Buoyed by successful vaccine rollout programmes and the sense that we are at the beginning of a positive new global economic cycle, stock markets around the world, notably in the US, UK and China, have bounced back strongly.
Now investors must confront a challenge: how to reconfigure their portfolios in the light of this cyclical economic recovery.
The problem is that classical cyclical stocks — industrial, hotel, airline, mining, energy and even cruise line shares — have already spiked sharply this year, with many reaching record levels.
While we are seeing a nascent economic recovery, backed by promises of significant monetary support, a big question is how sustainable economic growth will be when the fiscal props are removed.
It is remarkably difficult, even for disciplined investors, to judge correctly how this concern plays in the financial market and sell cyclical shares in good time.
It’s surely far wiser to invest in sustainable longer-term structural growth stocks — shares which are far less influenced by economic cycles.
Equally, mining stocks and consumer goods are easily categorised as cyclical. But what about those that are somewhere in between — shares that have been seen as cyclical in the past but which are suddenly seeing a structural growth surge? Take for example, the key industry of semiconductor manufacturing.
Historically very cyclical, the sector changed dramatically in 2019-20. Following a prolonged stretch of disappointing performance attributed to various factors including the Sino-American trade conflict, a crash in cryptocurrencies and fears of a global demand slowdown, the industry suddenly spurted ahead. In contrast to its declines in all previous recessions, the Philadelphia Semiconductor index, a key industry indicator, rebounded sharply, eventually rising more than three quarters through the virus-induced recession.
This is a direct result of global technological developments and the exponential growth in data consumption. While some developments were already taking shape well before the recession, the economic lockdowns further accelerated demand in high-tech businesses including cloud computing, data storage, big data management and artificial intelligence.
Looking ahead, we can see further exponential growth in data management with the rollout of 5G mobile networks, the internet of things and machine learning.
While semiconductors historically were mainly used in consumer and auto electronics — and were therefore very cyclical — they now play a much larger and more significant role in a far wider range of business, administrative and personal applications. In short, they have become the technological ‘staples’ of economic activity with excellent further sustainable growth potential.
Outstanding businesses have developed in three main areas: semiconductor design, the production of the manufacturing equipment, and circuit manufacturing. The supply chains are well established in advanced economies. While many of these businesses have to invest vast amounts of capital to update or create new capacity, overall profitability and cash generation is strong with solid returns on invested capital.
Despite the fact that many tech share prices remain at historically high levels; I still believe that companies in this sector are fairly valued. I do not look for “cheap” stocks, but instead ones that are priced appropriately for their current and future sustainable growth.
Two Nasdaq-listed companies — Cadence Design Systems and Synopsys — provide leading software design technologies for the manufacturing of integrated circuits.
Many manufacturers rely on them for cutting-edge technology to develop new semiconductors. Apart from the strong overall industry structural growth they enjoy, they benefit from clients such as Google parent Alphabet, Amazon and Apple which develop their own semiconductors and need expert support. Growing demand from China has also become prominent for these designers.
The chip equipment supply chain also features some well-established companies. Two US groups, Lam Research (Nasdaq-listed) and Applied Materials, produce fabrication equipment products. Then there is Dutch-listed ASML, formed from a partnership with Philips and today operating independently as the world’s largest and technologically most advanced supplier of photolithography systems for semiconductor manufacturing.
These companies benefit hugely from clients that are expanding their own manufacturing capacity, generating a record, multiyear order book for these sophisticated equipment manufacturers.
There is an array of semiconductor manufacturers. US multinational technology firm Nvidia is a particularly interesting example with a focus on the 3D graphics, data centre and cryptocurrency industries. The Nasdaq-listed company has made a bid for Arm, the UK-based semiconductor design business. Though it has been reported that the offer remains under regulatory scrutiny, this key deal may go through in some or other form, transferring ownership from Japan’s SoftBank.
Jensen Huang, Nvidia’s co-founder and chief executive, is perceived as an industry leader and is expected to focus more on artificial intelligence and autonomous driving. Nvidia can in some way be seen as the Tesla of the semiconductor industry, often ahead of others technologically.
The new Biden administration does not seem to have the appetite for reversing its predecessor’s clampdown on US companies’ high-tech trade with China, highlighted by the argument over Huawei, the huge Chinese electronics group.
The dispute with Beijing shows how reliant global chip production is on a small number of mainly western, Taiwanese and South Korean producers and their technologies, and how entrenched the established order is.
It is clear that it will take a very long time to disrupt the strategic positions of key companies, despite China’s efforts to increase self-reliance in semiconductors. Taiwan Semiconductor is an interesting company as it is a critical supplier to most nations, including China, with a huge production capacity and a $100bn three-year capital expenditure programme.
Meanwhile, Intel, for long the chipmakers’ bellwether, also recently announced an unexpectedly large $20bn expansion programme in the US.
There are many exciting opportunities in the sector: in our concentrated, 29-stock portfolio with a very strategic long-term orientation, we have to be as ruthless in our selection as we are diligent. While the semiconductor industry’s excellent operational results and its critical role in most aspects of technological advancement have not gone unnoticed among investors and are well-reflected in equity valuations, we still see good investment opportunities.
With global technological developments probably less than halfway through a revolutionary multiyear growth cycle, our view is that there is still plenty for strategic investors to go for.
Gerrit Smit is the fund manager of the Stonehage Fleming Global Best Ideas Equity Fund. It invests in Alphabet, Amazon, Cadence Design Systems