What is a Semiconductor?
A semiconductor is a material product usually comprised of silicon, which conducts electricity more than an insulator, such as glass, but less than a pure conductor, such as copper or aluminum. Their conductivity and other properties can be altered with the introduction of impurities, called doping, to meet the specific needs of the electronic component in which it resides. Also known as semis, or chips, semiconductors can be found in thousands of products such as computers, smartphones, appliances, gaming hardware, and medical equipment.
Semiconductor devices can display a range of useful properties such as showing variable resistance, passing current more easily in one direction than the other and reacting to light and heat. Their actual function includes the amplification of signals, switching, and energy conversion. Therefore, they find widespread use in almost all industries and the companies that manufacture and test them are considered to be excellent indicators on the health of the overall economy.
Types of Semiconductors
Broadly speaking, semiconductors fall into four main product categories:
- Memory: Memory chips serve as temporary storehouses of data and pass information to and from computer devices' brains. The consolidation of the memory market continues, driving memory prices so low that only a few giants like Toshiba, Samsung and NEC can afford to stay in the game.
- Microprocessors: These are central processing units that contain the basic logic to perform tasks. Intel's domination of the microprocessor segment has forced nearly every other competitor, with the exception of Advanced Micro Devices, out of the mainstream market and into smaller niches or different segments altogether.
- Commodity Integrated Circuit: Sometimes called "standard chips", these are produced in huge batches for routine processing purposes. Dominated by very large Asian chip manufacturers, this segment offers razor-thin profit margins that only the biggest semiconductor companies can compete for.
- Complex SOC: "System on a Chip" is essentially all about the creation of an integrated circuit chip with an entire system's capability on it. The market revolves around growing demand for consumer products that combine new features and lower prices. With the doors to the memory, microprocessor and commodity integrated circuit markets tightly shut, the SOC segment is arguably the only one left with enough opportunity to attract a wide range of companies.
- Found in thousands of electronic products, a semiconductor is a material which conducts electricity more than an insulator but less than a pure conductor.
- There are four basic types of semiconductors.
- The semiconductor industry lives – and dies – by a simple creed: smaller, faster and cheaper.
- Investors should bear in mind that the semiconductor industry is a highly cyclical one, subject to periodic booms and busts.
The Semiconductor Industry
Success in the semiconductor industry depends on creating smaller, faster, and cheaper products. The benefit of being tiny is that more power can be placed on the same chip. The more transistors on a chip, the faster it can do its work. This creates fierce competition in the industry, and new technologies lower the cost of production per chip so that within a matter of months, the price of a new chip might fall 50%.
This gave rise to the observations called Moore's Law, which states that the number of transistors in a dense integrated circuit doubles approximately every two years. The observation is named after Gordon Moore, the co-founder of Fairchild Semiconductor and Intel, who wrote a paper describing it in 1965. Nowadays, the doubling period is often quoted as 18 months—the figure cited by Intel executive David House.
As a result, there is constant pressure on chipmakers to come up with something better and even cheaper than what defined state-of-the-art only a few months before. Therefore, semiconductor companies need to maintain large research and development budgets. The semiconductor market research association IC Insights reported that the largest 10 semiconductor companies spent an average of 13.0% of sales on R&D in 2017, ranging from 5.2% to 24.0% for individual companies.
Traditionally, semiconductor companies controlled the entire production process, from design to manufacture. Yet many chip makers are now delegating more and more production to others in the industry. Foundry companies, whose sole business is manufacturing, have recently come to the fore, providing attractive outsourcing options. In addition to foundries, the ranks of increasingly specialized designers and chip testers are starting to swell. Chip companies are emerging leaner and more efficient. Chip production now resembles a gourmet restaurant kitchen, where chefs line up to add just the right spice to the mix.
In the 1980s, chip makers lived with yields (number of operational devices out of all manufactured) of 10-30%. To be competitive today, however, chip makers have to sustain yields of 80-90%. This requires very expensive manufacturing processes. As a result, many semiconductor companies carry out design and marketing but choose to outsource some or all of the manufacturing. Known as fabless chip makers, these companies have high growth potential because they are not burdened by the overhead associated with manufacturing, or "fabrication."
Investing in the Semiconductor Industry
Aside from investing in individual companies, there are several ways to monitor the investment performance of the overall sector. These include the benchmark PHLX Semiconductor Index, known as the SOX, as well as its derivative forms in exchange-traded funds. There are also indices that break the sector down to chip makers and chip equipment makers. The latter develops and sells machinery and other products used to design and test semiconductors.
In addition, certain markets overseas, such as Taiwan, South Korea, and to a lesser extent Japan, are highly dependent on semiconductors and therefore their indices also provide clues on the health of the global industry.
Special Considerations for Semiconductor Investing
If semiconductor investors can remember one thing, it should be that the semiconductor industry is highly cyclical. Semiconductor makers often see "boom and bust" cycles based on the underlying demand for chip-based products. When times are good, profit margins can run very high for chipmakers; when demand falls through, however, chip prices can fall dramatically and have a major effect on many industries' supply chains.
Demand typically tracks end-market demand for personal computers, cell phones, and other electronic equipment. When times are good, companies like Intel and Toshiba can't produce microchips quickly enough to meet demand. When times are tough, they can be downright brutal. Slow PC sales, for instance, can send the industry—and its share prices—into a tailspin.
At the same time, it doesn't make sense to speak of the "chip cycle" as if it were an event of singular nature. While semiconductors is still a commodity business at heart, its end markets are so numerous—PCs, communications infrastructure, automotive, consumer products, etc.— that it is unlikely that excess capacity in one area will bring the whole house down.
The Risks of Cyclicality
Surprisingly, the cyclicality of the industry can provide a degree of comfort for investors. In some other technology sectors, like telecom equipment, one can never be entirely sure whether fortunes are cyclical or secular. By contrast, investors can be almost certain that the market will turn at some point in the not-so-distant future.
While cyclicality offers some comfort, it also creates a risk for investors. Chip makers must routinely take part in high-stakes gambling. The big risk comes from the fact that it can take many months, or even years, after a major development project for companies to find out whether they've hit the jackpot, or blown it all. One cause of the delay is the intertwined but fragmented structure of the industry: Different sectors peak and bottom out at different times. For instance, the low point for foundries frequently arrives much sooner than it does for chip designers. Another reason is the industry's long lead time: It takes years to develop a chip or build a foundry, and even longer before the products make money.
Semiconductor companies are faced with the classic conundrum of whether it's the technology that drives the market or the market that drives the technology. Investors should recognize that both have validity for the semiconductor industry.