Even with falling PC sales, semiconductor stocks are worth a look

Uncertainty in China has opened a buying window for normally pricey semiconductor stocks

Tesla dashboard

Forget dwindling PC sales. There’s about $1,000 worth of semiconductors in a Tesla. (Bloomberg/Getty)

China’s economic woes have caused investors to pull out of anything and everything exposed to the Red Giant. That certainly applies to semiconductor stocks, for which China represents a fifth of the global market.The PHLX Semiconductor Sector Index has fallen 21% since June 1, with valuation ratios following suit. Qualcomm Inc., for instance, is down 23% over the past three and a half months, while its forward price-to-earnings ratio has sunk to 11.6 times from 15.

“A large swath of the semiconductor industry is trading at multiples below the S&P 500,” marvels Steve Barwikowski, manager of Fidelity Select Electronics Portfolio. “That’s for better growth, better margins and better dividend yield, too.”

The semiconductor industry is a cyclical sector to begin with—there are times when chip orders spike, such as when a major manufacturer launches a new phone—but it’s also affected by global GDP ups and downs. When the economy is expanding, people buy more electronics. Historically, the sector’s earnings growth has run at double the rate of GDP growth. But these stocks have also underperformed when the economy contracts or grows slowly, says Barwikowski.

Since China is the biggest market for semiconductors, a slowdown in that country’s GDP is bad for business. A real downturn there could sink this sensitive sector further. But valuations have become so attractive that it may be worth the risk.

The industry is more mature than it was during the dot-com crash, says Angelo Zino, a senior analyst at S&P Capital IQ. There has been a record number of mergers and acquisitions this year, which is a sign of a stabilizing industry, he explains, and many firms pay handsome dividends. But they still have plenty of growth potential. The range of products with chips in them has been proliferating. While personal computers and smartphones are still key demand drivers, it’s the growing number of connected automobiles that is making analysts excited.

The global auto industry itself grows by 1% to 3% a year, says Barwikowski, but semiconductor content per vehicle is growing closer to 6% a year. To put it another way, the average car has about US$400 worth of semiconductors in it, which is US$290 more than the average personal computer. A more electronics-heavy car, such as a Tesla, has about US$1,000 of semiconductor content inside.

The digitization of cars and the whole Internet of Things story—phones talking to thermostats and so on—is a positive for semiconductor makers. Keep in mind, though, that not all companies make the same kinds of chips. Investors should buy businesses with growing end markets, such as autos or the Chinese smartphone industry, says Zino.

Barwikowski advises owning the top one or two companies in a particular market. In this sector, the businesses with the best market share have the strongest margins, which then drives strong cash flows. These companies also have the ability to grow faster than their peers and expand through acquisition.

With China’s outlook unclear, investors should expect more volatility, but Zino and Barwikowski are both optimistic about the future. “There are real macro issues out there,” says Barwikowski, “but I also think there are some remarkable values.”