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

My followers know I’ve been bullish on the semiconductor sector for years. That is because of a number of highly effective catalysts. Amongst them are development throughout quite a lot of know-how sub-sectors: high-speed networking, information facilities, 5G handsets and infrastructure, EVs, clean-tech, and the on-shoring of supply-chains – simply to call a few. The VanEck Semiconductor ETF (NASDAQ:SMH) is a wonderful nice thematic play on these catalysts as a result of – with its 20% stake in Nvidia (NVDA) – it is usually excellently positioned to learn from what I consider goes to be a powerful multi-year stimulant for the sector: AI. In the present day, I am going to take a more in-depth take a look at the SMH ETF and clarify why all buyers ought to have direct publicity to what for my part is among the most dynamic and essential sectors for the twenty first Century. Certainly, 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:

Funding Thesis

Semiconductors have change into ubiquitous in fashionable life: whether or not in your telephone, TV, laptop computer, wi-fi router, or automobile (and your key-fob) – they’re actually all over the place. Trendy life would merely not be potential with out semiconductors. However, after all, some semiconductors are extra worthwhile than others. Nvidia at the moment makes among the most precious semiconductors on Earth, a lot in order that the U.S. authorities prohibits the sale of Nvidia’s top-end A800 and H800 AI processors from being bought to China. Nonetheless, Nvidia says it doesn’t count on “a near-term significant impression on our monetary outcomes” on account of sturdy international demand for these chips. Certainly, the corporate has had challenges merely assembly that demand.

I’ve been overlaying semiconductors and the SMH ETF on Looking for Alpha for fairly a while. My final article (an “Editor’s Decide”) was again in November of 2022 (see SMH: Buffett Takes Large Stake In ETF’s #1 Holding Taiwan Semiconductor). Since that BUY-rated article was printed, SMH has outperformed the S&P500 by virtually 3x and that pattern could be very prone to proceed shifting ahead and for a few years to come back. Certainly, in line with Precedence Research, gross sales for the worldwide semiconductor market are anticipated to roughly triple over the approaching decade:

Because of this buyers want to determine a core place within the semiconductor sector and to easily maintain it. It is usually why I’ve persistently put a “Purchase” score on SMH and advise buyers to scale right into a full-position over time with a purpose to make the most of market volatility.

From a extra near-term perspective, simply this morning (Wednesday) the Semiconductor Business Affiliation (“SIA”) reported that international chip gross sales rose in November for the primary time in additional than a 12 months. Based on the SIA, chip gross sales for November 2023 rose 5.3% yoy to $48 billion. That was a 2.9% improve as in comparison with October gross sales.

SIA president and CEO John Neuffer mentioned:

World semiconductor gross sales elevated on a year-to-year foundation in November for the primary time since August 2022, a sign that the worldwide chip market is continuous to achieve energy as we enter the brand new 12 months. Wanting forward, the worldwide semiconductor market is projected to expertise double-digit development in 2024.

Traders clearly have varied selections in methods to take part on this market: they’ll spend money on single semiconductor corporations, a extra diversified ETF strategy, or each (my private alternative). In the present day I am going to analyze the SMH ETF after which you may resolve what technique is greatest in your portfolio.

Prime-10 Holdings

The highest-10 holdings within the SMH ETF are proven beneath and had been taken immediately from the VanEck SMH ETF webpage, the place you could find extra detailed data on the fund:

As talked about earlier, the #1 holding with a 20.9% weight is Nvidia. Regardless of all of the chatter about Nvidia’s “sky-high valuation”, a current article within the Wall Avenue Journal at the moment factors out that, on a ahead earnings foundation, the inventory is definitely not considerably over-valued as in comparison with broad semiconductor sector as measured by the Philadelphia Semiconductor Index (see What Nvidia Does For An Encore):

That’s as a result of Nvidia’s data-center income is booming and, in consequence, so is its free-cash-flow. Certainly, the article factors out that over the previous 4-quarters, Nvidia has generated $17.5 billion in FCF – tying with it with Broadcom as the very best within the chip sector (this in line with information from S&P World Market Intelligence).

Meantime, Nvidia inventory has traded strongly this week and reached an all-time excessive after unveiling the brand new GeForce RTX 40 SUPER Sequence household of GPUs. The brand new RTX 4080 SUPER be out there beginning on Jan seventeenth and can retail for $999 – $200 lower than the RTX 4080.

The #2 firm within the SMH ETF is arguably the #1 semiconductor producer on the planet: Taiwan Semiconductor Corp (TSM), or, extra ceaselessly known as “TSMC”. As you recognize, TSMC is the corporate that truly manufactures the highest-end highest-performance chips that main tech corporations like Nvidia, Apple, and Broadcom design. But TSMC at the moment trades with TTM P/E of solely 18.6x, which is a relatively outstanding and important low cost to the S&P500 (25.7x).

Considered one of my favourite shares within the semiconductor sector, Broadcom (AVGO), is the #3 holding with a 6.0% weight. Broadcom is arguably the chief within the international high-speed networking market (though Nvidia actually has its eyes set on gaining important market-share …) and has been rising organically but additionally main by way of M&A. It is most up-to-date acquisition was VMWare (see Broadcom: The Magnificence Inside And Why VMWare Will Add To It). You will need to perceive that Broadcom has a partnership with Nvidia that permits VMWare’s full-stack software program resolution to run Nvidia AI software program and {hardware}.

