Investing in Semiconductor Stocks

Semiconductor companies design and manufacture computer chips and related components. They are part of the technology sector but are also manufacturers, which means their business is cyclical like any manufacturing or commodity business.

Picking top-performing semiconductor stocks in this industry can be tricky, and their performance is highly volatile as sales volumes ebb and flow. But the semiconductor sector is growing rapidly as the world enters a digital-first era in the wake of COVID-19. In fact, the industry’s largest chip company (as measured by annual revenue) Intel (NASDAQ:INTC) said recently it sees global spending on semiconductors reaching $1 trillion per year by the end of the 2020s, roughly double where it is today.

Clearly these building blocks of technology deserve investor attention.

What trends drive semiconductor stocks?

Computer chips have many uses, but up-and-coming semiconductor companies will likely focus on two areas of growth in the decade ahead:

In the U.S. -- which accounted for almost half of the $440 billion in global semiconductor spending in 2020, according to the Semiconductor Industry Association -- semiconductor chips are now the nation’s fourth-largest export. With one-fifth of semiconductor manufacturing budgets being spent on research and development, these small hardware components are responsible for many technological advancements in other areas of the economy.

Best semiconductor stocks

Here are two of our top picks for semiconductor stocks:

Skyworks Solutions

Skyworks Solutions (NASDAQ:SWKS) is a leader in connectivity, an emerging sector that is earning the company higher-than-average profit margins. Skyworks has money to invest in research to continue developing new products, pursuing new markets, and expanding its revenue.

This company is a key Apple (NASDAQ:AAPL) supplier, having profited from the smartphone boom over the past decade. That market has matured in recent years, but Skyworks has used its connectivity chip know-how to expand into new areas such as the Internet of Things, Wi-Fi chips, and 5G networks.

Skyworks is particularly doubling down on connected devices ranging from wearable devices to “smart” household appliances to connected industrial equipment and vehicles. Skyworks also has helped lead the charge in developing 5G network equipment, and the company has been making up for slowing growth and margins in its legacy smartphone business with sales of 5G equipment.

As a result, Skyworks has avoided some of the steeper sales declines other connectivity chipmakers have experienced while positioning itself to earn higher revenue in the years to come as mobile networks evolve. The company recently acquired the network infrastructure and automotive segment of Silicon Labs (NASDAQ:SLAB) for $2.75 billion to build on its momentum here. Before the takeover, only about one-third of Skyworks’ sales came from outside of smartphones, so this move will greatly diversify the company.

Nvidia

This semiconductor chip company is the industry's leading GPU maker. Nvidia (NASDAQ:NVDA) is also earning higher-than-average profit margins and using that money to invest in research and product development, pursue new markets, and expand revenue.

Nvidia started out designing GPUs for high-end computer game graphics and has been benefiting from the expanding uses of GPUs. The company has also developed an extensive software library and cloud computing platform -- often free for customers -- to facilitate the process of applying its chips to novel uses such as artificial intelligence (AI), machine learning, and self-driving cars.

As a GPU pioneer, Nvidia has a big head start on designing semiconductors for the AI movement. Global spending on AI is expected to increase by around 20% annually and approach $110 billion by 2024, according to the technology research firm IDC. More than just a semiconductor designer, Nvidia is also developing an ever-expanding library of cloud-based subscription software and services (such as a business AI software platform) built on its powerful hardware.

Nvidia has been applying its technology not just to GPUs. It completed its acquisition of the data-center networking and connectivity company Mellanox in early 2020. Its acquisition of chip design licensor ARM Holdings from Softbank (OTC:SFTBF) was pending regulatory approval as of late 2021, and doubt has arisen over the deal going through. Nevertheless, Nvidia has already started using ARM designs to go after other parts of the modern data center -- like the release of new central processing units (CPUs) to make further inroads against legacy chip leaders such as Intel.

Best semiconductor ETFs

If you would rather not select among the stocks of individual companies in the semiconductor industry, you can gain exposure to the more gradual overall growth of the sector by investing in exchange-traded funds (ETFs).

Two top semiconductor ETFs are:

• iShares Semiconductor ETF (NASDAQ:SOXX): This ETF contains 30 chip companies, has an annual expense ratio of 0.43%, and manages more than $7.6 billion in assets.
• VanEck Vectors Semiconductor ETF (NASDAQ:SMH): This fund owns 25 stocks encompassing semiconductor chip companies from around the globe. It has an annual expense ratio of 0.35% and manages $6.5 billion in assets.

Identifying the best semiconductor stocks

When looking for the best chipmakers and long-term undervalued semiconductor stocks to buy, consider these four key factors:

1. Sustainable revenue growth

Companies that gradually increase their sales over time are the best investments, but overall revenue growth matters even more for semiconductor stocks.

Many companies in this sector struggle to cope with the industry’s cyclical nature. Hardware, such as computer chips, tends to become a commodity over time. If a new market is growing quickly, other chipmakers pile on with similar products. Supply swells, prices fall, and individual company sales decline. If a semiconductor chip company isn’t constantly innovating and finding new outlets for its hardware tech, weathering the cycle can be unsustainable.

2. Above-average profit margins

Sales need to translate to profits. Companies that cannot control their expenses have low profit margins, and companies with high profit margins have a greater ability to reinvest in research and improve their operations. High gross profit, operating profit, and free cash flow generation are also positive indicators that the company is operating efficiently.

3. Attractive returns on invested capital

A company’s return on invested capital (ROIC) indicates how well it’s able to generate profit from the cash it raises via debt and equity it receives. A high ROIC means the company is likely innovating strategically and improving operations to increase efficiency.

4. Strong balance sheet

Manufacturing tends to be expensive, so it’s especially important to understand how semiconductor companies in this area -- like the world’s largest chip manufacturer Taiwan Semiconductor Manufacturing (NYSE:TSM) -- obtain the necessary financial resources to expand. Look at a company's balance sheet and compare debt levels relative to operating profit and cash on hand. Plenty of cash relative to debt, even if the debt seems high, means that a company is well positioned to pay interest and principal payments, even in a pinch.

Should you buy semiconductor stocks?

The performance of semiconductor stocks can be unpredictable. The semiconductor industry is complicated, with hundreds of steps involved in manufacturing the most advanced circuitry and dozens of players involved in producing the equipment used to make the semiconductor chips.

Even the most promising companies in the industry can be volatile, so investing in top-performing semiconductor stocks requires a willingness to accept a degree of uncertainty. Over the long term, though, as demand for semiconductor chips continues to edge up over time, investing in these building blocks of technology will likely continue to be profitable.