Why the chip stocks are down

A colleague recently asked if I knew why semiconductor stocks significantly underperformed the market over the past five years, even though chip sales have seen double-digit growth during the same period. Being a veteran of the industry, I surprised both of us by not knowing the answer. So I decided to find out.

First, the facts. The PHLX semiconductor sector index (SOX) declined at a rate of 2.9 percent per year over the past five years, while Merrill Lynch's semiconductor index exchange-traded fund (SMH) declined 1.0 percent per year.

The Nasdaq, on the other hand, experienced a 4.8 percent compound annual growth rate (CAGR) during the same period. Likewise, the Dow and S&P 500 respectively grew 3.7 percent and 3.9 percent annually.

Indeed, the semiconductor sector has significantly underperformed the broad market.

(Credit: Steve Tobak)

This is in stark contrast to worldwide chip sales. According to market analyst firm iSuppli, worldwide semiconductor sales grew from $181 billion in 2003 to $270 billion in 2007, a CAGR of 10.5 percent. The same firm expects worldwide chip sales to grow to $291 billion in 2008.

So what's going on? Why the continued long-term downward trend in share prices in the face of solid industry growth?

For one thing, the chip sector is far from homogeneous. For example, the current memory chip glut has weighed heavily on the entire sector, since memories account for more than 20 percent of the total semiconductor market.

Also, the above indices exclude Samsung, Toshiba, and a host of other top manufacturers that aren't listed on U.S. exchanges. That said, some of those firms are knee-deep in memory chips, so I'm not sure they would positively impact the indices.

Perhaps the best way to understand the gap is to look at individual companies' stocks. The included chart shows a five-year compound annual rate of growth or decline for the biggest United States-traded semiconductor stocks.

Not surprisingly, Qualcomm, whose business includes licensing its wireless technology, was the standout gainer. Marvell, Broadcom, Nvidia, and Texas Instruments--manufacturers of proprietary products used in high-growth segments--also showed reasonable annual gains that bucked the sector trend.

The big losers included memory chipmakers Micron and Infineon, as well as broad-line supplier STMicroelectronics and, of course, Advanced Micro Devices.

The chart demonstrates that the law of supply and demand has not abandoned the semiconductor market. Proprietary products in hot markets resist negative sector trends, while commodities suffer the most.

Lastly, I can't help but wonder if the effects of the dot-com bust are still in play here. The dot-com misnomer hides the fact that investors suffered big-time when the bubble burst on enormously inflated chip stocks such as AMCC, PMC-Sierra, and yes, even mighty Intel. You know what they say: once bitten, twice shy.

In summary, I think that chips will remain a stock picker's market for some time to come. I wouldn't be at all surprised if it takes a long, long time for broad investor confidence to return to this once high-flying sector.

Disclosure: I don't own shares in any of the stocks named in this post.

[bikerinpa]

Re: For example, the current memory chip glut has weighed heavily on the entire sector, since memories account for more than 20 percent of the total semiconductor market.


Why would the memory chip market hurt the overall semi sector more than in the past? It accounts for 20% of sales now, whereas in the past it accounted for 45%.

[stobak]

When a major group experiences oversupply, it drags down the indices and can cause investors to "throw the baby out with the bathwater." If post dot-com bust investors are skeptical of the chip sector, the likelihood of that happening increases. I think that's what we're seeing.

[Semi On]

Commodities are dragging down the sector? ONNN is up almost 300% over the same timeline. National is up ~100%. Both are more commodity suppliers than ST with their ASIC business.

[stobak]

On Semi's stock perked up when it turned a profit in 05+. The same is true of National. Change in fundamentals for a specific company can trump a sector trend. There are hundreds of companies to pick apart; we're talking about general trends here. Of the top 10 or 15 companies, the winners have clearly been companies with proprietary technology used in hot, growing markets.

Steve Tobak