This Industry Is Growing Three Times Faster than the S&P 500
There’s a theory in the tech world called “Moore’s Law,” named after Intel’s cofounder, Gordon Moore. The hypothesis is this:
The number of transistors per square inch on integrated circuits doubles every two years.
This law has become a de facto forecast for rapid technology growth. It suggests that smartphones, computers, and electronics will double their speed and capacity every other year.
But for a second, let’s take Moore’s Law literally. Let’s look only at microchips, circuit boards, and semiconductors.
Before your eyes glaze over, consider this: Semiconductor stocks grew by 48% last year. That’s almost double the tech industry average of 25%. And almost triple the S&P 500 average, which grew 18%. In fact, the best-performing company in the S&P 500 last year was a semiconductor company, Nvidia, which grew 238%.
This is a quietly booming industry. It is the backbone of all future technology, be it consumer electronics, self-driving cars, or artificial intelligence.
Question is will last year’s phenomenal growth continue?
The “Silicon” in Silicon Valley
In its simplest terms, a semiconductor is an electrical component. Combined together, they form a microchip processor that powers a computer.
Semiconductors are the brains behind every electronic device. Which means the potential applications are endless. They’re made of silicon – hence the nickname “Silicon Valley” – and we’ve reached a point where we can fit tens of millions of transistors on a single chip.
The industry is mostly dominated by established giants. Only large companies like Intel, Toshiba, Samsung, and NEC are capable of producing huge volumes at low prices. When it comes to basic circuits and chips, smaller companies can’t compete.
But there’s a change brewing. Specialist enterprises are breaking into the arena. Like Nvidia, which specializes in graphics chips. Or Coherent, which focuses on medical instruments.
These are called “system on a chip” companies. Their expertise is not in manufacture, but in innovation. In fact, these new companies tend to outsource production and double down on research and development.
This streamlining and innovation is part of what’s behind the sector’s fantastic growth.
What’s Driving the Industry?
First, the increase in semiconductor performance. Following Moore’s law, these devices are becoming faster, smaller, and cheaper. And the changes are so rapid, prices can fall 50% in a just a few months.
It means competition is fierce among semiconductor companies. Innovation is high, and new breakthroughs are commonplace.
Second, demand. Semiconductor stocks tend to follow a boom-and-bust cycle according to demand. For example, one ETF (exchange traded fund) that tracks the industry slumped 3.3% in 2015 but then popped 36.6% in 2016 as demand shifted.
It’s easy to correlate the drop to a slump in demand for smartphones. In the same period, Apple cut production of its iPhone and began a year-long period of sales decline.
And the buzz surrounding hybrid cars and electric vehicles played a part in the 2016 gain. Demand from the industrial sector was also high as systems became increasingly automated.
Is This Current Growth Sustainable?
As a rule, we’re cautious about investing in last year’s “big thing.” But there’s good reason to believe the trend may continue into 2017.
If you look at the hard figures, it appears that last year’s growth was merely a hint of what’s to come.
Despite the huge stock price rise, the industry as a whole chalked up only a modest 1.5% real growth in 2016. This year, that figure is expected to soar to 7.2%, according to tech research firm, Gartner.
In dollar terms, revenue across the semiconductor industry is expected to reach $364.1 billion. In other words, there’s plenty left in the tank.
The vice-president of Gartner confirmed this notion. “The turnaround that started at the end of the second quarter of 2016 will continue to gain momentum. [W]e expect the improved conditions to carry through 2017.”
A Word of Caution…
Last year’s roaring stock rise may be rooted in speculation and promise.
In part, it’s a bet on the future. And on artificial intelligence (AI) and electric and self-driving cars.
What if these technologies don’t take off? Semiconductor companies could find themselves with years of wasted investment.
Playing devil’s advocate, one tech analyst had this to say about Nvidia’s performance in 2016: “It’s not sustainable yet – the market’s too small.”
In other words, the semiconductor market is always operating years ahead of mass consumption. And that means it’s susceptible to hype.
Lastly, some have already pointed out the death of Moore’s Law. After all, there’s a limit to how small transistors can shrink. How will semiconductor companies adapt when they can no longer rely on reducing chip size?
As always, due diligence and extensive research is recommended.
How to Choose the Right Semiconductor Investment
If you are eager to expand your portfolio, here’s what to look out for in a semiconductor company:
Book-to-bill ratio. This is a good indicator of demand. Does the company have a surplus of orders? Or are they producing more than they deliver?
R&D investment. The semiconductor industry moves fast. The winners will be those that constantly evolve and innovate. A company’s commitment to research and development is a strong predictor of growth.
Semiconductors are a “right place, right time” investment. Nvidia’s 2016 growth coincided with the buzz around AI and self-driving cars. Keep your finger on the pulse of the tech revolution. And then figure out who’s building the brains for it.
If you thought Silicon Valley was all about Amazon, Google, and Facebook, think again. Semiconductors are the real brains behind tech, and they offer a useful way to diversify.
True, there’s a degree of speculation and hype behind the rise. But by and large, the applications are broad enough to deliver sustainable growth.
As always, due diligence will help you sort the good from the bad, but this could be a chance to get in close to the ground floor.
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