The majority of investors looking to add semiconductor stocks to their portfolio usually think of large-chip producers such as Nvidia (NVDA) and Intel (INTC).

But there is another way to cash in on the newest technologies: a select few of the major companies that provide semiconductor makers with the tools and equipment necessary to do the actual making of chips themselves. And with most of these stocks more than keeping pace with a falling broader equity market this year, they offer investors the opportunity to purchase these names at their cheapest valuations in over a decade.

“All roads lead to semiconductors." – Equity sector strategist for semiconductors and technology Abhinav Davuluri

“But we’re really excited about the stocks of those companies that are supplying the semiconductor companies with production materials,” Davuluri says. “Rather than worrying about who wins a deal, Nvidia vs. Intel, we’re focused on the ‘arms dealers’ in that battle. They make money one way or the other and will win the final chip design.”

5 Semiconductor Materials Stocks That Are Undervalued

• ASML (ASML)
• Teradyne (TER)
• Applied Materials (AMAT)
• Lam Research (LRCX)
• KLA (KLAC)

ASML is a worldwide establishment in the making of photolithography machines used in the manufacture of microchips, has tumbled 40.1% so far this year as of June 17. The stock is priced at approximately half of the top of the fair value estimate price range. The stock is more undervalued than it has been at any time since analysts began following the company in 2004.

Microchip quality-assurance testing equipment maker Teradyne is off 45.4% in 2018, and chip component maker Lam Research has dropped 41.3%, leaving each at valuations cheaper than any time since March 2009.

As equity markets plunged into bear territory, semiconductor equipment suppliers were hit harder than just about anyone.

The Global Semiconductor Equipment & Materials Index, a grouping of companies that design, develop, manufacture and market the tools and equipment of the trade, has plummeted 38.1 percent for the year through June 17. That is worse than the broader US Technology Sector Index, which was down 31.3% and the equity market’s 23.5% loss, as measured by the US Market Index.

As of June 15, 10 companies in the Global Semiconductor Equipment & Materials Index are trading at five-star discount prices, and another 48 companies are hot on their trail at four-star.

Long-Term Outlook for Microchip Parts Suppliers

For the most part, the microchip space is expected to increase, and semiconductor suppliers are expected to see profits, according to analysts.

“Our long-term view is very good. The semiconductor market itself, right now, is about $600 billion, it’s expected to be about $1 trillion by 2030,” Davuluri says.

Plus, “It’s a highly concentrated market. Five major players account for over 70% of all semiconductor equipment spend.” Davuluri doesn’t think these competitive dynamics will change any time soon.

“I think customers will be required to purchase new, advanced tooling,” he says. “They’re always going to be upgrading to the next-gen technology. And the costs will keep going up because the industry is consolidated.”

For the five-year period, ASML was up 313.9%, KLA was up 268.1%, Lam Research was up 230.7% and Teradyne was up 198%. Each companies’ moves more than tripled the 65.9% gain of the US Market over the same stretch. Applied Materials returned 140.3% over the past five years as well.

Digging deeper into the Global Semiconductor Equipment & Materials Index yields five high-quality, undervalued names with excellent historic performance. All five companies have Wide Economic Moat designation, which means their competitive advantages are of such a magnitude that they can repel competition and earn over 20 years of high returns on capital going forward.

Four of the five “key players” highlighted by Davuluri are among our list of companies. The fifth is Teradyne, which produces highly specialized equipment to test the semiconductors for quality, after they’re made.

ASML

“We think ASML has a wide economic moat derived from intangible assets tied to its equipment design prowess in addition to R&D cost advantages necessary to service the needs of leading-edge chipmakers. As a pioneer in photolithography equipment, the company shows marked scale and technology advantages against its peers. Because of its technical know-how and enormous R&D budget ($2 billion), it has a moat, but there are competitors (Nikon and Canon), although it is in a much lower league (according to Gartner, ASML commanded 89% of the $12.8 billion lithography stepper market in 2020). We also think that incumbent tool providers have ameliorative IRR related to equipment design based on service contracts and customer collaboration during process development and later high-volume production. Combined, these two types of competitive advantage enable top equipment companies to generate sustainable excess returns on invested capital for extended periods.

