How to Invest in Semiconductors

Where's the tech-sector love for semiconductors? These tiny chips power things like self-driving cars and AI but all too often get shafted by flashier things like, well, self-driving cars and AI. Not today!

In this week's episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Troy Springer home in on the semiconductor industry -- from the vague, vague sciencey basics you need to know what's going on to who the different players are and what sets them apart from each other. Tune in to hear what investors should look for in NVIDIA (NASDAQ: NVDA), Intel (NASDAQ: INTC), and AMD (NASDAQ: AMD) and what risks you need to be aware of before investing here.

A full transcript follows the video.

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This video was recorded on Sept. 7, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, September 7th, and we're talking semiconductors. I'm your host, Dylan Lewis, and I'm joined in the studio by The Motley Fool's investing intern, Troy Springer.

Troy Springer: How's it going, Dylan? Good to be back!

Lewis: Troy, you did such a knock up job last time, I had to have you back on. Today is tragically your last day at Fool HQ.

Springer: It is, I know. It's sad to see. I have a lot of stuff to clean up at my desk today.

Lewis: Yeah. Well, when new people start, they put quite a bit out on the desk. What was there waiting for you when you joined The Fool?

Springer: They gave me a little questionnaire about things that I liked coming in. I think I said my guilty pleasure was Taco Bell. So, they had a bottle of Taco Bell seasoning, sauce or something, on my desk.

Lewis: Which is hilarious, because for the rest of the time you're here, you're the Taco Bell guy. That's the association that everyone has of you at the office.

Springer: I'll gladly be the Taco Bell guy.

Lewis: Any particularly fond memories of -- you spent about three months here at HQ, right?

Springer: Yeah, I spent a decent amount of time. Fondest memory... I don't know. During the podcast probably has to be up there.

Lewis: That warms my heart.

Springer: I just liked hearing everybody's voices like you've heard on the podcast for years. It's cool.

Lewis: Probably pretty fun to hang out with David Gardner, too.

Springer: Yeah. Oh, I did get to drive his Tesla.

Lewis: What?! I haven't driven his Tesla yet.

Springer: That thing's like a rocket ship.

Lewis: [laughs] Yeah, I'd say that's pretty high up there in intern highlights.

Springer: Oh, yeah!

Lewis: I'm bringing you on today to talk about the semiconductor industry. This is a space that we've touched on a little bit on the show before, but I don't think we've done the primer episode on this space. To kick things off for folks that are not familiar, what is the semiconductor, and what does this industry look like?

Springer: The reason I wanted to talk about this is, I feel like people don't even know what a semiconductor is. Basically, the idea is, you have conductors, which are things like metal, copper, aluminum. Then you have insulators, which are things like wood or rubber. And then you have a semiconductor, which is in the middle. What it does is, when electricity flows through the semiconductor, different parts of the semiconductor are less conductive or more conductive. If you add a whole bunch of these things together, somehow, they turn into something that can actually process information. That's why it's called a semiconductor.

Lewis: These are the devices and the chips that really power many of the consumer electronics devices that we have in our pocket, on our wrist, everything.

Springer: Everything. They could be in your electric toothbrush.

Lewis: It's kind of impossible to talk about semiconductors without also briefly mentioning Moore's law, which is a big element of the chip space.

Springer: Moore's law was actually created by one of Intel's founding fathers. Moore's law is the idea that every two years, the number of transistors in a chip doubles, which leads to this exponential growth of processing power. It also puts a lot of burden on these semiconductor chip makers to actually deliver on Moore's law.

Lewis: Yeah, once you set the expectation that growth is going to look like a certain thing and innovation is going to be a certain way, the heat is on. That also leads to this arms race, I think, in the semiconductor space. You have companies continuing to try to put out the most powerful, most useful chips. That leads to a lot of R&D spend for these companies.

Springer: It does, it does. The thing about the R&D spend, it makes this a very cyclical business. When business is good, businesses are upgrading their computers. The computers are actually getting faster every two years. There's a need to do that. The companies can be very, very, very profitable. But there's a lot of fixed costs that go into the production of these semiconductors and the production of all the research and development that goes into it. Which means, when business is good, they're very, very profitable. When business is bad, because of the high fixed cost, that can impact their business a lot. That's one of the main things to think about when investing in semiconductors. Recently, we've seen NVIDIA and AMD have incredible years.

