GAM Investments’ Disruptive Strategist Mark Hawtin believes a decision on whether to invest in the semiconductor market should no longer be sector based but rather industry specific.
We have previously written on the semiconductor sector and the area remains a topic of intense debate among analysts and investors. We feel it is worth re-emphasising our views. A recent report from Capital International Group described semiconductors as the ‘new oil’ without which the wheels of disruption cannot turn. We would contend that there is certainly truth in the fact semiconductors are a critical piece of the jigsaw but, like oil to the petrol engine, we believe data is the new oil and semiconductors are the new engines – not as glamorous perhaps, but the workhorse of the new economy. Such is the hype that now surrounds the sector, we have seen valuations expand to extreme levels by historic standards. As Chart 1 shows, semiconductors have steadily become more expensive over the last 10 years when measured by price to sales ratios rising from less than 2x in the global financial crisis to over 7x today. This is at a time when gross margins have, in some cases, increased by 20%. The result is a huge expansion in price to earnings ratios that in many cases we find hard to justify.
Chart 1: Price to sales multiples for the semiconductor sector
At 7x, the price to sales ratio is similar to mainstream, mature software companies. This is comparable in our minds because of the maturity and growth profiles of these companies and yet software carries significantly higher gross margins. We therefore urge caution on a blanket approach to the sector and would suggest that the world has changed in such a way that semiconductors are no longer a homogeneous vertical, but rather a horizontal segment of the market where the end use vertical is far more important in deciding the outcome for individual names. We believe a decision on whether to invest should no longer be sector based but rather industry specific.
In the automotive industry, for example, there is a clear secular growth case as the dollar content in vehicles increases with autonomous and semi-autonomous driving capability. Recent research from Arete shows that the content per light vehicle has increased from USD 310 per car in 2015 to USD 397 per car in 2019, a pedestrian 6.4% compound annual growth rate (CAGR). This is expected to accelerate over the next five years to USD 630 per car, a CAGR of almost 10%. However, neither the historic nor the forecast growth rates match the pace of growth in software, where 10-15% is considered pedestrian in today's world and rates can comfortably exceed 30%. The issue in automotive semiconductors is rather one of scarcity; capacity is scarce particularly with regards to eight inch wafer fabs and this has led to a supply / demand imbalance that has resulted in component shortages and a belief that things can only go from good to better in the sector. History shows that this is not the case and when supply / demand issues are solved, reality sets in with a reversion to the mean. It is for this reason that we find it difficult to find value in the sector overall on long-term intrinsic valuations.
This does not exclude semiconductor names entirely. Indeed, we see attractive opportunities in companies exposed to the fourth digital pillar – Digital 4.0. In particular, names exposed to 5G, the Internet of Things (IoT), data and artificial intelligence (AI) could offer compelling investment potential, but these are clearly chosen on their thematic exposure, not their sector classification.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented and are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.