“Lithography machines make up a major part of chipmakers’ capital expenditures — next-generation extreme ultraviolet, or EUV, platforms cost over $150 million apiece. ASML’s immersion lithography tools have helped the company by building and holding its lead in the market and no other candidate like Nikon and Canon would even have the scale and resources to compete in the EUV. In 2012, ASML’s three largest customers at the time — Intel, Samsung, and Taiwan Semiconductor — volunteered to help fund part of what was the development of EUV and purchased an aggregate 23% minority equity stake in ASML (although these stake sizes have gradually fallen over the years).”
—Abhinav Davuluri, equity sector strategist

Applied Materials

“We think Applied Materials possesses a wide economic moat due to its intangible assets related to wafer fabrication equipment design expertise and research and development, or R&D, cost advantages needed to compete for the business of leading-edge manufacturers. Such characteristics have enabled it to ascend to become the leading vendor in the semiconductor equipment space. As a result, a research and development budget that exceeds $2 billion can serve cutting-edge technologies and therefore reap rewards from inflections like fin field-effect transistors, or FinFET, and 3D NAND. Applied scale and resources come into play here. Meanwhile, advanced tools in deposition and etch have become essential for multiple patterning to drive cutting-edge foundry and logic processes. Consequently, these sectors have outpaced the broader market in recent years, and companies such as Applied have directly benefited as it can outlay smaller chip equipment companies in research and development to develop increasingly sophisticated solutions.

“When semiconductor manufacturers have many fabs across the globe, improving throughput and minimizing process variability across their fleet of tools is a high priority. We expect incumbent tool providers (e.g., Applied) also have intangible value generated through service contracts and through customer interaction during process development and then in high-volume manufacturing following. On-site field service engineers at customer fabs are troubleshooting high-value issues to enhance yields and capacity, which drives productivity and lowers cost. We believe a virtuous circle is then established whereby leading equipment vendors use existing relationships and knowledge of future customer technology requirements to ultimately develop and provide better equipment. In addition, the resulting virtuous cycle is not readily repeatable by prospective new entrants. The largest installed base of tools — more than 43,000 at Applied gives us additional conviction in our wide-moat rating.”
—Abhinav Davuluri, equity sector strategist

Lam Research

“We think Lam Research has a wide economic moat, due to cost advantages and intangible assets. We see the scale and resources needed to win the business of leading-edge manufacturers as important barriers to entry, with such firms as Lam having R&D cost advantages relative to smaller peers. Similarly, strategic incumbents have intangible assets associated to equipment design gained in service contracts and customer cooperation in process development and subsequent high-volume manufacturing. Combined, these two asymmetric sources of competitive advantage enable leading equipment companies to earn excess returns on invested capital for decades.

“Lam is the leader in dry etch and has a strong portfolio in the deposition part of the wafer fab equipment (WFE) market. Deposition equipment coats surfaces in thin-film layers; while etching takes away the material selectively. This fusion is crucial to the chip fabrication process, with photolithography generating the mask, exposing the areas for the deposition or removal of materials. In these segments, Lam gives customers some of the most advanced tools available, and its leadership position fosters scale advantages feeding research and development dollars at spending levels that only Applied Materials and Tokyo Electron can rival. Being installed at 75,000 units in late 2021, Lam’s installed base grew from the like of 40,000 (2015). And this huge installed base creates stickiness that will eventually help Lam maintain its leadership position in key process steps for chipmakers’ process flows. It also gives us an intimate window on the problems that chipmakers are facing, into useful intelligence that we can use to implement solutions and additional capabilities into future tools,” Lam said in an interview.
—Abhinav Davuluri, equity sector strategist

KLA

“They have a wide economic moat due to a complete toolkit and leading technical know-how that allows their products to go in every major chip-manufacturing facility around the globe.” With a significant amount spent towards R&D each year, the firm stays on top of the process diagnostic and control (PDC) landscape (50+% share or 4× share of closest competitor). In addition, its library of defects found by customers and their fixes assist chipmakers with troubleshooting. The customers indirectly have access to this database via service contracts, which can dramatically reduce the time to problem resolution across their process flow, and in turn tool downtime and yield. The more customers that use this access to anonymously submit their own data to a collection, the stronger the network effect that pays off for everyone involved.

“We also see the increasing portion of service revenue as sticky and less cyclical, which should allow the firm to better weather cyclical troughs. In addition, for KLA, unlike rivals such as Onto Innovation, or less focused players like ASML and Applied Materials, it can afford to put a lot of resources into helping semiconductor manufacturers with yield management and metrology problems they face.”
—Abhinav Davuluri, equity sector strategist