Investors may not realize the impact that being tied to TSMC has on many semiconductor stocks.
Taiwan Semiconductor Manufacturing (TSM -1.27%) is a controversial stock from some perspective. The Taiwan-based foundry makes nearly all of the world’s most advanced chips. Yet most of the production takes place in Taiwan. Taiwan is in the middle of a geopolitical battle between the U.S. and China, which has led many investors, including Warren Buffett, to be wary of owning shares directly in the company.
TSMC’s chips are in demand in both the U.S. and China, so tensions are unlikely to lead to an invasion of Taiwan. But escaping that reality isn’t as easy as some chip-stock investors might imagine. So semiconductor investors need to not only be aware of their ties to the company, but also consider strategies to mitigate that risk.
TSMC investor connections
Many chip stock investors invest directly in TSMC because of the role it plays in the industry. The company makes cutting-edge chips for most of the most prominent chip companies, including Apple, Nvidia, Advanced Micro Devices, Qualcomm, and Intel, which have had to rely on TSMC despite their own extensive foundry capabilities.
More importantly, and less noted, this relationship means that TSMC’s risk is also its customers’ risk. Many investors refuse to own TSMC due to geopolitical concerns. And yet, investors don’t typically associate this risk with the Apples and Nvidias of the world.
This lack of connection doesn’t change the fact that most of these advanced chips are almost certainly made in Taiwan, so if the long-feared invasion actually happened, all of these companies would have no choice (or at least would have significantly reduced options) to find another manufacturer that could turn their designs into chips, and would be implicitly tied to Taiwan’s geopolitical situation.
To make matters worse, due to the aforementioned lack of correlation, chip design stocks typically trade at a significant premium, meaning they can fall by a larger percentage if the geopolitical situation worsens.
TSM PE ratio data from YCharts
Should investors buy TSMC instead?
Nevertheless, the rationale for holding TSMC instead of chip design stocks is unclear. Indeed, it would likely take a Chinese invasion of Taiwan to upend TSMC’s dominance. And despite companies like Samsung and Intel investing in cutting-edge equipment, there’s no evidence they’ll surpass TSMC’s technological advantage anytime soon.
This strength also applies to TSMC’s financials. Revenues for the first half of the year were $40 billion, up 28% from a year ago. Additionally, comprehensive income for the period was $17 billion, up 35% from a year ago, as expenses grew at a slower rate than revenue. And among chip stocks, TSMC has outperformed some of its largest customers over the past five years.
TSM data by YCharts
Still, there may be some increased valuation risk impacting customers. TSMC’s P/E ratio is currently at 30. While this is much lower than companies like Nvidia and AMD, it is above its five-year average P/E ratio of 24, making TSMC an overvalued stock. Thus, P/E ratios are unlikely to fall as much in a crisis, but the decline could still be substantial.
Going forward, I will be investing in semiconductor stocks such as TSMC.
Whatever the investment case for the stock, the premium valuation for some of TSMC’s customers indicates a mismatch between TSMC’s risk and its customers’ risk. Increased awareness of this issue could lead investors to demand discounted valuations.
However, putting all of the industry investment into TSMC will not be enough to deal with this situation. In fact, when investors buy TSMC, they are buying a higher quality company at a lower valuation. That said, TSMC has always traded at a discount to its chip customers, so the fact that its P/E ratio of 30x is still trading at above its long-term average earnings multiple should be a reason for investors to hold off on buying at this point.
Ultimately, chip investors should acknowledge the TSMC connection, but address geopolitical risk by waiting for TSMC shares and those of its foundry customers to remain cheap rather than exiting chip stocks or redirecting all industry investment to TSMC.
Will Healy has investments in Advanced Micro Devices, Intel, and Qualcomm. The Motley Fool has investments in and recommends Advanced Micro Devices, Apple, Nvidia, Qualcomm, and Taiwan Semiconductor Manufacturing. The Motley Fool recommends Intel and recommends buying January 2025 $45 calls on Intel and selling August 2024 $35 calls on Intel. The Motley Fool has a disclosure policy.