But it is a cyclical business. So, if you see, "Wow, this stock is killing it!" It doesn't have quite that competitive advantage to kill it every single year as, maybe, a more upstream company like an Apple would.

Lewis: Yeah, because at the end of the day, the people that are making whatever these consumer electronics devices are, are going to move to whatever the most powerful chips out there are. One of the reasons why this space has been so hot recently, and I think such a focus, a lot of the stocks here have done very well, is a lot of the major tech trends play on increased computing power. You have artificial intelligence, which requires a lot of processing. You have driverless cars and the automation that's happening there. All of those things require chips that can handle a ton of power, and can make a lot of things happen for devices.

Springer: Definitely. The biggest reason why we've seen NVIDIA go from a company that was founded in the 90s, and was basically just a market performer from the time that it was founded in the 90s until 2016, where it's gone up -- it's almost been an 11 bagger, which has been ridiculous. That just goes to show you that the technology trends toward the GPU, which is what NVIDIA specializes in, totally shifted in their favor, even after this long period of regular performance.

Lewis: For the unacquainted, what is a GPU?

Springer: GPU vs. CPU. The original uses of GPUs were for gaming on your computer. That's where NVIDIA buttered their bread. They were seen as a gaming company. If you were a hardcore gamer, you'd need to buy their chips and their computers to run the game. A CPU is a little bit different in. The CPU is more of a linear thinker. Think of it, the CPU can do three or four things really, really well, really, really fast. A GPU can do a lot of things, but it doesn't have as much processing power per thing it's doing. It's more of a multitasker. But as GPUs have become more and more powerful, they're able to take a whole bunch of scattered information and make sense of it better than a CPU does, because the CPU is more of a linear thinker.

Lewis: So, GPU is the jack of all trades; the CPU is the specialist.

Springer: Yes, yeah.

Lewis: OK, cool. We are going to do a rundown of some of the companies in the space.

All right, Troy, why don't we kick this off with NVIDIA? We briefly mentioned them on the first half of the show. To your point, in the semiconductor space, this has been one of the biggest names because the stock returns have been so good for this company over the last couple of years.

Springer: NVIDIA, as I talked about before, was just known as a video gaming company until recently, when we started talking about AI and self-driving cars. The reason why AI and self-driving cars lends itself to the GPUs is because, say you have a whole bunch of random, scattered information, and you want some sort of intelligence to come in there and find patterns in this random assortment of information. That lends itself more to a GPU than a CPU. Same thing for a self-driving car. If you're driving your car and your car has to pick up on all of this information on the road, some of it's random, some of it's not random, and they have to come up with a pattern to find the signal from the noise in that. That lends itself more to the GPU, again.

NVIDIA has a very strong brand and loyal fan base with the gaming side of the business. The gaming side of the business, make no bones about it, is still the bellwether of the business. That's what drives top line growth. A lot of the growth that we've seen in the past few years in the stock price has been a little bit speculative, based on AI and self-driving cars. But NVIDIA is the clear leader. They have the unquestioned best GPUs in the world, which I think sets them up in a pretty good position.

Lewis: Yeah, I think the story with this stock was, they were putting out a best in class chip to begin with. Then, the industry tailwinds came in and said, "Hey, we need to be able to do this. We're going to turn to you guys because you're the best." And they've become really the de facto chip for anyone that's operating in the AI or driverless car space.

Springer: Yep. I have an NVIDIA chip in my computer. I'm proud of that.

Lewis: Are you a gamer?

Springer: I'm not too much. I honestly just was like, "I'll get this computer. Oh, this one has an NVIDIA chip. Ooh, that's nice, NVIDIA."

Lewis: It's a stamp of approval that you needed. Why don't we switch over to another semiconductor company that has also put up some pretty good returns as of late? That's AMD.

Springer: AMD is the best-performing stock on the market this year. AMD has usually played second fiddle to Intel throughout their career. AMD specializes more in the CPUs. Where AMD has differentiated themselves from Intel a little bit is, they've added more graphics processing power to their CPU. They've made a little bit more of a hybrid CPU with some GPU ability. As of recently, that's led them to find a little bit more success in some areas than Intel. For example, AMD's differentiated themselves by, those are the chips that actually power your PlayStation 4, and they're the chips that power your Xbox One.

Because of the cyclicality of this business, and because AMD has usually been the second fiddle and it has periods of not profitable to super profitable to not profitable, this is a stock that, for its entirety, tends to go up and down a lot throughout its whole year. There's usually a hype train. "Wow, maybe AMD is going to make some inroads on Intel," and the stock gets traded up. Then it's not actually happening, and the stock goes back down, then just kind of goes from there.

