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: Buy the pullback in chip stocks — and focus on these 6 companies for the long haul

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In the rolling correction that’s running through the stock market, chip makers have been hit harder than most.

The iShares Semiconductor ETF
SOXX,
+0.52%

is down over 6% from recent highs, compared to declines of 2% or less for the S&P 500
SPX,
+0.68%
,
Nasdaq Composite
COMP,
+0.99%

and the Dow Jones Industrial Average
DJIA,
+0.56%
.

Does that make chip stocks a buy? Or is this historically cyclical sector up to its old tricks and headed into a sustained downtrend that will rip your face off.

A lot depends on your timeline but if you like to own stocks for years rather than rent them for days, the group is a buy. The chief reason: “It’s different this time.”

Those are admittedly among the scariest words in investing. But the chip sector has changed so much it really is different now – in ways that suggest it is less likely to crush you.

You’d be a fool to think there are no risks. I’ll go over those. But first, here are the three main reasons why the group is “safer” now – and six names favored by the half-dozen sector experts I’ve talked with over the past several days.

1. The wicked witch of cyclicality is dead

“Demand in the chip sector was always boom and bust, driven by product cycles,” says David Winborne, a portfolio manager at Impax Asset Management. “First PCs, then servers, then phones.” But now demand for chips has broadened across the economy so the secular growth story is more predictable, he says.

Just look around you. Because of the increased “digitalization” of our lives and work, there’s greater diversity of end market demand from all angles. Think remote office services like Zoom, online shopping, cloud services, electric vehicles, 5G phones, smart factories, big data computing and even washing machines, points out Hendi Susanto, a portfolio manager and tech analyst at Gabelli Funds who is bullish on the group.

“There is no aspect of the modern digital economy that can function without semiconductors,” says Motley Fool chip sector analyst John Rotonti. “That means more chips going into everything. The long-term demand is there.”

He’s not kidding. Chip sector revenue will double by 2030 to $1 trillion from $465 billion in 2020, predicts William Blair analyst Greg Scolaro.

All of this means the widespread supply shortages you’ve been hearing about “likely won’t be cured until sometime late next year,” says Bank of America chip sector analyst Vivek Arya. “That’s not just our view, but one confirmed by a majority of large customers.”

2. The players have consolidated

All up and down the production chain, from design through the various types of equipment producers to manufacturing, industry players have consolidated down into what Rotonti calls “earned” duopolies or monopolies.

In chip design software, you have Cadence Design Systems
CDNS,
+0.97%

and Synopsys
SNPS,
-0.23%
.
In production equipment, companies dominate specialized niches like ASML
ASML,
+0.17%

in extreme ultraviolet lithography (EUV). Manufacturing is dominated by Taiwan Semiconductor 
TSM,
-1.54%

2330,
-1.25%

and Samsung Electronics
005930,
-0.55%
.

These companies earned their niche or duopoly status by being the best at what they do. This makes them interesting for investors. The consolidation also means players behave more rationally in terms of pricing and production capacity, says Rotonti.

3. Profitability has improved

This more rational behavior, combined with cost cutting, means profitability is now much higher than it was historically. “The economics of chip making has improved massively over past few years,” says Winbourne. Cash flow or EBITDA margins are often now over 30% whereas a decade ago they were in the 20% range.

This has implications for valuation. Though chip stocks trade at about a market multiple, they appear cheap because they are better companies, points out Lamar Villere, portfolio manager with Villere & Co. “They are not trading at a frothy multiple.”

The stocks to buy

Here are six names favored by chip experts I recently checked in with.

New management plays

Though Peter Karazeris, a senior equity research analyst at Thrivent, has reasons to be cautious on the group (see below), he singles out two companies whose performance may get a boost because they are under new management: Qualcomm
QCOM,
+0.82%

and ON Semiconductor
ON,
+0.78%
.

Both have solid profitability. Qualcomm was recently hit by one-off issues like bad weather in Texas that disrupted production, but the company has good exposure to the 5G phone trend. ON Semiconductor is expanding beyond phones into new areas like autos, industrial and the Internet of Things connected-device space.

A data center and gaming play

Karazeris also singles out Nvidia
NVDA,
+3.07%
,
which gets a continuing boost from its exposure to data center and gaming device chip demand — because of its superior design prowess.

Read: Nvidia earnings top Street view with record data-center, gaming revenue, but supply constraints still a concern

Design tool companies

Speaking of design, when companies like Qualcomm and NVIDIA want to design chips, they turn to the design tools supplied by Cadence Design Systems and Synopsys.

Their software-based design tools help chip innovators create the blueprint for their chips, explains Rotonti at Motley Fool, who singles out these names. “They are not the fastest growers in the world, but they have good profit margins.” They also dominate the space.

An EUV play

To put those blueprints onto silicon in the early stages of chip production, companies like Taiwan Semiconductor and Samsung turn to ASML. Its machines use tiny bursts of light to stencil chip designs onto silicon wafers, in a process called extreme ultraviolet lithography. “No one else has figured out how to do it,” says Rotonti.

In other words, it has a monopoly position in supplying machines that do this – which are necessary for any company that wants to make leading edge chips.

Risks

Here are some of the chief risks for chip sector investors to watch.

Oversupply

Chip production has become politicized. The U.S. wants more production at home so it is not vulnerable to disruptions in Chinese supply chains. China wants to make 70% of the chips it uses by 2025, up from 5% now, says Winborne.

The upshot here is that there’s lots of government support to boost manufacturing – so there will be much more of it. The risk is oversupply at some point in the future. This might also create a pull forward in chip equipment purchases — leading to a lull down the road which could hurt sales and margin trends at equipment makers.

Next, big tech companies like Alphabet
GOOGL,
+0.79%

GOOG,
+0.78%
,
Apple
AAPL,
+1.06%

and Ammazon.com
AMZN,
+0.37%

are all doing their own chip design, which threatens specialized chip companies that do the same thing.

Quantum computing

Computers using chip designs based on quantum physics instead of traditional semiconductor architectures have superior performance, points out Scolaro at William Blair. “While it probably won’t become mainstream for at least another five years, quantum computing has the potential to transform everything from technology to healthcare.”

A disturbing signal

A blend of global purchasing managers (PMI) indexes peaked in April and then decelerated for three months. Meanwhile chip sales growth continued. Normally the two follow the same trend, points out Karazeris, who tracks this indicator at Thrivent. He chalks the divergence up to inventory building which is less sustainable than true end-market demand. So, he takes the divergence as a bearish signal for the chip sector.

Another cautionary sign comes from the forecasted weakness in pricing for dynamic random-access memory (DRAM) chips. “These are typically things you see at tops of cycles not the bottoms,” says Karazeris.

But it’s also possible the slowdown in the global PMI is more a reflection of chip shortages than a sign that the shortages aren’t real (and are just inventory building). “The divergence doesn’t necessarily mean that chip orders are going to roll over and die. It means chip manufacturing has to catch up,” says Leuthold economist and strategist Jim Paulsen.

Ford
F,
-1.61%
,
for example, just announced it had to curtail production because of chip shortages, not a shortfall in underlying demand.

Paulsen predicts decent economic growth is sustainable because of factors like high savings rates, the rebound in employment and incomes as well as pent-up demand for big ticket items. If he’s right, the continued economic strength would support demand for all the products that use chips – including Ford cars.

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested CDNS QCOM, ON, NVDA, GOOGL and AMZN in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.

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