Chip Shot: Picking semiconductor stocks requires expertise. Here's an expert.
By Christopher Graja, Bloomberg Personal Finance, November 2001 issue.
When a sector known for cycles of
feast and famine plunges and then seems to hold its ground for more than half a year, it's tempting to believe the worst is over. So it seemed to be this summer with microchip, or semiconductor, stocks: After losing about $400
billion in market capitalization--half its value--in the previous 12 months, the benchmark Philadelphia Semiconductor Index appeared to have stabilized in 2001, dropping only about 2.4 percent through August 31. But the wise
resisted temptation. Despite the index's apparent leveling out, the gap between its best- and worst-performing members was huge, with analog chip maker National Semiconductor up 65 percent and memory designer Rambus down 82
percent. And the leveling off proved temporary: From the end of August through September 10, the index lost another 10 percent. In other words, this was a market demanding stock-picking expertise.
One expert picker in the
silicon-chip sector is Manoj Nadkarni. Nadkarni is president of ChipInvestor.com, an online service that analyzes companies in the business of making the microchips that run computers, electronic devices, and networks. According to
the web site, $10,000 invested in his ChipInvestor portfolio on April 1, 1999 (when he launched the service) would have grown, by August 31, 2001, to $62,901, versus $15,179 for an investment in the semiconductor index. Nadkarni's
impressive record is partly attributable to his background: He has a master's in engineering from the Massachusetts Institute of Technology and, before becoming an analyst, worked for Advanced Micro Devices, National Semiconductor,
and Panasonic. But even nonengineers could improve their chip-stock-picking by following these five tips he offers:
1. Study the different businesses within the semiconductor sector.
To ensure that his analysis compares like companies with like, Nadkarni segments the heterogeneous semiconductor stocks into three subsectors: chip manufacturers that have their own fabrication facilities; companies without such plants, often termed "fabless"; and the companies that make the equipment used to manufacture the chips. Within the first group--known as integrated device manufacturers, or IDMs--Nadkarni further differentiates companies based on their products: microprocessors (Intel, INTC; and Advanced Micro Devices, AMD, for example); memory chips (Micron Technology, MU); specialty memory chips (Cypress Semiconductor, CY; and Atmel, ATML); high-speed gallium arsenide devices (Vitesse Semiconductor, VTSS; and TriQuint Semiconductor, TQNT); and analog circuits (Maxim Integrated Products, MXIM; and Linear Technology, LLTC). Though burdened with high capital investment in plants, these companies can benefit from economies of scale when times are good. As demand increases, Nadkarni says, their plants are utilized more efficiently, so the profit margin increases on each chip produced.
The fabless group, including Altera (ALTR) and Xilinx (XLNX), avoids the high capital costs of building manufacturing plants by outsourcing fabrication to companies, such as Taiwan Semiconductor Manufacturing (TSM), known
as foundries. Nadkarni believes that in a downturn, fabless companies should be better able to maintain their operating margins than IDMs, because they don't have as many fixed costs. The equipment makers, of which Applied
Materials (AMAT), KLA-Tencor (KLAC), and Novellus Systems (NVLS) are the largest, benefit from high barriers to entry posed by the complex technology and the rarity of the required expertise.
For more on industry basics,
Nadkarni suggests visiting www.sematech.org, the web site for International SEMATECH, a coalition of 13 semiconductor manufacturers. He recommends IBM's site, www.chips.ibm.com, for information about new semiconductor technologies.
2. Follow the trends.
Watch out for commodification, when an old product loses its niche, resulting in price competition that reduces the maker's margins; a unique new product, in contrast, often fattens the bottom line. Also look for large capital outlays, which could depress near-term earnings but increase profitability in the long run.
Nadkarni currently sees a few clear trends in chip technologies. One is the scaling down of the tiniest structures on chips, to 0.13 from 0.18 of a micron (one-millionth of a meter). "With smaller
structures," he explains, "you can reduce power consumption, lower voltage, and get better performance." Another trend involves the wiring on chips. The industry, Nadkarni says, is switching from the old standard,
aluminum, to copper, which has much less electrical resistance, enabling chip makers to use thinner wires.
3. Look for sustainable revenue growth.
Growth is critical to any chip stock. But Nadkarni believes specific growth predictions are less important than whether the current rate is sustainable. "Some of the most trusted CEOs don't know for sure what their revenues will be next year," he notes. To determine if a high growth rate is sustainable, he suggests looking at qualitative factors, such as whether, based on information you've gathered in the first two steps, the business should benefit from industry trends. Nadkarni, for instance, believes that in the next upturn both Novellus and MKS Instruments (MKSI), a stock he holds, could do well--the first because it is a leader in copper-based technology, the second because it manufactures the subsystems that control the gases and power used in producing semiconductors, and, he notes, "when you go to smaller geometries, you need better control devices."
4. Check your margin of safety.
Nadkarni claims this concept, defined more than 50 years ago by Benjamin Graham in his book The Intelligent Investor, is still valid. "If your margin of safety--the amount by which your estimate of a stock's value exceeds its market price--is large," he says, "and you make an error in judging growth prospects, the stock price is likely to fall less than if your margin of safety was small."
5. Know when to sell.
Nadkarni gives two reasons for unloading a chip stock. No. 1 is a worsening of fundamentals, such as a narrowing of operating margins. No. 2 is an exorbitant valuation, even with good fundamentals. You may want to replace such a stock with one having a larger margin of safety.
Christopher Graja, CFA, is executive markets editor for Bloomberg Personal Finance. The above article appeared in the Bloomberg Personal Finance Magazine, November 2001 issue. © 2001 Bloomberg L.P. All rights reserved. Reprinted with permission. Visit www.Bloomberg.com |
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