The "Super 7" – Apple, Microsoft, Google, Amazon, Tesla, Meta, and Nvidia – have partly helped lift the tech-focused Nasdaq index up over 30% this year. All of them have outperformed the broader market, with the top performer Nvidia more than doubling its share price.

These tech giants are all part of the latest artificial intelligence (AI) revolution, largely driven by the rise of ChatGPT and other generative AI apps earlier this year. Apple's smart headset, Vision Pro, is an example of how this technology is being applied. Microsoft has invested in OpenAI, which is a prominent player in this wave of technological innovation. Nvidia makes chips that provide necessary processing power to train AI models, and its CEO Jensen Huang claims publicly that "the iPhone moment of artificial intelligence" has arrived.

More than a decade ago, the first generation of iPhone was released, marking the watershed moment for mobile Internet. Are we witnessing a similar turning point for AI? Recent stock rallies in AI-related sectors seem to suggest that some investors are buying into this idea.

A quick look at ChatGPT's industry chain on moomoo reveals a wide range of businesses are involved in this booming business, many of which are publicly traded companies. Among them are semiconductor companies that play a key role in providing the computing power needed to train large AI models and support their applications.

In this article, we'll be examining the semiconductor industry from the following perspectives:

1. Overall landscape

2. Industry chain

3. Characteristics

4. Investment considerations

1. Overall Landscape

"Life is like a snowball, all you need is wet snow and a very long hill," says Warren Buffett. It's an apt metaphor for investing, where finding a growing, sustainable industry is key. So what about the market size and growth rate of the semiconductor industry?

The semiconductor industry has a substantial market. Our technological world relies heavily upon chips as they are critical to the production of everything from smartphones to cars.

According to a report by the Semiconductor Industry Association (SIA), the global semiconductor market was worth USD 574 billion in 2022 and has quadrupled over the past 21 years, growing at a compound annual growth rate (CAGR) of 7%.

McKinsey, a consultancy, estimates the industry's aggregate annual growth could average 7% a year up to 2030, resulting in a $1 trillion dollar industry by the end of the decade.

2. Industry chain

To narrow our focus within the vast and complex semiconductor industry, it is important to find a segment with higher growth potential and understand how each division works.

Chips can be categorized into eight types, including logic chips, such as the Central Processing Unit (CPU) and Graphics Processing Unit (GPU), memory chips for data storage in computers and phones, and analog chips , such as 5G chips commonly used in telecommunications. Among them, logic chips create the largest revenue stream, accounting for over 30% of the industry's total sales in 2022.

Within the category of logic chips, CPUs are adept at performing complex serial computations, whereas GPUs - originally developed for graphics processing - are well-suited for handling simple parallel computations. As AI continues to advance, there is an increasing demand for the kind of simple yet powerful computing capabilities that GPUs can provide, making them a vital component in the industry. According to Verified Market Research(VMR), GPUs may experience a growth rate exceeding 30% in the future.

A chip generally goes through three stages before its application: design, manufacturing, and packaging and testing. Most chipmakers specialize in part of the process except for Intel and Samsung which have integrated chip production.

Let's first look at chip design. Just like one must first have a blueprint before building a house, chip design companies serve as the initial step in the semiconductor industry supply chain. They have significant influence and work directly with their clients.

In the GPU design field, Nvidia dominates the market with over 80% personal computer (PC) GPU market share in Q4 2022 according to Jon Peddie Research (JPR). AMD and Intel followed closely behind, with most of their revenue generated from CPUs.

Then let's move on to chip manufacturing, which may be considered one of the most advanced and sophisticated industries in the world.

TSMC and Samsung are the major players in chip manufacturing, with TSMC holding almost 60% of the market share in Q4 2022 according to Counterpoint.

Lastly, chip packaging and testing are less sophisticated than other stages, with few listed companies in the US and Hong Kong involved in this field.

In addition to the three main stages of chip manufacturing, there are numerous auxiliary aspects that exist throughout the entire semiconductor industry supply chain. These aspects have given rise to many publicly traded companies.

For instance, Cadence (CDNS) and Synopsys (SNPS) are major software providers for chip design companies.

