The Capital Note

Semiconductor Cycle: Is This Time Different?

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Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the semiconductor shortage, funds considering new prime brokers, Amazon workers say no to union, and a look at the capital cycle. To sign up for the Capital Note, follow this link.

Chip Shortage

Since late last year, a shortage in computer chips has slowed production of everything from cars to video-game consoles, as semiconductor manufacturers struggle to keep up with growing demand. The shortage is so severe that President Biden has pledged to take action to boost output. Meanwhile, chipmakers are ramping up capacity, with Intel, Applied Materials, and Taiwan Semiconductors all projecting significant increases in capital expenditures over the next few years.

The shortage has led to a rally in semis stocks, driving the PHLX Semiconductor Index up 17 percent for the year, well outperforming other technology verticals. However, the history of the semiconductor industry suggests investors should be cautious before buying into the sector. Computer chips perennially see volatile cycles, whereby supply shortfalls lead to excessive capital investment and eventual oversupply. Because manufacturers must project output at least nine months in advance, supply tends to lag demand, causing major fluctuations in investment and returns.

In response to the chip shortage, Intel announced plans to enter the foundry business, producing chips designed by other businesses. Applied Materials, one of the sector’s best performers, is forecasting $85 billion in spending on fabrication equipment by 2024.

As elucidated in Capital Returns: Investing through the Capital Cycle, “No part of the technology world has been more prone to cyclical booms and busts than the semiconductor industry. In good times, prices pick up, companies increase capacity, and new entrants appear, generally from different parts of Asia.” We are currently in the “good times” phase of the capital cycle, but analysts should be wary of extrapolating the good times out into the future. While the PHLX Semiconductor Index has skyrocketed of late, its performance before the COVID-19 pandemic has been highly volatile and weak overall.

Some argue that this time is different. A recent Goldman Sachs note points out “severe supply tightness across a wide range of device types and the sense of urgency on the part of governments to re-design/onshore supply chains will support a cycle that is ‘stronger for longer’ compared to past upturns.” On this view, government support will lengthen the semis cycle, while fundamental changes such as reshoring weaken the link between growing capital investment and diminishing returns.

Yet that sense of “urgency” could just as easily contribute to excessive capital investment, driving down returns for chipmakers. An analyst at Raymond James argues government intervention “could potentially lead to structural oversupply over time, which could depress industry profitability despite subsidies.” And while reshoring may be a boon to certain manufacturers, it is unlikely to benefit the industry as a whole.

The much-discussed chip shortage is just an organic outgrowth of semiconductor cycle.

Around the Web

Hedge funds reconsider prime brokers after Archegos blowup

Executives are weighing up whether to switch lenders they use as their prime brokers — banks that offer a range of services including stock lending, leverage and trade execution. The head of one London-based hedge fund said the firm had “initiated an internal process” to evaluate its prime broking relationships in the wake of the Archegos debacle. The top concern was reputation, particularly whether their clients believed they were “associated with the bad people” in the sector, the person said.

Amazon Workers in Alabama Vote Against Forming a Union Inc. employees in Alabama voted not to unionize, handing the tech giant a victory in its biggest battle yet against labor-organizing efforts that fueled national debate over working conditions at one of the nation’s largest employers.

An estimated 71% of the Bessemer, Ala., warehouse workers who cast ballots voted against joining the Retail, Wholesale and Department Store Union, according to the National Labor Relations Board, which on Friday finished counting all the votes that weren’t challenged. The federal agency has yet to certify the results but noted that the challenged ballots aren’t enough to exceed the vote margin against unionization.

Random Walk

Earlier we discussed the semiconductor cycle. Capital Returns: Investing through the Capital Cycle, a compendium of reports by Marathon Asset Management, explains how capital flows can influence returns at the industry level:

Typically, capital is attracted into high-return businesses and leaves when returns fall below the cost of capital. This process is not static, but cyclical – there is constant flux. The inflow of capital leads to new investment, which over time increases capacity in the sector and eventually pushes down returns. Conversely, when returns are low, capital exits and capacity is reduced; over time, then, profitability recovers. From the perspective of the wider economy, this cycle resembles Schumpeter’s process of “creative destruction” – as the function of the bust, which follows the boom, is to clear away the misallocation of capital that has occurred during the upswing.

High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow – perhaps they are equally hubristic, or maybe they just don’t want to lose market share. Besides, CEO pay is often set in relation to a company’s earnings or market capitalization, thus incentivizing managers to grow their firm’s assets. When a company announces with great fanfare a large increase in capacity, its share price often rises. Growth investors like growth! Momentum investors like momentum!

Investment bankers lubricate the wheels of the capital cycle, helping to grow capacity during the boom and consolidate industries in the bust. Their analysts are happiest covering fast-growing sexy sectors (higher stock turnover equals more commissions.) Bankers earn fees by arranging secondary issues and IPOs, which raise money to fund capital spending. Neither the M&A banker nor the brokerage analysts have much interest in long-term outcomes. As the investment bankers’ incentives are skewed to short-term payoffs (bonuses), it’s inevitable that their time horizon should also be myopic. It’s not just a question of incentives. Both analysts and investors are given to extrapolating current trends. In a cyclical world, they think linearly.

— D.T.

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