Lewis: Yeah, and the reason for that dynamic is, Intel is colloquially known as Chipzilla in this space. They are a massive company in comparison to AMD and NVIDIA. They have been this industry stalwart for such a long time.

Springer: The biggest differentiator between AMD and Intel is, one, Intel can just spend more money than AMD. AMD is $28 billion company and Intel is a $200 billion company. But Intel is also more vertically integrated, meaning they actually own more of their manufacturing processes. They have built-in cost advantages over AMD. If AMD comes out with the chip that might be better than Intel's, Intel can just kind of compete on price until they find something in their house over there to compete back with Intel.

Lewis: Yeah, that's the perks of being big. You can either enjoy larger margins because you have those fixed costs that you laid out, or you can decide to compete on price and be a little bit more competitive.

Springer: Right. The one thing I'd say about that is, technology has never been a huge source of competitive advantage. It's usually the cost advantages and brand that's a competitive advantage. Sometimes, you spend money on research and development, and it's kind of a gamble. Sometimes it works, sometimes it doesn't. Sometimes one company will come out with something that's a game changer. That's something that's really hard to predict. But once somebody comes out with something that's a game changer, every other company is pouring in to try to figure out how to catch up. It's usually not been sustainable. Things like cost advantages, things like brands, scale, usually are.

Lewis: I know I said we were going to talk about a couple on this back half of the show, but do you want to briefly touch on Micron Technology, too? That's another company that's kind of in this space. They haven't come up yet, but I think it's worth mentioning them.

Springer: Part of the reason why I want to do this show is, you just see so many people talk about AMD and Micron Technology, because they have the potential to go up and also go down a lot. Micron Technology specializes more in the storage part of computers. They actually make the solid-state drives. They're the leader in a process called dynamic random-access memory.

Lewis: DRAM.

Springer: DRAM, yes, exactly. Which is supposed to be able to render memory faster. When you're scrolling through your computer and want to open a file, it'll come a split second faster than the rest.

Lewis: [laughs] It's hard to very eloquently state all of this stuff. I appreciate you going through the motions here and making it happen. Of the companies that we've touched on today, is there one that you're particularly interested in? The story with AMD and NVIDIA is high growth stocks that have put up stellar returns over the last couple of years for investors. The story is a little different for Intel, because it is a dramatically larger company. It's a company that pays a dividend, I believe?

Springer: Yes.

Lewis: The growth profile looks a little different for this business. That's important to keep in mind as you're looking at these companies. Is there one that you particularly like out of them?

Springer: I'll say, I don't own any of these companies. But, I've been looking long and hard at Intel. Intel is a bigger company. It's also trading at a huge discount to these other companies. Intel currently trades at a forward price to earnings of about 10X earnings, which sounds very, very cheap for a technology company.

Lewis: Especially given how frothy the market has been.

Springer: Right. And you have companies like NVIDIA trading at 40X earnings. And after this recent run-up for AMD, trading at 90X earnings. I think that makes Intel look pretty attractive. Intel, throughout their history, they've had periods where they were kind of considered the boring company, the company that wasn't innovating. Everyone knows about boring Intel, I'd rather have AMD, this new chip that came out. But they have a really great management team, a really great process, vertical integration. In an expensive market, I kind of like the value of Intel right now vs. a lot of these high flyers.

Lewis: It's important to note, looking at these companies, the profiles are different, and I think the expectations are a little different.

Springer: Yes, they are.

Lewis: If you were looking for a safe, low-risk exposure to this market, Intel might be the way to go. If you are willing to take on a little bit more risk and understand that you're going to be buying some high-flying companies that have a lot of expectations built into their current stock prices, that's where AMD and NVIDIA currently live.

Springer: Yep, exactly.

Lewis: Man, Troy, I wish you were here a little bit longer. I'd love to have you on the show a couple of more times. If you wind up making a trip back to HQ sometime the next couple of months, maybe we'll make something happen.

Springer: Yeah, I'll let you know. It's a blast! Thank you for inviting me on, Dylan!

Lewis: Happy to have you! Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Troy Springer, I'm Dylan Lewis. Thanks for listening and Fool on!

Dylan Lewis owns shares of Apple and Tesla. Troy Springer has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple, Nvidia, and Tesla. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.