: 

  • Memory.
  • Logic.
  • Commodity integrated circuits.

Memory refers to products such as DRAM and NAND flash, commonly found in smartphones, PCs, servers, and more. Logic refers to products that tend to process data in a non-trivial way, such as PC processors, graphics chips, cellular baseband chips, and mobile applications processors. The last category consists of commodity integrated circuits, which, according to Investopedia, are "built in large batches for routine processing purposes."

Now, it may seem that the focus here is solely on the manufacturing part of semiconductor devices -- and, indeed, manufacturing is critical -- but the design of such devices, particularly with logic devices, is also very important. In fact, in today's semiconductor world, the companies that design logic devices, referred to as "fabless semiconductor companies," tend to be separate entities from the companies, or "foundries," that actually build these devices.

There are companies that do both, though these "integrated device manufacturers" are becoming increasingly rare, as fewer companies can sustain the kind of revenue needed to profitably operate such chip manufacturing plants.

How big is the semiconductor industry?

The semiconductor industry generated revenue of $325.6 billion during 2013, which represented 8.5% growth from 2012 levels, according to IDC. Further, according to IDC, the entire semiconductor market is expected to grow by an additional 3.6% during 2014 to reach $336 billion. Longer term, IDC expects a 3.4% compounded annual growth rate from 2013 to 2018, with 2018 semiconductor revenues hitting $384 billion.

What are the drivers of the semiconductor industry?

Semiconductors are technologies that are sold as part of a larger device. A mobile applications processor, for example, is useless unless it powers a larger device. The semiconductor industry, then, is heavily dependent on the sales of the end devices that these chips go into -- and the end devices, in turn, are dependent on the macroeconomic environment, among other things.

So in trying to determine whether a semiconductor stock could outperform or underperform the broader industry, it's important to understand the end markets a particular company is exposed to. For example, in 2013, Intel -- the largest semiconductor company by revenue -- saw its semiconductor sales drop 1% against an industry that grew 5%, since it was heavily exposed to the then-weakening PC market.

Snapdragon

Qualcomm's Snapdragon chips have led to strong financial results for the company. Source: www.talkandroid.com.

In contrast, Qualcomm -- which is heavily exposed to the booming smartphone and tablet growth megatrends -- saw its semiconductor sales grow a whopping 30.6% in 2013, handily outperforming the broader semiconductor market.

In addition to broad secular trends, the economics of the semiconductor industry, particularly in memory and logic, has been guided by a principle referred to as Moore's Law, which states that the number of transistors (that is, the building blocks of a semiconductor device) in an integrated circuit doubles every two years. The tacit assumption embedded within this "law" is that that the doubling of the transistor count can be done economically -- that is, the cost per transistor goes down with each new manufacturing technology generation.

While this has been the historical norm for countless generations, major fabless semiconductor companies have voiced concerns that the Moore's Law party is set to end beginning with the 20-nanometer manufacturing technology. If this turns out to be a long-term trend, it could fundamentally shake up the semiconductor industry, as companies will then need to be much more selective about which products should move to next-generation technologies -- significantly slowing down performance, power, and feature enhancements across all but the most bleeding-edge applications.

Cost

Source: Broadcom. 

However, from a broader perspective, the semiconductor industry is tied to the trends in the end products that these chips go into, and companies that can meaningfully and consistently participate in secular growth markets -- and there's almost always a hot new technological trend for chip companies to profit from -- will tend to do quite well over the long run.

Ashraf Eassa owns shares of Intel. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and Qualcomm. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.