Are semiconductors signalling a tech crash?

Peter Garnry

Head of Equity Strategy

Semiconductor stocks came under pressure yesterday as chip equipment maker KLA-Tencor lowered its outlook for Q4. The news immediately sent semiconductor stocks down 5-10% across the board, extending into the Asian session. As we have said since January, semiconductors and cars are the two most vulnerable parts of the economy in a trade war between China and the US as the two industries have an extensive global supply chain. The bigger question here is whether semiconductor weakness is a sign of potential broader weakness in the global technology sector that has been the primary engine behind gains in global equities and aggregate earnings.

Software is king

It’s likely no surprise that the largest industry group in the S&P 500 is Software  Services. But what will likely surprise many is the fact that its index weight is 15.6%, or nearly twice the second-ranked Pharmaceutical, Biotechnology & Life Science industry group with an index weight of 8.2%. If you add the two other industry groups in the technology sector, Hardware Equipment and Semiconductors, the technology sector has an index weight of 26% in the S&P 500 with Hardware Equipment and Semiconductors having index weights of 6.6% and 3.4% respectively.

The biggest change in the technology sector over the past 23 years is the size and influence of software companies. Historically, the technology sector was dominated by hardware companies such as IBM, HP, Dell, and Apple. But as digitalisation has expanded into every corner of society, software companies have grabbed a larger share of the economy and equity markets. Today the Software & Services sector is 60% of the technology index with the Hardware Equipment and Semiconductors industry groups having technology sector index weights of 25% and 15% respectively. Software companies are mostly shielded from the trade war as they don’t have global supply chains. Software companies obviously live off large data centers which consume semiconductors and memory chips but input costs from this utility are low. If semiconductor prices fall, it will only lower the input costs for software companies. 

The software revolution has been under way for decades in the physical world. But in financial markets, the period post- the Great Financial Crisis has been the golden period for software stocks. Since 1995, the Software & Services industry group has delivered a 2,000% total return in USD or 13.8% annualised, easily surpassing the S&P 500’s performance. As the performance chart below shows, the majority of the return has come in the period 2009-2018. Will it continue?

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Unless regulation is significantly increased, our view is that software companies will continue to outperform other parts of the equity market. Software companies are unique because their capital expenditure needs are much lower than traditional industries. The industry also experiences higher top line growth and a return on invested capital that far exceeds the cost of capital compared to older industries.

Because of these effects, we are not particularly worried about the recent decline in semiconductors. What matters for the technology sector is the Software & Services industry group, and here we see few headwinds in the short term.

Here are some interesting facts on the S&P 500 Software & Services industry group:

● 12-month forward EV/EBITDA is 14.4x compared to 11.3x for the S&P 500 (27% premium)
● 12-month forward P/E ratio of 22.5x
● Cash flow yield is 6.8% for an industry growing at ~10% per year
● Negative net debt


In essence you are paying a 27% premium for higher growth, zero interest rate sensitivity, and a 6.8% cash flow yield which is still higher than what is offered in high yield credit. There are no good arguments for not being overweight Software & Services.

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