XSD - SMH: You Need Exposure To The Vibrant And Lucrative Semiconductor Sector

2024-01-10 15:23:25 ET

Summary

• The VanEck Semiconductor ETF has been significantly outperforming the broad market indexes and has an average annual return of 24%+.
• Nvidia, the top holding in the SMH ETF with a 21% weight, is generating strong growth in revenue and free-cash-flow and is arguably not over-valued.
• Global semiconductor sales are projected to triple over the next decade. As a result, all investors need to have exposure to this dynamic and very lucrative sector.

My followers know I have been bullish on the semiconductor sector for years. That is due to multiple powerful catalysts. Among them are growth across a variety of technology sub-sectors: high-speed networking, data centers, 5G handsets and infrastructure, EVs, clean-tech, and the on-shoring of supply-chains - just to name a few. The VanEck Semiconductor ETF ( SMH ) is an excellent great thematic play on these catalysts because - with its 20% stake in Nvidia ( NVDA ) - it is also excellently positioned to benefit from what I believe is going to be a strong multi-year stimulant for the sector: AI. Today, I'll take a closer look at the SMH ETF and explain why all investors should have direct exposure to what in my opinion is one of the most dynamic and important sectors for the 21st Century. Indeed, the SMH ETF has been outperforming the broad market averages (as represented by the S&P500 ( VOO ), DJIA ( DIA ), and Nasdaq-100 ( QQQ ) ETFs) for years:

Investment Thesis

Semiconductors have become ubiquitous in modern life: whether in your phone, TV, laptop, wireless router, or car (and your key-fob) - they are literally everywhere. Modern life would simply not be possible without semiconductors. But, of course, some semiconductors are more valuable than others. Nvidia currently makes some of the most valuable semiconductors on Earth, so much so that the U.S. government prohibits the sale of Nvidia's top-end A800 and H800 AI processors from being sold to China. However, Nvidia says it does not expect "a near-term meaningful impact on our financial results" due to strong global demand for these chips. Indeed, the company has had challenges simply meeting that demand.

I have been covering semiconductors and the SMH ETF on Seeking Alpha for quite some time. My last article (an "Editor's Pick") was back in November of 2022 (see SMH: Buffett Takes Big Stake In ETF's #1 Holding Taiwan Semiconductor ). Since that BUY-rated article was published, SMH has outperformed the S&P500 by almost 3x and that trend is very likely to continue moving forward and for many years to come. Indeed, according to Precedence Research , sales for the global semiconductor market are expected to roughly triple over the coming decade:

This is why investors need to establish a core position in the semiconductor sector and to simply hold it. It is also why I have consistently put a "Buy" rating on SMH and advise investors to scale into a full-position over time in order to take advantage of market volatility.

From a more near-term perspective, just this morning (Wednesday) the Semiconductor Industry Association ("SIA") reported that global chip sales rose in November for the first time in more than a year. According to the SIA, chip sales for November 2023 rose 5.3% yoy to $48 billion. That was a 2.9% increase as compared to October sales.

SIA president and CEO John Neuffer said:

Global semiconductor sales increased on a year-to-year basis in November for the first time since August 2022, an indication that the global chip market is continuing to gain strength as we enter the new year. Looking ahead, the global semiconductor market is projected to experience double-digit growth in 2024.

Investors obviously have various choices in how to participate in this market: they can invest in single semiconductor companies, a more diversified ETF approach, or both (my personal choice). Today I'll analyze the SMH ETF and then you can decide what strategy is best for your portfolio.

Top-10 Holdings

The top-10 holdings in the SMH ETF are shown below and were taken directly from the VanEck SMH ETF webpage , where you can find more detailed information on the fund:

As mentioned earlier, the #1 holding with a 20.9% weight is Nvidia. Despite all the chatter about Nvidia's "sky-high valuation", a recent article in the Wall Street Journal today points out that, on a forward earnings basis, the stock is actually not significantly over-valued as compared to broad semiconductor sector as measured by the Philadelphia Semiconductor Index (see What Nvidia Does For An Encore ):

That is because Nvidia's data-center revenue is booming and, as a result, so is its free-cash-flow. Indeed, the article points out that over the past 4-quarters, Nvidia has generated $17.5 billion in FCF - tying with it with Broadcom as the highest in the chip sector (this according to data from S&P Global Market Intelligence).

Meantime, Nvidia stock has traded strongly this week and reached an all-time high after unveiling the new GeForce RTX 40 SUPER Series family of GPUs. The new RTX 4080 SUPER be available starting on Jan 17th and will retail for $999 - $200 less than the RTX 4080.

The #2 company in the SMH ETF is arguably the #1 semiconductor manufacturer on the planet: Taiwan Semiconductor Corp ( TSM ), or, more frequently referred to as "TSMC". As you know, TSMC is the company that actually manufactures the highest-end highest-performance chips that leading tech companies like Nvidia, Apple, and Broadcom design. Yet TSMC currently trades with TTM P/E of only 18.6x, which is a rather remarkable and significant discount to the S&P500 ( 25.7x ).

