SOXQ - SOXQ: Rich Valuation Wait For A Pullback

2023-11-16 19:46:33 ET

Summary

• The semiconductor industry has been going through inventory correction since late 2022, but it is closer to the end now.
• SOXQ has rebounded strongly in 2023, recovering most of its losses from 2022.
• Semiconductor stocks are riding on several megatrends, but their valuation is expensive, and a recession may pose downside risk.

Introduction

Semiconductor industry has been going through inventory correction since late 2022 following a period of strong demand during pandemic. Has this inventory correction come to an end now? Is this the time to invest? In this article, we will analyze Invesco PHLX Semiconductor ETF ( SOXQ ) and provide our insights and recommendations.

ETF Overview

SOXQ owns a portfolio of 30 large-cap semiconductor stocks globally. The fund basically tracks the PHLX Semiconductor Sector Index. SOXQ was only introduced in 2021 and hence we do not have a lot of its performance data. However, we do know that PHLX Semiconductor Sector Index has outperformed the broader market by delivering a total return over 7 times in the past 10 years. SOXQ’s expense ratio of 0.19% was low among other semiconductor ETFs. Its peer funds iShares Semiconductor ETF ( SOXX ) and First Trust Nasdaq Semiconductor ETF ( FTXL ) have much higher expense ratios of 0.35% and 0.60% respectively.

Semiconductor stocks in SOXQ’s portfolio should be able to grow strongly on several important technological trends in the coming decade. Although the industry’s inventory correction is about to over, macroeconomic uncertainties may still result in a weak demand in the near-term. Given the industry’s rich valuation, we think investors may want to patiently wait for a pullback.

Fund Analysis

SOXQ has rebounded strongly in 2023

Let us begin with a brief overview of how SOXQ performed in the past few years. Like many equities, SOXQ’s fund price dwindled in most of 2022 due to the Federal Reserve’s aggressive rate hike to combat inflation. In fact, the fund has lost nearly 46% from the peak to the trough in 2022. Fortunately, SOXQ’s fund price has now recovered most of its losses. It is now only 8% below the peak reached in early 2022.

We are more closer to the end of the inventory correction than the beginning

The semiconductor industry has been going through inventory adjustments since 2022. Fortunately, this inventory adjustment appears to be more closer to the end than the beginning. We will use two charts in this section to illustrate our point. Both charts show the days sales in inventory of important semiconductor companies. The reason we are using two charts is to avoid confusion as there are many companies involved. As can be seen from the first chart below, companies such as Nvidia ( NVDA ), Micron ( MU ), MediaTek, and Intel ( INTC ) experienced inventory buildup in the second half of 2022. Fortunately, they have been able to reduce their inventories. In the case of Nvidia and MediaTek, their inventory levels are now comparable to the levels in early 2022. Micron and Intel on the other hand saw their inventory declined but still somewhat elevated, suggesting that they are still dealing with some inventory adjustments.

Below is another chart that shows the same days sales in inventory for another batch of semiconductor companies. As can be seen from the chart, the inventory levels are mostly within the range of 50 to 150 days. We do noted that several companies such as AMD ( AMD ), Texas Instruments ( TXN ), and Qualcomm ( QCOM ) are still experiencing slightly higher than normal inventory levels. Together with the first chart, we observed that the inventory correction is likely still ongoing. While some have completed their inventory adjustment process, others are still adjusting.

Semiconductor industry is riding on several mega trends

The semiconductor industry has been growing very fast in the past. This is evident in the fact that the PHLX Semiconductor Sector Index grew by more than 7 times in the past 10 years. In addition, as can be seen from the chart below, the industry’s operating earnings has been on a rapidly rising trend in the past 3 decades.

Looking forward, we expect the sector to continue to grow rapidly fueled by several important technological trends such as the demand for artificial intelligence, electric vehicles, autonomous driving, Internet of Things (IoTs), industrial automation, cloud computing, augmented reality, virtual reality, etc. In fact, according to Proficient Market Insights, global semiconductor market size is expected to reach $1 trillion by 2030. This is significantly higher than the market size of $607 billion in 2023 and represents a compound annual growth rate of 9.18% between 2023 and 2030.

However, semiconductor stocks are not cheap

Let us take a look at SOXQ’s valuation. Below is a chart that shows the average valuation of semiconductor stocks in the S&P 500 index. Since there are significant overlaps between semiconductor sector in the S&P 500 index and SOXQ, we think looking at the valuation of semiconductor stocks in the S&P 500 index is valid. As can be seen from the chart below, the current forward P/E ratio is nearly 25x. This is towards the high end of its historical valuation range, which is between 10x and 25x since 2010. Hence, its current valuation of nearly 25x appears to be quite expensive.

Since our base case is that there will be a recession coming up in the first half of 2024, we think there is still substantial downside risk especially given its rich valuation. As can be seen from the chart above, semiconductor sector is not immune to an economic recession such as the one in 2008/2009. The reason we are not seeing one yet is because it usually takes more than a year for the monetary policy to transmit through different channels of the economy. Therefore, we anticipate a recession to arrive in the first half of 2024. Given macroeconomic uncertainties, it may be wise for investors to remain cautious.

Investor Takeaway

Stocks in SOXQ’s portfolio should continue to benefit from important technological trends in the upcoming decade. However, valuation of the semiconductor sector appears to be rich. Given macroeconomic uncertainties, we think investors may want to patiently wait for a pullback before initiating a position.

Additional Disclosure : This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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