Chip manufacturing companies also need to acquire specific equipment and raw materials before they can begin producing chips. The manufacturing process involves multiple stages, involving many publicly traded companies, such as ASML - a Dutch company, currently boasting a market capitalization of several hundred billion dollars, which specializes in making lithography machines critical to chip production.

3. Characteristics

Understanding an industry's unique characteristics is important as they could inform our investment strategies. In the internet industry where monopolies could occur, it's wise to focus on leaders when considering an investment. For cyclical industries, it's important to consider how long a cyclical boom will last, while with growing industries, taking a long-term approach is prudent.

When it comes to the chip industry, it exhibits characteristics of both a growing and cyclical industry. While the overall industry grows at an average rate of 7%, the GPU segment is expanding at an impressive rate of over 30% as VMR projected. This growth has largely been driven by emerging sectors such as cloud computing, blockchain, autonomous driving, and AI, which all require GPUs.

The cyclicality of the semiconductor industry is often caused by a mismatch between supply and demand. As chip design companies like Nvidia or Intel receive orders from their clients, they place orders with contract chipmakers such as TSMC or Samsung to manufacture chips at scale. However, when demand rises, contract chipmakers may lack the capacity to produce the required amount of products. So they build more plants and acquire more equipment, which can take two to three years to complete.

Once capacity comes online, supply may overtake demand, resulting in an inventory buildup and falling prices. This can lead to a downturn in the industry.

4. Investment considerations

When considering investment strategies for the semiconductor industry, it's important to account for both its growth potential and cyclical nature.

To begin with, investors may consider timing-based strategies that focus on the ups and downs of the industry to navigate its cyclicality.

The inventory turnover ratio, which is calculated by dividing operating expenses by average inventory, may be a valuable indicator for understanding the state of the semiconductor industry. When downturns occur, supply exceeds demand, resulting in a buildup of inventory and a lower inventory turnover ratio. This leading indicator is more sensitive than revenue and net profit, making it a useful tool for forecasting market trends.

After a period of steady growth, the inventory turnover ratio of key players in the semiconductor industry may grow at a slower pace or even turn negative. This trend could suggest an impending cyclical downturn, and investors may be cautious about potential risks.

On the other hand, if the decline in the inventory turnover ratio of these companies slows down or even reverses, it may be a signal of an upcoming industry upswing or boom.

Let's take a closer look at Nvidia's inventory turnover ratio and its stock price movements.

Between July 2018 and October 2019, the company's inventory turnover ratio started to decline, and its stock remained stagnant during this period. However, from January 2020 to October 2021, the pandemic sparked an increase in demand for remote work and cloud computing, leading to a surge in chip demand. Consequently, Nvidia's inventory turnover ratio increased significantly, and its stock price also rose considerably during this period.

It is worth noting that history does not necessarily repeat itself, and cycles can be disrupted by unforeseen events. For instance, while statistics suggest that the chip industry should be reaching a trough, the rise of artificial intelligence has led to a surge in demand for logic chips. As a result, the stock prices of chip makers have been on the rise over the past few months, with the market seemingly expecting a potential bottom.

When considering investment strategies based on the semiconductor industry's growth potential, some investors tend to take a long-term view and carefully evaluate its value over time. Since few people can accurately time the market, many investors opt for a long-term approach. However, it's important to note that investing in the industry at the top of its cycle could result in losses that persist for a prolonged period.

For those who are not adept at selecting individual stocks, they may look at semiconductor ETFs. These funds offer exposure to the average performance of the entire industry, potentially delivering more returns than those achieved by most individual investors.

In summary, the semiconductor industry may present a vast and largely untapped market with a high growth rate. Among the eight types of chips, logic chips - including GPU and CPU - currently represent the largest revenue source, with GPU VMR projected to experience accelerated growth.

Design, manufacturing, and packing and testing are the three main stages of chip production. The whole process is complex and involves many public companies.

The semiconductor industry exhibits characteristics of both a growing and cyclical industry. Its cyclicality is largely caused by the dynamics of demand and supply.

To navigate the cyclical nature of the industry, investors should evaluate the current stage of the cycle. The inventory turnover ratio is a useful metric that can help with this analysis. Additionally, some investors may consider taking a long-term approach to tap into the semiconductor industry's potential for growth.

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