One of my favorite stocks in the semiconductor sector, Broadcom ( AVGO ), is the #3 holding with a 6.0% weight. Broadcom is arguably the leader in the global high-speed networking market (although Nvidia certainly has its eyes set on gaining significant market-share ...) and has been growing organically but also primary through M&A. It's most recent acquisition was VMWare (see Broadcom: The Beauty Within And Why VMWare Will Add To It ). It is important to understand that Broadcom has a partnership with Nvidia that enables VMWare's full-stack software solution to run Nvidia AI software and hardware.

Broadcom stock is +85% over the past year and currently trades at over $1,000/share, making it a likely c andidate for a 20:1 stock split this year (ala Google and Amazon in the recent past).

While Nvidia may match Broadcom's FCF, it isn't close in terms of its dividend (Nvidia only pays $0.16 annually). After all, as I have been reporting on Seeking Alpha, Broadcom has been the best dividend growth company in the entire S&P500 over the past 5-years. AVGO's latest quarterly increase was 14% to $5.25, or a whopping $21.00/share on an annual basis. Despite AVGO's big stock run, that is still good enough for a near 2% yield.

The fund also has ~11% allocated to Intel ( INTC ) and AMD ( AMD ), both of whom are trying to carve out their own niches in the AI space. AMD announced the new Radeon RX 6700 XT graphics card at the Consumer Electronics Show Monday. The stock is up ~9% over the past 5 trading days.

The semiconductor equipment makers are well represented in the top-10 holdings with ~17.5% of the portfolio allocated to ASML Holdings ( ASML ), Lam Research ( LRCX ), and Applied Materials ( AMAT ). All of these semi-equip companies have excellent growth prospects with the diversification and on-shoring of critical supply-chains away from China as well as the never-ending quest in the industry for higher-performance and lower-power semiconductor processes and solutions.

Performance

As mentioned earlier, the SMH ETF has been a terrific performer for years. The average annual returns chart below shows why the fund carries an overall, 3-year & 5-year 5-Star rating from Morningstar:

As you can see from the graphic, the fund has an average annual return over the life of the fund (since 2011) of a remarkable 24.2%.

The graphic below compares the 5-year performance of the SMH ETF to some of its peers: the Fidelity Select Semiconductors ETF ( FSELX ), the SPDR S&P Semiconductor ETF ( XSD ), the iShares Semiconductor ETF ( SOXX ), and the Invesco Semiconductors ETF ( PSI ):

As you can see, the SMH ETF has acquitted itself quite well, only lagging the leader - FSELX - by 16% while significantly outperforming all of the other peers shown in this comparison. Note the domestic semiconductor funds do not hold Taiwan Semiconductor stock. Considering TSMC is arguably the leader in semiconductor manufacturing, that is a major advantage of ETFs like SMH. FSELX, for example, also has a position in TSMC (5.4%) and a larger position in NVidia as compared to SMH (26%).

Risks

SMH's expense fee is 0.35%, which is generally more than I like to spend on funds. However, in this case it is well worth it given the fund's excellent long-term performance track record.

As the charts above demonstrated, semiconductor funds can be very volatile. They can trade off of geopolitical events, the rise/fall of the U.S. dollar (it was a rising U.S. dollar that helped sink SMH over 20% in Q2FY2022), and the health (or perceived health) of the overall tech-sector. That being the case, I strongly advise investors who want to establish a position in the fund to scale-in over time so as not to buy at market tops and to take advantage of market volatility. For example, it took me ~2 years to establish a full-position in SMH, and I still add from time-to-time on dips.

The ETF's 9% stake in TSMC is obviously somewhat risky given China's militaristic attitude toward Taiwan. That said, an attack on Taiwan would likely render TMSC's fabs totally useless because not only would they likely suffer severe physical damage, but the plants are also not worth anything without the know-how of the Taiwanese engineers that manage and operate it.

As recent warnings by companies like Micron ( MU ) and Samsung ( OTCPK:SSNLF ) suggest, there is still some weakness and inventory flushing that needs to take place in the memory market. Samsung is not currently held in the fund and the allocation to Micron in SMH is only 2.07%.

SMH is a large and popular fund with $11+ billion in assets under management. That being the case, there are no liquidity issues whatsoever.

From a valuation perspective, Yahoo Finance reports the SMH ETF currently trades with a TTM P/E of only 14.8x and a dividend of 0.60%. That said, the primary investment opportunity with the SMH ETF is clearly capital appreciation, not income. Meantime, I don't pay a whole lot of attention to short-term valuation metrics on an ETF like SMH because, as stated before, I consider SMH to be the kind of core long-term holding a well-diversified portfolio should buy and hold. And when I say "buy", again, I advise investors to scale-in over time (or "dollar cost average" if you prefer) to take advantage of market volatility - and to do so through the semiconductor cycle when valuation levels as reported by P/E can rise and fall rather dramatically. Today the P/E is relatively low because we are arguably coming out of somewhat of a down-cycle - even though it did not impact all companies equally.

Summary & Conclusion

The SMH ETF is an excellent way for investors to gain diversified exposure to the top semiconductor companies on the planet. That said, if you already have a position in Nvidia, and given its 20% weight in SMH, I suggest the XSD equal weight semiconductor ETF as a better alternative for those wanting to build a more well-diversified approach (see XSD: "Xtra" Semiconductor Diversification ). Regardless of how you want to play it, I strongly advise all investors to have some direct exposure to the dynamic and very lucrative semiconductor sector.

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