Since February, semiconductor stocks have been getting cheaper relative to the rest of the market and that could be an opportunity for long term investors. Price action in the sector has lately been choppy as investors weigh the upward momentum of an ongoing chip shortage against a potential surge in production capacity going into next year.

Earlier this month, for example, leading chip-maker Micron Technology, Inc. plunged 15 per cent over a five-day period on concerns about falling DRAM prices. DRAM’s, or dynamic random access memory chips are considered a commodity product where prices are largely governed by supply and demand factors. Meanwhile, industry bell weather Texas Instruments fell sharply on the day of its last earnings release in late July. The company posted a solid 41 per cent increase in revenue and beat bottom line earnings expectations, but the chipmaker’s third quarter forecast did not live up to some analysts’ expectations.

However, not all reactions have been negative. Innovative chip designer, Advanced Micro Devices (AMD) recently soared to record highs on second-quarter results which solidly beat estimates while offering a robust forward-looking revenue outlook. Revenue was $3.85 billion versus $3.62 billion expected, up 99 per cent year-over-year and up 12 per cent sequentially from Q1.

Demand for semiconductors continues to rise on both a cyclical and secular basis with industry research sources forecasting higher worldwide volumes. World Semiconductor Trade Statistics (WSTS) recently predicted 19.7 per cent semiconductor market growth in 2021, up from 6.8 per cent last year. Similarly, the Semiconductor Industry Association (SIA) said global chip sales increased by 26.2 per cent last May on a year-over-year basis. WSTS sees the market for integrated circuits (IC’s) to exceeding $500 billion for the first time ever.

While demand has been steadily rising, supply constraints and production bottlenecks are keeping prices elevated, at least until additional capacity can come on-line. In fact, the worldwide chip shortage has been affecting many other industries which rely on this key component. Automobile production has been severely depressed due to a shortage of semiconductors. Last week, Toyota Motor Corporation slashed its projected production by 60,000 to 90,000 vehicles largely due to supply chain constraints, including semiconductors shortages.

As long as global demand remains robust, the net near term results will likely to be positive on both the top and bottom lines of most companies, but innovative designers will be the most resilient to price fluctuations and these companies are being rewarded with the highest valuations.

On a secular basis, the nascent rollout of 5G wireless platforms by the world’s largest carriers will be a significant tailwind. 5G is the fifth generation of wireless networking technology and offers lower latency (the time between an input or request for data and the network’s response) together with download speeds up to one hundred times faster than 4G.

Apple Inc.’s typical fall product launch is fast approaching and one of the new iPhone’s big changes is the adoption of 5G technology. Well positioned semiconductors in this space include Qualcomm, Skyworks Solutions and Advanced Micro Devices. Apple also intends to make its own chips.

A potential industry headwind is semiconductor nationalism, or the increasing politicization of the subsector. Clearly, the ongoing US-China trade war adds an additional element of uncertainty into the equation. Once hoped for cooperation appears to be out the window, even within the context of America’s new political regime.

In recent months, China’s increasingly aggressive actions against foreign investors and their own capital markets has not helped matters. For example, leading chip fabrication tool maker, Applied Materials (AMAT) has been restricted from shipping tools to certain customers, such as domestic Chinese foundry SMIC. Likewise, China’s flagship telecommunication equipment supplier, Huawei was banned last year from buying US semiconductors due to national security concerns.

The high variance in price action between key players highlights the importance of innovation. The most innovative chip designers, AMD and Nvidia have seen improving relative strength, with their stock prices rising 429 per cent and 242 per cent respectively over the past three years, easily outpacing the 64 per cent gain in the broader S&P 500 stock index. Over the same time period, industry laggard, Intel Corporation gained just 19 per cent despite being America’s second largest semiconductor company and possessing one of the largest research and development budgets in the sector.

In terms of the commodity chipmakers, hope remains for broader strength over the complete market cycle. Companies leveraged to commoditized memory chips, such as Micron have been under pressure this summer, but some analysts see a shorter cycle with less bumps than in the past. According to Citigroup analyst, Peter Lee “with the bear-camp projecting memory downcycle in (the second half of 2021 and 2022). Contrary to the market concerns, we expect memory recovery will begin from second quarter 2022 due to a shorter memory cycle, limited availability of additional cleanroom space, and hyperscalers’ inventory depletion.”

Regardless of how we got to the current chip shortage, the longer-term opportunity is clear. Semiconductors reside at the heart of almost all present and future technology, representing the highest value-added component in many cases. Winner and losers will rise and fall with innovation but the sector as whole is well positioned for further growth.

Bryan Dooley, CFA is Head of Portfolio Management at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.