Investing in Semiconductor Stocks

Semiconductor companies design and/or manufacture computer chips and related components. They are part of the technology sector, but are also manufacturers, which means their business is cyclical, as business is for companies in any manufacturing or commodity industry. Picking stocks in this industry can be tricky, and investing in them highly volatile, as sales ebb and flow.

What trends drive semiconductor stocks?

Computer chips have many uses, but in the decade ahead, semiconductor stocks will likely focus on two areas of growth:

In the U.S. -- which accounted for nearly half of the $420 billion in global semiconductor spending in 2020, according to the Semiconductor Industry Association -- chips have grown to become the nation’s fourth-largest export. With one-fifth of semiconductor makers’ budgets being spent on research and development, these small hardware components are responsible for many technological advancements in other areas of the economy.

What are the best semiconductor stocks?

These two companies are two of of the industry's most promising investments, as leaders in connectivity and GPUs, respectively, and the emerging markets they’ve focused on have meant higher-than-average profit margins. That means they’ve had money to invest in research to continue developing new products, pursuing new markets, and growing their revenue.

• Skyworks Solutions (NASDAQ:SWKS) – This standout in connectivity is a key Apple (NASDAQ:AAPL) supplier, having ridden the smartphone boom over the last decade. That market has matured in recent years, but Skyworks has used its connectivity chip know-how to expand into new areas like the Internet of Things and 5G networks.
  
  As a result, it has avoided some of the steeper falloff in sales that other connectivity chipmakers have experienced while setting itself up for higher revenue in the years to come as mobile networks evolve. What started with the smartphone boom has morphed into connected things -- from wearable devices to household appliances to industrial equipment.
  
  Skyworks also helped lead the charge in developing 5G network equipment, and it has been replacing lower sales and increasingly commoditized hardware from its legacy smartphone business with newer 5G equipment.
  
• NVIDIA (NASDAQ:NVDA) – A company that started out designing GPUs for high-end computer game graphics that has been pushing the boundaries of the GPU into new markets. The company has also developed an extensive software library -- often free to use for its customers -- to help smooth out the process of applying its chips to novel use cases such as self-driving cars and artificial intelligence.
  
  As a GPU pioneer, NVIDIA has a big head start designing semiconductors for the AI industry -- spending on which is expected to increase some 20% a year and approach $110 billion by 2024, according to tech researcher IDC.
  
  NVIDIA has been expanding its technology beyond GPUs as well. It completed its acquisition of data-center networking and connectivity hardware company Mellanox in early 2020, and its $40 billion acquisition of chip design licensor ARM Holdings from Softbank (OTC:SFTBF) was pending regulatory approval in late 2020. These two acquisitions will broadly expand NVIDIA’s presence in data centers, and the ARM acquisition could grant NVIDIA new access to the mobile chip industry.

How can I find good semiconductor stocks on my own?

When looking for the best semiconductor stocks to invest in, consider four key areas.

1. Sustainable revenue growth

Investors generally prefer companies that can grow sales over time, but revenue growth matters even more for semiconductor stocks.

Many companies in this sector struggle to break out of the industry’s up-and-down cycles. Hardware, such as computer chips, tends to get commoditized over time. If one new market is growing quickly, other firms pile in with similar products; supply swells, prices fall, and sales shrink. If a company isn’t constantly innovating and finding new outlets for its sales, the cycle could wind up being a roller-coaster ride ending nowhere.

2. Higher-than-average profit margins

Sales don’t help much if a company can’t hold on to that cash on the bottom line. Think of profit margins as a net a company uses when hunting dollars. The higher the margins, the smaller the holes in the net, and the more dollars a company holds on to.

Investing in semiconductor businesses with tightly woven nets is important. The more dollars a company holds on to, the greater its ability to reinvest in research and improving its operations to ensure that its nets don’t spring any large holes.

So look at a semiconductor company’s gross profit (its revenue minus the cost of producing its products) and operating profit (gross profit minus other fixed and variable expenses like staff, research and development, and corporate overhead). The higher the gross and operating profit margins, the better, especially relative to a company’s closest peers.

3. Solid returns on invested capital

A company’s returns on its investments can show you how well it’s able to innovate and continuously capture more dollars over time. Look at a semiconductor company’s return on invested capital. Higher returns mean the company’s better at innovating in the right places and improving operations to increase efficiency and the bottom line.

4. Strong balance sheets

Finally, manufacturing tends to be expensive, so it’s important to note how semiconductor businesses have been using their resources to expand. Check how much cash and debt a semiconductor company has on its balance sheet. While debt alone isn’t a red flag, high debt relative to operating profit and cash on hand can be. On the other hand, plenty of cash relative to debt means a company has lots of wiggle room to invest or make acquisitions.

Finding the best semiconductor stocks for the long term

Investing in semiconductor stocks, even those with the best prospects, can be a volatile journey. Investors would do best to buy during sales cycle slumps and reassess a company’s performance relative to peers during boom periods. Over the long term, though, these building blocks of technology will be profitable in spite of the ups and downs.