The Moat Show Ep. 3: Semiconductors with Morningstar's Brian Colello

On The Moat Show, we uncover the companies with economic moats, one stock at a time, by bringing on analysts from Morningstar to share their in-depth insights with you.

Visit VanEck.com/MOAT or VanEck.com/SMOT for the latest VanEck Morningstar Wide Moat ETF or VanEck Morningstar SMID Moat ETF holdings on the stock discussed in this episode.

The views and opinions expressed herein are those Debbie Wang of Morningstar as of 5/18/2023, and are not intended as financial advice, a recommendation to buy or sell any securities mentioned, or any call to action. Actual future performance of any securities mentioned is unknown. Certain statements may constitute forecasts, projections, or other forward-looking statements which are valid as of the recording date, for illustrative purposes only, subject to change without notice, and do not necessarily reflect those of VanEck or its employees.

CHELSEA: It's our third episode for the Moat Show. And today we're covering the semiconductors. We have on Morningstar's director of technology equity research, Brian Colello. Brian, there are a lot of different types of semiconductor chips. What are the main chip types and why are they all so integral in today's world?

BRIAN: Hi Chelsea, thanks again for having me. It's nice to be here. There's many different types of semiconductor chips. You know, we hear a lot of focus on those from Intel and Nvidia, Apple and others, but there are many different types made by many different companies all around the world. So I think perhaps the most important are processors. So the ones that actually run software on electronic devices. So you can think about the Intel or A and B CPU inside your computer, you could think about the Apple processor inside of the iPhone or the Qualcomm processor inside of an Android phone. Nvidia special, AMD specialized in graphics processors. Those handle a lot of the graphics for gaming. So consumers are familiar with that too. But there's a host of peripheral types of semiconductors as well. So around any sort of digital chip or processor, you often have handle analog chips which handle real world signals, capturing things like temperature, pressure, handling the voltage. There's a whole host of types of power semiconductors to make sure that the proper electric current is going through the electronics device at the proper, consistent voltage so as to not harm the system. There's a whole line of microcontrollers which are simple processing. So on and off, think about like the power windows in your car and just on, on, off making those switches. There's a host of memory chip data. If you're buying ever buying an SD card or, you know, flash memory, there's a whole host of semiconductor content there. And then there's the supply chain beyond that. So, these are the companies that most that I mentioned are just designing the chips. But then a lot of the manufacturing is outsourced to foundry. Taiwan Semi is the largest in the world there. That requires a lot of chip equipment. So in the semiconductor space you have companies like ASML, Lam Research, Applied Materials, and then there even beyond that, there's a whole host of companies in materials packaging other steps in the process. Why they're integral, again, more and more electronics devices are being used around the world. Things are becoming smarter, requiring more connectivity, more sensing, more processing

COULTER: Wow, so you kind of touched on a little bit, Brian, because in there you're talking about, today's world, there's a lot of trends that are there technologies that are coming to light and people are taking advantage of that just require more computing power and these chips might be needed for those. So, what sort of emerging technologies or themes, you know, are do you see, you know, leading as opportunities, you know, for this industry?

BRIAN: Yeah, glad the you know, I think still there's a lot of demand or a lot of chip usage in PCs and smartphones and so you're in is still see development there. We all require more computing power in a lot of different ways. What we're seeing specifically more exciting trends I guess, in the enterprise is cloud computing. So companies shifting their data centers online. That requires more processing power. It's sort of these hyperscale or cloud companies, the Amazons, Microsofts of the world. Data Center spending of requires all the networking semis to sort of route the traffic to power all of that Internet traffic going all over the world, both on a wired and wireless basis. But even beyond that, we're seeing more and more smart devices being used by consumers and businesses. And this requires some of the simpler chips that we see the analog chips, the microcontrollers. One of our favorite trends is automotive. If you think about all the bells and whistles that the car manufacturers try to sell you on, whether it's active safety systems or more advanced infotainment, that's all powered by electronics and thus powered by semi's is a very favorable trend towards the Internet of Things. So to the extent you have smart devices in your home, that again, that's a big boost for chips. And finally, I say chips are a big part of the green trend electrification and they're a big part of electric vehicles. If you have a Tesla and a big battery, you're trying to get all that voltage around the system. And we've all seen the dashboards on those, which is really just looks like a large tablet that that all requires chip content more so than the gas powered cars of five, ten, 20 years ago. So I would say cloud computing, automotive, Internet of Things, and then artificial intelligence, probably as part of the cloud computing trend, though, those are the really exciting pieces we see in semis.

