Semiconductors Demystified w/ Nick Rossolillo: Supply Chain, Cyclicality, and Top Chip Stocks

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1:58Go to liquidiv.com and get 20 % off your first purchase with code investing at checkout. That's 20 % off your first purchase with code investing at liquidiv.com. Nick is underselling the complexity of what's going on here. I watched a video the other day talking about how the GPU is made and all the different steps and how long it takes. I want to say it was three months to make one chip because of the layering that everything has to go through and all the different processes that it has to go through. This is an incredibly, incredibly complex manual. Love this podcast because it crushes your dreams of getting rich quick.

2:42They actually got me into reading stats for anything. You're tuned in to the Investing for Beginners podcast. Led by Andrew Sather and Dave Ahern. Step-by-step premium investing guidance for beginners. Your path to financial freedom starts now. Starts now. All right, folks. Welcome to Investing for Beginners podcast. Today, we have a new friend joining us. We have Nick from the Chip Stock Investor joining us today to talk to us about semiconductors and all kinds of things related to that. So, Nick, welcome to the show, and thank you very much for joining us today. Thank you, Dave. Really happy to be here.

3:24And we're talking about semiconductors, so when you invited me on, it was like, well, yeah, let's do it. Yeah, let's do this. So this is something we've talked a lot about, and you're an expert, and I am decidedly not. So this will be a fun conversation. So let's start with an easy softball one. What the heck is a semiconductor? What is a semiconductor? Well, maybe I should answer that question by first saying I am also not an expert. I have come to the realization that I think actually even within the industry, there are not very many experts because semiconductor is such a broad term anymore.

4:04But in general terms, a semiconductor is a material that under certain conditions is a conductor of electricity and under other circumstances does not conduct electricity. And so silicon is one of the most plentiful elements on Earth. It's very cheap. uh there are extensive manufacturing processes uh that have been established to do all sorts of really cool high-tech scientific things with silicon and so that's the most common semiconductor material that has become the basis of really the the modern the modern world it's like the infrastructure of the economy. Yeah, it truly has become that. And the more I've read about it, and the more I've watched your videos and others, the more amazed I am at how we humans came across this whole idea and the technology itself.

5:10It's really quite fascinating. Yeah, you could argue, many people could argue very easily that the transistor is one of the greatest inventions ever made. Yeah, and doesn't get enough love. No. No, for sure. All right, so when we think about semiconductors and how they come to be, so to speak, can we talk a little bit about the supply chain of them? Most people are listening to this probably are familiar with NVIDIA, and they are not the beginning and the end of how a semiconductor is made. And I think that probably surprises a lot of people. So maybe can we talk a little bit about the supply chain or the different parts and how it fits together to go from silicon to what we use in our iPhones or our computer today?

6:05Yeah, there's a lot of different layers to the supply chain these days. As the industry has gotten so big, entire sub-industries have been created within the semiconductor, the broader semiconductor industry that focus on just one step. But in the biggest terms, I guess, possible, you have engineers that design the chips, and then you have the manufacturers that make the semiconductors, the chips, that eventually wind up in our electronic devices or whatever, anything. I mean, you can get literally anything with a semiconductor in it these days with some sort of embedded intelligence. The steps along the way, though, essentially what they do, you start with silicon, sand, could be actually literally like beach sand.

7:01And they have a process where they turn these things into a crystal bowl. It looks like a big log of salami. And then they slice it like salami into very thin slices. That's actually compliments of Casey, who's usually sitting next to me during these episodes. Casey's semiconductor kitchen, we call it. So yeah, they slice these things up into slices of salami. They can range anywhere from just a few inches in diameter to up to 12 inches in diameter. And then there's this very, very intricate, many dozens of process steps to develop what you call developing the wafer, the resulting wafer. Sometimes you see people in those lab suits holding them.

7:53And the series of steps is what creates the little microscopic patterns on what ultimately becomes the chip. uh they create those patterns they get diced up into into little squares and then packaged onto a circuit board and then shipped to an an end customer like apple so that they can they and their partners can install it in an iphone and then and then sell it to to you and i and it Nick is underselling the complexity of what's going on here. I watched a video the other day talking about how the GPU is made and all the different steps and how long it takes. I want to say it was three months to make one chip because of the layering that everything has to go through and all the different processes that it has to go through.

8:51This is an incredibly, incredibly complex manufacturing process, and there's a lot of effort that goes into making these. If you had to throw out a few companies that you think are important in these processes, who would be some companies that would kind of spring to mind? Let's maybe start with what we consider to be the top of the supply chain. Some really not very well-known companies that actually control their sub-industry. They're an oligopoly, not a total monopoly, but an oligopoly. Synopsys and Cadence design systems, you could think of them as like AutoCAD, Autodesk, but for the semiconductor industry.

9:45There's a third company that's owned by Siemens in Germany. They also have EDA, but the biggest two are Cadence and Synopsys. Absolutely critical. Literally everybody in the industry uses software from those very large companies. They have a lot of capabilities. Moving down the supply chain, there's another key bottleneck, like a cog in the machine that if it were to suddenly seize up and stop working, the whole industry literally comes to a standstill. And it's the fab equipment providers, wafer fab equipment providers. And some of these are a little bit more well-known. I think a lot of investors now know who ASML is based in the Netherlands.

