Increasing numbers of smart and connected devices means increasing demand for semiconductors. As a result, the market for semiconductor stocks is expected to grow at around 8% annually for the next five years. This makes semiconductor companies attractive for me as an investor.
Warren Buffett’s most important advice to investors is to stay well within their circle of competence. Unfortunately, when it comes to semiconductors, my circle of competence isn’t that wide. For example, I have no idea how long it will take Intel to produce a 7nm chip, or how far ahead of them Advanced Micro Devices will be when they finally do. But I think that I’ve found a way to invest in semiconductor stocks while following Buffett’s instruction.
Microchip Technology
The stock I’m looking at buying is Microchip Technology (NASDAQ: MCHP). Unlike other semiconductor stocks, Microchip doesn’t make chips for gaming laptops or 5G smartphones. Instead, it makes microcontrollers for devices such as electric toothbrushes, soap dispensers, and thermostats. I think that the economics of the company’s core business are both attractive and easy to understand.
There are two main features of Microchip’s business that I view favourably. First, it is difficult for its customers to change to a different company’s products. Microchip’s microprocessors are integrated into devices and changing them would involve redesigning the entire product, which is often prohibitively expensive. This helps the company maintain its market share.
Second, Microchip’s microprocessors go into products that don’t depend on leading edge technology. This means that it is less important for Microchip to spend its resources on research and development, compared to companies in more competitive parts of the chip industry, such as Intel and AMD. Lower research and development costs in turn help Microchip maintain high margins.
I can understand these two important features of Microchip’s business. This allows me to consider it as an investment proposition without violating Buffett’s instruction to stay within my circle of competence.
Valuation
The biggest risk that I see with this investment is the amount of debt that the company it has on its balance sheet. The company’s total debt at the end of 2021 was just under $8bn, which I regard as a lot for a company that produced just under $2bn in free cash flow. In my view, however, Microchip’s overall valuation offsets the risk of its debt load.
Microchip has a market cap of around $40.5bn. If we add the company’s $8bn in debt and subtract its $315.5m in cash, we get a value of just over $48bn for the entire company. Against this, a free cash flow return of just under $2bn amounts to an investment return of 4.12%. If Microchip achieves growth of 8% per year for the next decade, in line with the expected growth of the semiconductor market, I expect an investment return of 6% on average.
In the current market, this is reasonably attractive to me. It’s more likely, however, that I’ll wait for a better opportunity with this stock. The appeal of a market that is forecast to grow at 8% per year might make it tempting to invest outside of my circle of competence. But I think that Microchip Technologies allows me to participate in the anticipated growth of semiconductor stocks while following Warren Buffett’s advice.
This post was originally published on Motley Fool
