Investing in Semiconductors

Investing in Semiconductors

We have been manufacturing semiconductors since the 1970s, and ever since their invention, our lives have been forever changed. As we are coming to the end of the global COVID pandemic, we are finding out the after-effects of the shift towards remote working. The sudden increase in the demand for consumer electronics has caused the price of semiconductors to skyrocket to unprecedented levels, thus pushing the revenues to record highs.

This guide is a bootstrapping lesson for fellow honey badgers who are interested in learning the following:

  • What are semiconductors?
  • Who are the major players in the semiconductors manufacturing space?
  • How can we invest in semiconductors, and when is the next opportunity?

What are semiconductors?

A semiconductor is a material that can conduct electricity only under certain conditions. Hence the prefix "semi". This characteristic makes the material an excellent medium for controlling the flow of the electrical current and suitable material for manufacturing chips used in electronics.

Types of semiconductor products?

  • Memory chips, commonly referred to as Random-access memory (RAM), store data and programs on computers and other modern electronic devices. The current biggest manufacturers are:
    - Samsung
    - SK Hynix
    - Micron Group
  • Microprocessors contain one or more central processing units (CPUs). Computer servers, PCs, tablets, and smartphones may have multiple CPUs. The current biggest manufacturers are:
    - AMD
    - Intel
    - Nvidia
  • Technically a type of microprocessor, Graphics Processing Unit (GPU) is capable of rendering graphics for display on an electronic device. The current biggest manufacturers are:
    - Nvidia
    - AMD
    - Asus
  • Commodity integrated circuits (CICs) are simple chips used for performing repetitive processing routines. For example, vending machines, calculators, barcode scanners, etc. The current biggest manufacturer is:
    - Taiwan Semiconductor Manufacturing Co. (TSMC). Many of the manufacturers mentioned above are clients of TSMC, which makes TSMC the lower semiconductor supplier that everyone depends on. TSMC produces and provides the primitive chips that are the building blocks for the higher level manufacturers put together to make their specialised chips.

Semiconductors as new-age commodities

The conventional definition of a commodity is an economic good, usually a resource, with whole or substantial fungibility. The market treats instances of the good as equivalent or nearly so with no regard to who produced each unit. While semiconductors, i.e. the small chips, are not precisely raw materials, they do fit this definition quite well, and it is a commodity business at heart. For example, the semiconductors industry shares the same characteristics as oil.

Enormous capital expenditures resulting in large supplies

The state-of-the-art semiconductor factories are one of the most expensive to build across all the industries, and it could easily be ten times more costly than an off-shore drilling oil rig. Due to its outrageously high cost, these factories only make sense to utilise the economies of scale to produce chips at their total capacity. The marginal cost to manufacture the chips at 80% capacity vs 100% is minimal.

Drastic price cycles due to supply and demand

Like other commodities, semiconductors also have price cycles caused by distortions in supply and demand dynamics. With the high cost of manufacturing and the mandate to produce in huge batches, manufacturers need to estimate and adjust their production levels constantly. To add to this complexity, each generation of chips have a relatively short life and become obsolete when new and faster applications are developed like the latest smartphone models.

When high demand and times are good, manufacturers overestimate demand and produce more than the market can absorb. Over time, the increased production level becomes unsustainable as inventory builds, leading to an oversupply. When this happens, manufacturers lower prices and cut down on production as they work through excess inventory, causing sales growth to fall - even as demand remains relatively stable.

Should you invest in semiconductors?

After establishing the passive income portfolio, I believe that all honey badgers should look to invest in semiconductors as part of their riskier growth portfolio. The first chart of this article above shows that global semiconductor revenues continue to grow despite their short-term cycles. This is obvious if you consider the ever-growing consumer and industrial electronics demands.

The highly volatile prices of the semiconductors directly impact the manufacturer's revenues, affecting the stock prices. The volatility of these stocks is so high that it almost resembles that of Bitcoin rather than a company stock. Since most retail investors invest in cryptocurrencies because of their high volatility to get rich quick, I almost always recommend volatile stocks. This is because the stock markets are highly regulated and transparent, you can learn enough about the industry to make sound investment decisions.

What should you buy and hold long-term?

Simply put, buy a semiconductors ETF like the VanEck Semiconductor ETF. For retail investors like us, I always recommend purchasing the thematic ETFs over individual stocks for the following reasons.

  • ETFs significantly reduce risk and volatility with diversification.
  • Most importantly, your research and decision making should stop at the decision to invest in a specific industry. Beyond this point, you should let the ETF maintainers do the continuous ongoing research and balancing of the underlying stocks.

When should you get in?

At the time of this writing, which is the beginning of 2022, we just came off the COVID pandemic crisis that drove the demands for semiconductors to record highs. A significant shortage of semiconductors has caused even car manufacturers to halt their production, becoming very severe. Big corporations and even the governments are taking actions to reduce the dependencies on a few Asian suppliers that have become the bottleneck. There will be an unprecedented amount of efforts to meet the overshot demands in the next couple of years. In other words, we haven't yet hit the highest peak of the cyclical price cycle and now is probably not the time to buy.

I will be sure to pay close attention to the progress made on the supply side in the coming years and post the updates in the blogs. Starting from 2023, depending on this progress, it would be ideal to start taking some profits from other existing investments to accumulate some cash reserves. Eventually, the prices of the semiconductors will begin to drop, the companies will start to report the declined revenues, and their stock prices will have some corrections. That is when we should be buying the ETF to hold for the next 5-10 years.

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