2023-11-06 14:43:57 ET
Summary
- Tensions with China look to be easing and this augurs well for PSI's holdings.
- Also, with its equal-weighted approach compared to more concentrated ETFs like SMH and SOXX, it could benefit from lower risks in the future.
- In this case, Generative AI, which I think has been responsible for the rise of these two semis ETFs, could see more normalization in 2024.
Times have changed with geopolitical tensions with China seeing some de-escalation which is positive for semiconductors (semis). Therefore, it would be tempting to invest in either the VanEck Semiconductor ETF ( SMH ) or the iShares Semiconductor ETF ( SOXX ) which both charge only 0.35% - or less than the Invesco Semiconductors ETF's ( PSI ) 0.57%. On top of that, they have delivered much better performances in the last year as shown below.
Comparison of Metrics (seekingalpha.com)
However, after the enthusiasm created by the Generative AI theme this year whereby only a handful of stocks have driven these two funds to new highs, 2024 should be more of a normal year with the hype around everything that drives artificial intelligence fading away. Also, moving forward, there is an increased likelihood of the economy slowing down. Against such a backdrop, the objective of this thesis is to show that it is PSI that is a buy.
Its shares have delivered one-year gains of 34% but remain below its August peak of $48.2. I start with the recent price action which saw the stock rising from $38 to around $40 in a matter of days while highlighting the two catalysts that could cause the upside to continue.
Rate Cuts, Geopolitics, and PSI's Holdings
First, there was the November 1 FOMC (Federal Open Market Committee) meeting where it was decided to leave the Fed's benchmark rate unchanged to the 5.25% to 5.5% range. This was the second consecutive meeting during which the “pause” mode was favored. This caused treasury yields to plunge as fixed-income investors bought more corporate government bonds, in anticipation of a further pause and even a rate cut, possibly in the first half of 2024. This was followed by an upside in equities including semis with PSI gaining more than 6% over Thursday and Friday.
Second, looking through this Fed-led market euphoria, there were also some signs of geopolitical tensions between the U.S. and China easing . This follows the Chinese Commerce Minister meeting with Micron’s ( MU ) CEO Mehrotra in Beijing on November 3 and informing him that his company was welcome to expand in China provided that it played by the rules of the land. As a refresher, Micron which is PSI's second top holding and a giant computing memory chip producer, had its products flagged by China’s Cybersecurity Administration as posing security risks for the nation's critical information infrastructure in May.
Now, Micron constitutes 6.18% of PSI’s overall weight as shown below and any further upside in the memory maker’s stock which is still well below its Jan 2022 high of $97.36 will positively reverberate on the ETF’s value.
Top Holdings as of 11/02/2023 (www.invesco.com)
There has also been some good news for Intel ( INTC ) which has been able to generate growth and improve its bottom line after it slashed prices on its Arc Alchemist GPUs (Graphics Processing Units) which compete directly with Nvidia's ( NVDA ) GeForce and Advanced Micro Devices' ( AMD ) Radeon series. These price cuts have resonated well with gamers in a period where high inflation continues to dent people’s disposable income.
Another of Intel’s advantages is that it also supplies CPUs (Computing Processing Units) which are required alongside GPUs in gamers' motherboards. This enables the company to bundle game offerings together with subscriptions astutely.
Easing of PC Slump and Stabilization in Data Center
The company has also booked more deals for its foundry business and given its sizeable China exposure, any improvement in relationships with that country bodes well for the chip maker whose earnings call on October 26 was also an opportunity to obtain an idea of both the state of the PC and the data center markets.
In this respect, Intel's management pointed to an easing of the PC slump with such an improvement confirmed by Taiwan Semiconductor Company's ( TSM ) CEO during the company's latest earnings call one week earlier. He indeed mentioned an "early sign of demand stabilization in the PC and smartphone end market". Looking further, there was also a surge in the Taiwanese company's data center business, but this pertains more to AI-related demand. In this respect, Nvidia's GPU chips which are driving OpenAI's ChatGPT come to mind.
However, Intel is also present in this space with its Gaudi AI processors which are seeing a lot of traction, with its executives highlighting $2 billion of revenue visibility from the pipeline. Now, this is still well below the $10.3 billion of sales enabled by Nvidia's H100 GPUs, but Intel's Gaudi is expanding rapidly as corporations have to chart a cost-effective path to deploying AI. For this purpose, Intel's processor is good for certain AI workloads while being more affordable.