Broadcom inventory is +85% over the previous 12 months and at the moment trades at over $1,000/share, making it a possible candidate for a 20:1 inventory cut up this 12 months (ala Google and Amazon within the current previous).

Whereas Nvidia might match Broadcom’s FCF, it is not shut when it comes to its dividend (Nvidia solely pays $0.16 yearly). In spite of everything, as I’ve been reporting on Looking for Alpha, Broadcom has been the very best dividend development firm in the complete S&P500 over the previous 5-years. AVGO’s newest quarterly improve was 14% to $5.25, or a whopping $21.00/share on an annual foundation. Regardless of AVGO’s large inventory run, that’s nonetheless adequate for a close to 2% yield.

The fund additionally has ~11% allotted to Intel (INTC) and AMD (AMD), each of whom are attempting to carve out their very own niches within the AI area. AMD introduced the brand new Radeon RX 6700 XT graphics card on the Client Electronics Present Monday. The inventory is up ~9% over the previous 5 buying and selling days.

The semiconductor gear makers are effectively represented within the top-10 holdings with ~17.5% of the portfolio allotted to ASML Holdings (ASML), Lam Analysis (LRCX), and Utilized Supplies (AMAT). All of those semi-equip corporations have glorious development prospects with the diversification and on-shoring of important supply-chains away from China in addition to the endless quest within the trade for higher-performance and lower-power semiconductor processes and options.

Efficiency

As talked about earlier, the SMH ETF has been a terrific performer for years. The common annual returns chart beneath reveals why the fund carries an general, 3-year & 5-year 5-Star score from Morningstar:

As you may see from the graphic, the fund has a median annual return over the lifetime of the fund (since 2011) of a outstanding 24.2%.

The graphic beneath compares the 5-year efficiency of the SMH ETF to a few of its friends: the Constancy Choose Semiconductors ETF (FSELX), the SPDR S&P Semiconductor ETF (XSD), the iShares Semiconductor ETF (SOXX), and the Invesco Semiconductors ETF (PSI):

As you may see, the SMH ETF has acquitted itself fairly effectively, solely lagging the chief – FSELX – by 16% whereas considerably outperforming the entire different friends proven on this comparability. Word the home semiconductor funds don’t maintain Taiwan Semiconductor inventory. Contemplating TSMC is arguably the chief in semiconductor manufacturing, that may be a main benefit of ETFs like SMH. FSELX, for instance, additionally has a place in TSMC (5.4%) and a bigger place in NVidia as in comparison with SMH (26%).

Dangers

SMH’s expense price is 0.35%, which is usually greater than I prefer to spend on funds. Nonetheless, on this case it’s effectively price it given the fund’s glorious long-term efficiency monitor report.

Because the charts above demonstrated, semiconductor funds may be very unstable. They’ll commerce off of geopolitical occasions, the rise/fall of the U.S. greenback (it was a rising U.S. greenback that helped sink SMH over 20% in Q2FY2022), and the well being (or perceived well being) of the general tech-sector. That being the case, I strongly advise buyers who need to set up a place within the fund to scale-in over time in order to not purchase at market tops and to make the most of market volatility. For instance, it took me ~2 years to determine a full-position in SMH, and I nonetheless add from time-to-time on dips.

The ETF’s 9% stake in TSMC is clearly considerably dangerous given China’s militaristic perspective towards Taiwan. That mentioned, an assault on Taiwan would probably render TMSC’s fabs completely ineffective as a result of not solely would they probably endure extreme bodily injury, however the vegetation are additionally not price something with out the know-how of the Taiwanese engineers that handle and function it.

As current warnings by corporations like Micron (MU) and Samsung (OTCPK:SSNLF) recommend, there’s nonetheless some weak spot and stock flushing that should happen within the reminiscence market. Samsung shouldn’t be at the moment held within the fund and the allocation to Micron in SMH is barely 2.07%.

SMH is a big and in style fund with $11+ billion in belongings beneath administration. That being the case, there are not any liquidity points in anyway.

From a valuation perspective, Yahoo Finance reports the SMH ETF at the moment trades with a TTM P/E of solely 14.8x and a dividend of 0.60%. That mentioned, the first funding alternative with the SMH ETF is clearly capital appreciation, not earnings. Meantime, I do not pay an entire lot of consideration to short-term valuation metrics on an ETF like SMH as a result of, as said earlier than, I take into account SMH to be the sort of core long-term holding a well-diversified portfolio should purchase and maintain. And once I say “purchase”, once more, I counsel buyers to scale-in over time (or “greenback price common” in the event you choose) to make the most of market volatility – and to take action by way of the semiconductor cycle when valuation ranges as reported by P/E can rise and fall relatively dramatically. In the present day the P/E is comparatively low as a result of we’re arguably popping out of considerably of a down-cycle – though it didn’t impression all corporations equally.

Abstract & Conclusion

The SMH ETF is a wonderful approach for buyers to achieve diversified publicity to the highest semiconductor corporations on the planet. That mentioned, if you have already got a place in Nvidia, and given its 20% weight in SMH, I recommend the XSD equal weight semiconductor ETF as a greater various for these wanting to construct a extra well-diversified strategy (see XSD: “Xtra” Semiconductor Diversification). No matter the way you need to play it, I strongly advise all buyers to have some direct publicity to the dynamic and really profitable semiconductor sector.

Editor’s Word: This text discusses a number of securities that don’t commerce on a serious U.S. alternate. Please pay attention to the dangers related to these shares.