Technology: Semiconductor, Software Firms On Sale

Technology names took a beating in the fourth quarter, with the Morningstar Global Technology Index down 18% through Dec. 20 as concerns about a U.S.-China trade war have put pressure on tech stocks (Exhibit 1). We believe that tariffs have led to worries about both the health of the Chinese consumer and potential disruptions to a highly interwoven tech supply chain that would be quite difficult for the U.S. and China to unwind.

Exhibit 1: After months of outperformance, we're seeing opportunities in tech.

In general, tech looks a lot cheaper than it did a few months ago. The median technology stock trades 15% below our fair value estimate today compared with a 3% premium at the end of the third quarter. Meanwhile, the number of 5-star tech stocks has more than doubled, with 4% of our coverage now in strong buy territory (Exhibit 2). Opportunities are most plentiful in semiconductors, with the median stock trading at a 23% discount.

Exhibit 2: Semiconductors is the most attractive subsector of tech

The near-term picture in semis is relatively weak after a couple of years of tremendous growth. New-car sales have been sluggish in recent months, while commentary from suppliers suggests a down year for Apple iPhone unit sales. Nonetheless, we foresee no slowdown in demand for more processing power, connectivity, and sensing capabilities in a wide variety of devices, such as automotive (Exhibit 3), all of which bodes well for long-term chip demand. We generally view these cyclical downturns as the times to buy high-quality leaders, as such firms remain well-positioned to weather the storm.

Exhibit 3: We see no signs of automotive chip revenue slowing down

Among chip equipment companies, memory chipmakers like Samsung were huge spenders in 2017 and much of 2018, but an inevitable pause appears in the cards for 2019. Yet looking at stock prices across the industry, we think the market is assuming that chip equipment revenue will never recover to 2018 levels, whereas we foresee a recovery at some point down the road as leading chip manufacturers start investing again (Exhibit 4).

Exhibit 4: We foresee a long-term rebound in chip equipment spending

Finally, the median online media name also appears about 20% undervalued to us. Data and privacy concerns have weighed on U.S. bellwethers like Alphabet (Google) and Facebook, while the health of the Chinese economy has made regional champions like Tencent and Baidu undervalued in our eyes, as well.

Top Picks

Tencent Holdings TCEHY

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $64

Fair Value Uncertainty: High

5-Star Price: $38.40

We think wide-moat Tencent has numerous growth opportunities. We think the current pause in game approval in China is due to a restructuring of the government departments with no intention to target Tencent specifically. We estimate that approval will resume in mid-2019, which is when we will see a substantial pickup in gaming revenue. In the meantime, Tencent's network effect continues to be very strong, with over 1 billion WeChat/Weixin monthly active users and 800 million payment users, which should give Tencent many monetization opportunities in the long run.

Microchip Technology MCHP

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $112

Fair Value Uncertainty: Medium

5-Star Price: $78.40

We view wide-moat Microchip Technology as one of the highest-quality firms under our semiconductor coverage. Microchip remains a leading supplier of the "brains" needed for a variety of smart devices categorized as the "Internet of Things." We find Microchip under the hood (figuratively and often literally) of the latest cars with the most advanced electronics and think it is poised to profit from rising chip content per vehicle. Microchip is adept at navigating the various industry cycles and, at this point, we see no reason this latest potential industry slowdown will be an exception.

KLA-Tencor KLAC

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $128

Fair Value Uncertainty: High

5-Star Price: $76.80

We believe wide-moat KLA-Tencor's shares are trading at an attractive discount. KLA-Tencor dominates the PDC, or process diagnostic and control, segment of the semiconductor equipment industry. During the chip fabrication process, wafers must be inspected for defects and proper critical dimensions to identify and correct problem sources. As customers pursue Moore's Law, smaller chips must meet increasingly precise specifications, which increases the need for advanced PDC tools and bodes well for future demand for KLA.

Exhibit Sources: Morningstar, Gartner. Data as of Dec. 20, 2018.