COULTER: Wow, it's really interesting. So it's like, when you start digging into a lot of the semiconductor, there's a lot of different types of chips that are used in different applications. And there's a lot of companies involved in the process of both designing and then also manufacturing, you know, these chips. So I guess from your perspective and from the Morningstar analysis perspective, I know the economic memory and are you guys proud is a substantial one. And as I like to kind of think of it as, you know, a measure of a company's quality, in essence. Can you talk briefly about moats and kind of what types are most you see within the semiconductor industry and how you value and think about all those different areas of the market?

BRIAN: Yeah, gladly. So our economic moat rating and so Warren Buffet sort of coined the term of a company having a moat around a castle to protect its business. So we think about it in terms of a durable or sustainable competitive advantage. The wide moat companies that we look at, that's our highest rating. That's the best of the best, highest quality company. There are plenty of no moat or narrow moat companies that we rate that you've all heard of and are familiar with but don't necessarily generate that strong of an economic profit or might not all be that sustainable. So to give it get our wide moat rating, we have to have confidence a business is going to generate excess returns for a decade and more likely than not over 20 years. That's often a high bar for us in technology and in semiconductors because the landscape changes so rapidly. But so, again, you know, when we're looking at wide moat names, we're thinking of the best of the best and we see several in semis. And the first are sort of those peripheral chips that I talked about, wide moat names. I personally cover Texas Instruments, Analog Devices, Microchip technology. These companies have tens of thousands, if not 100,000 customers, tens of thousands of products. They're you know, simple chips are going into virtually everything. But Texas Instruments, the average price of their chip is $0.40. So massive volume. So, imagine trying to be a startup, trying to develop the IP for, you know, tens of thousands of products at work, try to find hundreds of thousands of customers. And then, oh, by the way, you have to undercut them by a nickel. And that's going to be a really hard barrier. So, you know, we don't see companies really enter the space. So that's one segment of wide moats. Another one would be chip equipment. You know, these are very complex, technologically advanced, you know, pieces of equipment needed to make virtually all of these processors. And even the analog charts, even the trailing edge is still extremely complex. And it's really hard for any company to just build this equipment from scratch. Another name would be in Nvidia, and they're the hot topic in some years now because of their exposure, they really dominating graphics processors, which is really it's been strong in gaming for decades. It looks like it'll be strong in artificial intelligence for decades more, and they have the expertise around it and not just the hardware, but even the software too. They've made some really shrewd moves to build out an ecosystem. So that way, even if a company could build a comparable CPU in terms of new transistors or speed or things like that, NVIDIA has the software around it. And so these A.I. models are trained on online video GPUs, and it's going to be really hard to rip that out. So those are some examples of the wide moat names, the best of the best, the companies that are really strong and should be okay for a decade or more. We have a lot of narrow moat names, too. So, the Intel, AMD, Qualcomm, Marvell, like they don't even get our wide moat rating because there is uncertainty about the way I will go over the next decade, among other among other reasons. So, you know, the wide moat is a bar even above that.

COULTER: Wow, great. And I know another area of your analysis and in Morningstar's analysis is on valuation. And I know a big deal more that we kind of look at a lot as you know, the estimate of fair value that you and other analysts and Morningstar kind of come up with these companies. Can you kind of give a high level overview of what that entails and how you arrive at that and you kind of also how do you see the valuation of this and get out their space today?

