In 2021, global semiconductor revenues hit a record 527.9 billion, yet so far, 2022 has been horrible for microchip stocks. Since the end of December 2021, the 30-stock Philadelphia Semiconductor benchmark, or SOX for short, has fallen 43%.

For comparison, the S&P 500 has lost about 23%, the tech-heavy Nasdaq Composite 33%.

Stock valuations have been ransacked, even for standout sector names, like Nvidia (NVDA:NASDAQ), Qualcomm (QCOM:NASDAQ), Intel (INTC:NASDAQ), TSMC (2330:TPE) and ASML (ASML:AMS).

It’s not hard to see why investors are concerned. A chip shortage that has hobbled the manufacturers of everything from smartphones to medical equipment, toys to wind turbines, stubbornly rumbles on, the global economy is starring hot inflation squarely in the face and recession hangs like a dark cloud over many of the world’s largest economies.

But you know what they say, when the market mood is peak bleak, that’s often time to buy. ‘I think there is an absolutely massive opportunity here, and it might be realised quite quickly at this point,’ says William de Gale, a fund manager who followed and analysed the semis industry for 20 years at BlackRock.

Now running his own Bluebox Global Technology Fund (BN4H3T7), de Gale remains wedded to the semis sector, with 37% of the fund’s assets tied up in the space, in names such TSMC, ASML and Applied Materials (AMAT:NASDAQ).

WHY IS THE MICROCHIP INDUSTRY IN TROUBLE?

Given that semiconductors are critical building blocks of modern society, often have compelling cash flow metrics, and generally have positive end market growth trajectories, what’s gone wrong.

The semiconductor industry initially eased back on manufacturing in 2020 as coronavirus lockdowns made it difficult to keep chipmaking facilities fully staffed. As restrictions eased, fabrication (fabs) started to move back towards capacity, with a long-lasting demand surge for PCs, smartphones, TVs, gaming consoles and much else replacing orders put on ice by other markets, including the auto industry. As those latter sectors recovered, it put enormous strain on fabs, which simply could not ramp up to meet the suddenly sky-high demand.

The effort to stabilise and boost chip supplies also faced headwinds from geopolitical conflicts, an increasingly fractious relationship between Washington and Beijing, natural disasters, and recurring Covid-19 outbreaks near important manufacturing hubs in China.

How long microchip supplies will remain tight is still an open question, but the consensus indicates that semiconductor fab capacity will fall short of incoming orders at least until the first half of 2023. However, some recent rumblings have raised the hopes of a faster recovery.

For example, automotive computing giant NXP Semiconductors (NXPI:AMS) saw signs of improvement in July’s second-quarter earnings announcement. Chief executive Kurt Sievers noted that NXP is ‘probably moving away from supply constraints’ in the mobile chip market and the auto industry has started to increase its vehicle-building volumes.

Of course, the order backlog is still growing and NXP’s customers have to count on lead times of several months, but NXP sees light at the end of the chip-shortage tunnel.

Just last week 19 October, ASML shares jumped 7% after the Dutch lithography equipment maker told investors that it would beat fourth-quarter analyst estimates and that it won’t be badly impacted by the latest US restrictions on sales of silicon chips and technology to China.

As inflationary fears hold consumers back from spending on new smartphones and other chip-powered devices, fading demand here will free fab capacity for microchips needed for industrial purposes, helping manufacturing giants to get back on track. Contract microchip maker TSMC supported this view in its own July earnings release

‘Softness’ on the consumer side allows the company to reallocate its manufacturing capacity to support more substantial order flows, where demand remains steady or rising. This way, TSMC is inching closer to meeting total market demand. However, the fight isn’t over quite yet. TSMC said that the manufacturing pipeline will ‘remain tight throughout 2022’.

This year has seen ‘great pricing power come through, like TSMC putting up prices by about 20%... its order book remains incredibly robust,’ said Nick Clay of the Redwheel Global Equity Income Fund (BMBQMY8).

That said, TSMC has had to adjust, cutting this year’s capital spend budget by 10% to realign its growth plans.

So even optimists agree that semiconductor shortages are likely to remain for some time yet. Given that the problem depends, to some degree at least, on macro and geopolitical issues, trying to predict exact timings is a mugs’ game.

SEMICONDUCTORS ARE LONG-RUN THEME

Foretelling the future is an exercise Bluebox’s de Gale typically sidesteps, but he does feel ‘80% confident’ of improvements for the sector are incoming, and he makes an interesting point. ‘Third-quarter reporting represents the end of the news vacuum,’ he says, stressing the limited information that usually emerges from the industry during May to September.

This could see concerns of worrying inventory build-ups ease as quarterly reports emerge from sector players over the coming days and weeks. Higher inventories suggest that microchips already manufactured are not finding homes as quickly as they might, which is sometimes seen as a signpost to softening demand and weakening margins. Conversely, with expectations already low for this year and 2023, near-term financial results could be stronger than expected and prompt a sharp revaluation of sector stocks, especially given the long-run opportunity.

‘Over the long run, semiconductor revenues are likely to oscillate around a trend line,’ said analysts at Deloitte in their semiconductors industry outlook earlier this year. ‘Still, that trend line looks steeper than ever before as we enter a period of robust secular growth.’

This is backed up by robust growth forecasts years into the future. According to Worldwide Semiconductor Trade Statistics, the market is expected to increase 13.9 percent in 2022, while figures presented by the Fortune Business Insights report predict compound average growth rates of nearly 13% a year out to 2029, which would imply revenues in excess of $1.38 trillion

This growth will be in part powered by a vast spending spree that many chipmakers have embarked on. In January 2022, TSMC, the world’s biggest contract manufacturer, said it would spend up to $44 billion on new capacity in 2022. That is up from $30 billion last year, triple the number in 2019 and ahead of earlier plans to spend over $100 billion in total over the next three years.

Elsewhere, Intel earmarked $28 billion of investment this year, with new fabs in Ohio set to come onstream by 2025 at a total cost of $20 billion. An option to build six more later would take the overall price tag to $100 billion. Samsung (005930:KS) has hinted that its capital spending for 2022 will surpass last year’s $33 billion, and others in the sector are also splurging on capacity expansion.

This is an industry with big structural drivers, with almost everything from cars to industrial infrastructure needing microchips, says Redwheel’s Clay. ‘ We feel the backdrop to that market, the ability to put up prices and structural demand put them in strong position.’

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