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The hidden gems of the technology sector

Everyone is familiar with the technology sector, right? It’s hard to escape it. We use the products and services of companies like Google or Microsoft on a daily basis. It would require a conscious effort not to, one which would probably require you to go on holiday or undertake some kind of digital detox.

But we are only dimly aware of the technology companies that stand behind the products and services of our most familiar tech giants. The key to powering our tech-dominated lives is the humble semiconductor chip. Once you understand this space, it opens up a whole new sector for potential investments.

An overview of the semiconductor world

Broadly speaking, semiconductors are used in anything requiring computer processing power. Semiconductor manufacturers have four main end markets: personal computers, smartphones, telecoms networks and data centres. Investors wanting exposure to the semiconductor sector tend to look towards either the US or Asia, though there are some notable exceptions, such as ASML in Europe, which is one of the leading manufacturers of machinery to make semiconductors.

How is the semiconductor sector faring?

Semiconductor related companies have had a challenging eighteen months, with the sector having been caught in the crosshairs of rising US-China tensions. While the price impact of most tariffs can be absorbed, the uncertainty around planned production is what causes real difficulties. Tariff uncertainty leads to higher stockpiles of products and lower factory utilisation, with both factors potentially depressing profits.

The semiconductor sector has also been hurt by some weakening in end markets like smartphones. This is driven by a slowdown in both the number of people buying a smartphone for the first time, and the number of people upgrading their smartphone. Most of the global population which wants a smartphone, and can afford one, now has one, and the rate of improvement between different versions of the same phone has slowed, leaving people happy to hang on to their current model. Smartphones are unlikely to see a pick-up this year, but 2020 may be better as the rollout of 5G networks encourages people to upgrade.

Over the long term, however, there is increasing demand for semiconductors. Providers of cloud computing services like Amazon or Microsoft have been spending tens of billions of dollars on building new data centres, driving significant demand for the semiconductors. But both Microsoft and Amazon tend to ‘build and optimise’ – essentially building data centres and then waiting for demand to catch up with their increased capacity. Ultimately, this leads to big swings in orders for semiconductors, so investors have to be careful not to over-extrapolate strong periods of growth.

Outlook for investors in semiconductor land

There a number of interesting areas for investors to consider going forward. Netherlands based ASML, for example, makes machines for the most expensive and critical stage of the semiconductor manufacturing process. They have a near monopoly in next generation products, with their extreme ultraviolet lithography (EUV) technology able to be sold for three to four times the price of their current offering.

Another interesting company is AMD, which develops computer processors and related technologies. It has unique intellectual property and new products should help it to regain market share from competitors like Intel and Nvidia. While I would be cautious about paying too high a price for either company, both have attractive businesses and are ones I follow closely.

Conclusion

Investing in the semiconductor sector is not for the faint hearted. This can be a volatile part of the market, with lumpy economic cycles feeding into high share price volatility. Tensions between the US and China add another layer of complication. Given the structural trends in favour of the semiconductor industry, however, it is worth looking beyond the more familiar technology names and diversifying your portfolio.

 

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