BRIAN: Yeah, gladly. You know, when we look at companies, we try to value what they're worth on any given day in any given point in time. So we value companies based on a discounted cash flow analysis. So just classic, you know, the revenue they'll earn, the profitability and how that translates into cash for investors. And based on all that, we try to determine how much a business is worth, then we let the stock price determine whether that stock is cheap or not. And so often, you know, we try to focus on the fair value, often factors like momentum or technical factors or short term trading, you know, may sway it, but it may give investors opportunity if you're going to take a long term perspective. So those are the opportunities that we really look for. Right now. Semis are slightly undervalued, not significantly. You know, tech has had a nice rally in 2023 so far. So we saw more of a margin of safety earlier in the year. Some names we like are in that automotive chip space. So AXP, Infineon, ST Micro, we think those are a little undervalued. The chip industry has had benefited from a shortage or the automotive sector had a chip shortage for a couple of years. So that's been very good for the chip makers in terms of pricing and being able to sell everything they have. That's probably coming to the end. And so, the short term doesn't look as great as it did a year ago, obviously during shortage conditions. But we think maybe some investors have exited for that reason. But we would still stick with this theme in the long term. On the other end of the spectrum in video is just had a terrific run. They reported the best quarter I've ever seen in semiconductors or guidance was amazing. But we do think it's overvalued today. A lot has to go right to justify that valuation, not just this year. Yeah, I think this year will be spectacular for a video. But you know, to justify trillion dollar valuation, you need to assume that it might double again and perhaps double again the year after that. And just massive, massive growth for ten years, not just one or two. So we don't necessarily like the risk/reward there.

CHELSEA: Brian, here's a question that I know a lot of investors are wondering. Certain semiconductor stocks, like you mentioned, experienced quite this surge due to the release of generative AI applications like ChatGPT. So for the semiconductor names that have this direct exposure to AI applications, are there any attractive opportunities still out there or do you think most of these stocks are perhaps overextended?

BRIAN: Sure. And so, I touched a little bit on Nvidia. They are clearly the belle of the ball right now in AI. There is just extremely hot demand for those GPUs and they'll sell everything they can they can make this year. I think the market has properly recognized that and then maybe bid up the stock too much. So that's not one where I would feel great about buying it at $1,000,000,000,000 valuation. We liked it six, nine months ago when it sold off sort of during the crypto crash. If it were to sell off again, we might see some opportunities. But I think it's a little late to dive into that one. Now the other thing I would say, to be bearish against Nvidia, you have to be bullish on someone else and Nvidia's capturing tremendous profits from this A.I. theme and so every Hyperscaler you know, Microsoft, Amazon, Google and every competing chip maker is going to want to get into this space. And so we see AMD coming out with a pretty impressive GPU based on its standards. Again, the software is sort of protecting Nvidia for now, but it'll likely be overcome at some point in time. And the Hyperscalers have all the reason in the world to try to get a second source of GPUs to help out and the second source of software to run these models. So AMD is a name that is a little bit undervalued, but that is also still a bet on the future, not necessarily what they have today in A.I., but just sort of logically thinking of who is the next best competitor, who's going to help keep Nvidia at bay. And AMD is probably the best bet there. Intel is discussed, you know, in the AI space. We think it's fairly valued. We're not super bullish on that. One is an AI play, I guess the other places you could look, I would continue to keep an eye on names that are tied to a video or supply Nvidia and you might see opportunities there. So actually in Taiwan, Taiwan semi we think is an undervalued name like are they're going to sell every chip they can make for an Nvidia and so they're going to be in good shape there And that's a name that is a wide moat name that we think is a bit undervalued. You may see opportunities in some of the indirect companies on the Nvidia play.

COULTER: And I know we've talked quite a bit about sort of what we see coming in terms of opportunities and sort of, you know, tailwinds for a lot of these semiconductor chips. But I think it's also important to focus on, you know, some of the potential headwinds or risks that might be out there in the market today. I mean, for the space. So what sort of, you know, risk do you see out there for the semiconductor industry? I know topics like geopolitics and trade tensions, you know, have been on the mind of many investors lately. So…

