- Marko Papic says betting on semiconductor producers is a bad deal.
- Tensions between China and Taiwan have put pressure on producers to expand outside the region.
- Investing in capital expenditure is a better way for investors to gain exposure to the sector.
US House speaker Nancy Pelosi's visit to Taiwan on Tuesday sent a wave of tensions into the region and prompted China to retaliate both militarily and economically. The Chinese military announced it would hold a live fire exercise near the self-ruled island and banned more than 2,000 food exports from Taiwan.
"That tells you that China is very, very upset," said Marko Papic, a partner and chief strategist at Clocktower Group, an alternative investment asset management firm.
He believes her visit signals the Democrats' intention to look tough on China, which views independently governed Taiwan as part of its territory. But the historic move had a ripple effect in many areas, including global markets and, in particular, Taiwan. The small island holds the second-largest market share of the world's semiconductor production, following China.
Tuesday saw global semiconductor stocks slip as fears over escalating tensions made headlines. The island is home to some of the largest manufacturers in the sector.
On the day of Pelosi's visit, Taiwan Semiconductor (TSM) was down by about 4.5% from the previous week's closing. While United Microelectronics Corp (UMC) was down by about 4.7% for the same period.
"The good times are over for semiconductor manufacturers. I would put it that way," Papic said.
The last five years saw big gains for some semiconductor stocks with companies like TSM up 144%, and United Microelectronics Corp (UMC) up by 204%. The PHLX Semiconductor Index (SOX) is up by about 110% in the last three years.
While recent chip shortages may make the sector seem like a good long-term bet on a recovery, these market dips are the tip of the iceberg, according to Papic.
"Semiconductor producers are at the mercy of geopolitics, and not just tensions over Taiwan. This is an important point to me because this Nancy visit to Taiwan didn't really catalyze anything new," Papic said.
He continued, "I think a much bigger point is that policy makers around the world have become obsessed with chips, with semiconductors. And I would argue erroneously, by the way. I think they're just obsessed with it because it's like chips sound cool. Literally, I think it's that simple."
Countries are putting pressure on semiconductor producers to expand outside of Taiwan in a very inefficient way, and that's going to be expensive, he added.
Related story
Last month, the US House passed the CHIPS Act, which provides a 25% tax credit for semiconductor manufacturing, and pledges $52 billion in subsidies for US computer chip manufacturing. The European Chips Act, which was adopted by the European Commission, aims to make the region an industrial leader in the sector.
"Five years from now, we're going to have so many semiconductors you're going to be using them as coasters in your office," Papic said. "So that's what the pressures are right now. We're creating national security-motivated redundancy because we think it's the smart thing to do."
However, if you're the manufacturer tasked with this expansion, you don't want the redundancy for two main reasons: First, you prefer the scarcity, and second building all these factories costs money.
Intel is building a $20 billion facility in Ohio. Taiwan Semiconductor Manufacturing Company (TSM) is also building a $12 billion plant in Phoenix, Arizona, set to start up production by 2024.
"So, you don't want to invest in companies that are scrambling to build more factories so they can build more of the goods they produce so they can reduce the price of those goods. That seems to me like a losing bet," Papic said.
However, that redundancy is going to require the stocking up of new factories with machines and equipment. Therefore, investors should consider the companies that provide the capital expenditures (CapEx).
Those listed in an index constructed by Clocktower Group to track the sector's performance include Applied Materials, Inc. (AMAT), Lam Research Corporation (LRCX), KLA Corp (KLAC), MKS Instruments, Inc. (MKSI), and Advanced Energy Industries, Inc. (AEIS)
Below is a chart that demonstrates relative performance of semiconductor CapEx companies relative to semiconductor producers. The indexes were constructed by Clocktower Group with data from Macrobond.
"What it shows is the long term trend of performance of CapEx over producers," Papic said of the chart's trend line. "It seems to have lost some momentum right now, but I think that chart will continue to show outperformance."
With this in mind, he noted that investors need to consider that the sector is cyclical. On one end, there's a slowing down in economic growth. So it's probably not yet a good entry point for investors.
This decline may run for the next three to six months or however long it takes for investors and the market to be satisfied that the recession is going to be mild and not heavy.
Below is a chart of a semiconductor CapEx index constructed by Clocktower Group with data sourced from Macrobond showing performance relative to the global broad market.
"You can see that semiconductor CapEx plays are starting to lose to the broad market, and that speaks to that cyclicality I've been talking about," Papic said.
However, by the end of the year or next year, there should be a good entry point into CapEx stocks. When investors do get an appetite to start bottom fishing, this is the sub-sector they should focus on, he noted. Betting on this business model over the next three years will pay off, he added. Therefore, it's not a short term play.