Moreover, with customers now having a viable alternative with Intel, Nvidia is no longer likely to enjoy the same near-monopolistic market conditions it enjoyed in the first half of this year as its shares surged by more than 200% since the start of 2023. Looking across the industry, Advanced Micro Devices ( AMD ) another key producer of GPU chips has also experienced upbeat market enthusiasm as it launched the AI-capable MI300 back in January and its shares have gone up by over 80%. TSMC has also benefited as it is perceived as the main beneficiary of AI from the chip manufacturing perspective given that it provides foundry contracting services to both Nvidia and AMD.
PSI Subject to Fewer Concentration Risks
Now, it is precisely thanks to holding more shares of these three companies (Nvidia, AMD, and TSMC) as a percentage of overall assets that SMH has outperformed PSI as tabled in the introduction. Thus, the VanEck ETF dedicates a sizeable 19.6% and 13.02% of its overall weight to Nvidia and TSMC respectively, while it also holds AMD. As for the iShares ETF, it dedicates 9.07% and 7.79% of its assets to AMD and Nvidia respectively.
SMH and SOXX Holdings (www.vaneck.com)
Thus, already holding the appropriate stocks at the right time, these two ETFs have benefited from the AI hype. Going forward, one would think that more rational thinking would prevail, firstly, by customers as they question the quality/price rationale of owning an H100 Vs a Gaudi. Second, investors will likely question whether these three companies deserve their higher valuation premiums. For this matter, Seeking Alpha Quant has a Hold rating on all three.
To further support my statement, there is the Gartner Hype Cycle whereby after studying thousands of emerging technologies and for years, the firm's researchers have come to the conclusion that when a technology is successfully launched, it creates a high level of expectation. This increases till reaching a "peak of inflated expectations", which is eventually followed by a "trough of disillusionment" when people realize that some of the perceived gains may have simply been exaggerated. Now, such a disillusionment scenario could happen in 2024 given that the U.S. economy is losing momentum while inflation persists above the Fed’s 2% target and interest rates are above 5%.
Still, Gartner adds that there should ultimately be a "plateau of productivity" when people realize what the actual benefits of Generative AI are, not those expected. For this purpose, I have valued the productivity gains offered by this innovation in a previous thesis.
Consequently, having a technology that provides tangible benefits on the one hand, and faced with the perspective of a burst in the hype bubble in 2024 on the other, the best ETF to opt for is PSI. The reason is that it tracks the Dynamic Semiconductor Intellidex Index comprised of 30 American chip companies. As such, it is weighted with the first eight holdings consisting of larger valued stocks collectively receiving 44.2% of the total index weight or an average of 5.5%. The remaining twenty-two smaller stocks collectively receive 55.8% of the total index weight. Thus, compared to SMH or SOXX which are more heavily concentrated in big names, PSI's relatively more equal-weighted approach makes more sense to navigate through normalized demand-supply conditions.
As for valuations, based on its lower price-to-earnings multiple of 16.31x compared to SMH's P/E of 18.90x , PSI trades at a discount. Adjusting the current share price of $40.48 to account for a 15% upside, I have a target of $46.55.
A Fair Target in View of Uncertainties
Now, this target remains below the previous peak of $48.2 but is a fair one as it also takes into consideration that economic conditions are no longer what they were in the first half of 2023. Furthermore, there are implications for Apple's supply chain after the company recently announced financial results and its consensus revenue estimates for the quarter ending in December being revised downwards . This implies that Apple's chip suppliers like Qorvo (NASDAQ: QRVO ) could be impacted. Now, with its massive scale and $2.75 trillion market cap, any revenue shortfall for the iPhone company should reverberate across its long list of suppliers many of which are semiconductor plays.
Therefore, investors could witness volatility in case demand for chips is lower when Apple and public cloud providers selling AI-as-a-Service report earnings in January and February next year Also, there are some U.S. lawmakers requesting the Biden administration to constrain China's increasing use of open-source (RISC-V) to develop custom-made AI processors. Therefore, given the sensibility of the matter on both sides of the Pacific Ocean, any action by the U.S. Department of Commerce in this connection could result in a tit-for-tat reaction.
Still, despite all the volatility risks that this implies, I am positive in the longer term as the semiconductor industry remains a cyclical one. In this respect, the stabilization noted for the earlier PC and data center markets is also supported by a report from the Semiconductor Manufacturing Monitor which stipulates that the industry is near the end of the down cycle. The report further adds that the recovery should begin in 2024.
In conclusion, after the AI hype seen this year, PSI, with its more equal-weighted strategy to holding the chip stocks that make artificial intelligence possible, could better shield investors from concentration risks and represent a more balanced approach to investing in semis going forward into 2024.
For further details see:
PSI ETF: A More Balanced Approach To Investing In Chips