BRIAN: gladly Yeah. There is exposure in risk to the chip manufacturing space I think the entire world recognized during COVID a couple of years ago the most being the Taiwan semi is a foundry that manufactures half the chips worldwide. And if you're the US government, you woke up and realized that about 90% of semiconductors are built overseas. And so that led to sort of the U.S. Chips Act and a focus did bring some of this manufacturing back onshore. The problem is it's not necessarily easy to do. It's not a 1 to 1 replacement. And if Taiwan semi is the best process and is ahead in the arms race there, we can't just throw money at the problem. We meaning the U.S. to easily match that intel is sure going to try and they they're trying to carve out their fair share and make those investments and they're trying to catch up for, you know, for their own motives and reasons as a business. So, the US government likely wants more chip manufacturing in the U.S. Europe does as well. And so we're going to see more investment in fabs. And these fabs are extremely expensive, you know, up to tens of billions of dollars for each one. There's the second issue of once you build the fab, are you going to get the best chips coming out of those fabs and that sort of a second issue. But that is a risk. And I guess the risk right now today is even if you're looking at Nvidia or even Apple with its processors, they're all made by Taiwan Semi out of Taiwan, and Taiwan Semi requires EUV equipment from ASML, which is based in the Netherlands, to make those semis. So you have, you know, these sort of three headed monsters for some of these massive types of chips, like none of them can survive without the other two. They're all sort of exposed in their own region. So it is truly a global interwoven supply chain to the extent any of them go down, that would be a problem for the entire, you know, tech sector, I suppose. Depends how draconian you want it to be. But, you know, if China were to invade Taiwan or if the U.S. were to get involved in Taiwan, semi were to be knocked off line, I'd really be catastrophic for the U.S. or I shouldn't even say U.S., worldwide supply chain. Even if a company had no exposure to Taiwan semi at all, that ship likely sits on an electrical board next to another ship that came from Taiwan Semi. So, during the automotive chip shortage we had this golden screw problem where you know, if you're trying to complete an electronics device, I have the chips for nine out of ten, but I'm missing that 10th one. My car wasn't getting shipped. And so that was a big problem we saw in autos. That's something that could certainly happen again.

COULTER: I know you sort of touched on the chip stocks. That was chip tech that was passed recently in the U.S. You know, I have to think that this would, you know, increase supply, perhaps further down the road for semiconductors. But how do you how do you view that in that potential shift in supply, you know, coming down the road based off of the chip act? Is that is that good or negative for the industry? You know, as a whole?

BRIAN: I think there will be winners and losers that certainly the chip equipment are winners because you're building sort of redundant fabs. I think the way, the reason all of this manufacturing ended up in Taiwan is because of the efficiency that these machines are extremely difficult to build. And so you want to build one fab and make it as efficient as possible. And any fab that sits empty is just a massive waste of capital. And so, that's why you don't see empty or half empty fabs throughout the rest of the world. So we're going to try and build these fabs and we're going to try and fill them up and eventually, you know, over the next decade or so, the demand for semis will sort of fill in those spots. So I think we will have that. So chip equipment is probably a good place to be. It's questionable on the Taiwan semi front or even Intel. They're going to build these fabs. It's a very high cost. Are they going to receive enough demand to fill those fabs and receive strong enough pricing to justify the higher cost? It's going to be more costly to make these chips in the U.S. and Europe than out of Taiwan. So we'll have to see how that plays out. You know, it might even be a negative for the customers as well. I think Apple would have been perfectly fine having all of its semis made in Taiwan and just going to sleep at night knowing that Taiwan is going to be safe and that they will never be knocked off-line and there's not a problem. So, you know, to the extent Taiwan builds factories in the U.S., which is already in the works and others worldwide. And those make means the processors are more expensive. That probably gets passed on to Apple. Then again, that probably gets passed on to us as consumers as well. So, you know, it's the trade off between efficiency versus diversification. And I think the global realized that we tried to skew the other way towards efficiency and not enough towards protecting itself from any of these geopolitical disruptions. And then finally, I guess the bigger, bigger one is I don't necessarily think all the world realized how important the semiconductors were in national defense for each of these countries. So between artificial intelligence and the algorithms and cybersecurity stuff going there, or even just the processors used in missile systems and things like that, I think when people realized that while we don't control these semis that are key parts of our, you know, national defense, not just U.S., China, Europe as well, that that led to a real awakening and stressed the importance of this industry.

COULTER: Wow. I mean, that's interesting. I mean, it really is a multifaceted industry. And there's a lot of angles to it. So. Well, great. Thank you for the insight, Brian. Really appreciate your time here today.

BRIAN: Yeah, Coulter, Chelsea, it is my pleasure.

COULTER: Of course. And thank you again to all of our viewers as well for tuning in to this episode of The Moat Show. Don't forget to like and subscribe to our channel for more of VanEck’s investment insights. And if you would like to receive the latest investment research, you can do so at vaneck.com slash subscribe where you can sign up for our investing emails. So thanks again all for joining and see you next time.

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