10:29They make the lithography equipment. They have a natural monopoly, a technology monopoly on the most advanced lithography equipment, extreme ultraviolet equipment. These equipment providers, you can think of them as tech-powered industrialists. They control the ultimate manufacturing of the chips. It's another spot in the industry supply chain where there's an oligopoly there and they've really come to control that part of the supply chain absolutely critical and then you move down a little bit further out of the manufacturers you have of course tsmc taiwan semi manufacturing the controlling of the the actual manufacturing itself the most advanced manufacturing taiwan semi manufacturing and then some of the actual designers of the product is where you kind of get the sexier names, NVIDIA, AMD, Broadcom, not really such a sexy name, but definitely has become so in the last few years.

11:41Stock prices going up several hundred percent tend to do that. So those are some of the critical players, key spots in the supply chain. yeah and those are those are all you know great companies to investigate and learn about how this whole industry works together and you know i'm i'm a big fan of trying to work backwards from sometimes the the big names like nvidia which is getting all the press and it's very sexy and obviously they're very very important but sometimes you can find potential great investments along the food chain, Taiwan semiconductor, applied materials, maybe a cadence or synopsis, those kinds of things.

12:28This is a question I have. So the more you learn about this industry, the more I worry, how much of the tech do I really need to understand? How much do do I need to understand the technical specifications of a particular chip or a particular product that is making a chip? How important is that to really understand to potentially invest in some of these companies? Mm-hmm. That is up for debate. And I imagine some that hear this may take that up, take that debate up. But you could argue that most of the investments made, the most important investments made in the semiconductor industry, you don't need to have the most technical understanding of what's actually going on.

13:23In fact, this is true, I think, in a lot of technology. Those that really, really get down into the nitty gritty details can actually make some big mistakes because you're focused so much on this one item that you kind of miss the bigger picture and what's going on. And that's one of the things with all technology, including especially semiconductors, because it's so expensive, it's so complicated to produce these things. Some of the projects that are just now coming to market now have actually been in the works for many, many years, perhaps a decade or more. And what that means is because you have such a long roadmap, you're probably not the only one working on this technology.

14:11In fact, someone may know you're working on that technology and is already working on something else to leapfrog it, just, you know, just a skosh to get some sort of technological edge and outsell you. So there is risk that if you get too focused on the technological details, you end up missing more important items, and especially economic items and big industry shifts and big changes. There's a lot going on, obviously with this semiconductor industry that extends into really, really big projects like data centers and data centers in support of AI. So there's more to more other items that should preoccupy time than just the minutiae of it all of the tech itself.

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17:21That makes a lot of sense. And that is actually helpful for me personally. I have a tendency to dive into the minutiae. And sometimes, to your point, that can distract from what's really more important. So how do you feel about all the changes that are going on in the industry? It seems like even in the short time that I've been trying to learn more about it, it just seems like every day I'm reading about something new coming out. Is it my inexperience with the industry that makes it feel like it's changing faster than it really is? Or is it accelerating faster than maybe it was five years ago?

18:03No, things are moving very quickly. Um, that, that is true. Uh, I also like digging into the minutia as well. So, you know, I, I call that risk out knowing that that's something we struggle with something we both do. Exactly. Um, no, things are moving very quickly. And the thing, the thing with this industry, I mentioned earlier, a lot of these companies, they're actually just industrialists. You can really actually think of semiconductors and the whole supply chain that cropped up around it as an extension of the previous industrial revolutions, plural. This really kind of grew out of the commercialization of electricity over a century ago.

19:00That's really kind of where the groundwork was laid for where we are now. And so the thing to think about with industrial companies, which maybe we can contrast that with the other part of the IT industry, the other major part of the IT industry, software, it's a very different type of business model where you have a lot of human capital that you have to worry about. With an industrial business, you have to be very, very careful in planning your expenses on property and equipment. It's not just developing great tech and then you're going to land a sale. You have to spend a lot of money to research the technology and then go manufacture it at a big enough scale that you can sell it for a profit.

19:50And so these companies are moving quick, but at the same time, you can see that they're throttling themselves a bit too. Because if you overspend, you're done. You're toast. You will literally go bankrupt. And there's a few examples where this actually happened recently with a company like Wolfspeed. great technology called silicon carbide as composite semiconductor silicon and carbon and it was a pretty hot new power semiconductor for things like electric electric vehicles a few years ago and they overbuilt and they went bankrupt they've re-emerged from bankruptcy but they're still deep in the woods.

20:45So if you're not careful with the spending, you're done for. So things are moving quickly, but in our view, you can observe there is still caution there. These companies haven't completely lost a grip on generating a positive investment return for their shareholders. Right? Yeah, for sure. So I heard you talking on one of your shows about something that I've heard other people say, and you had a bit of a different take, which I kind of like, and I think it'd be interesting for you to share that with our listeners. You've heard this phrase, semiconductors are the new oil. So how do you interpret that and what do you think of that idea?

21:39They're absolutely not the new oil. I don't know where that comparison came from, but oil is a commodity needed, is one of many inputs to get something done. It can be refined into a plastic and then made into a thing, or it can be used for transportation, but it's a basic commodity. Some semiconductors are also a commodity, but there's a lot of work that goes in to get them turned into a product. And so it's more like the infrastructure layer. If we were going to draw a comparison with the previous industrial economy with the new digital economy, we would call data the new oil. Digital data is like the raw commodity powering the digital economy.

22:44Semiconductors are more like the infrastructure layer, the middle part used to create products and services, the really, really big part of the economy when we start talking about GDP every year and$20 trillion in GDP in the United States, that's like the end ultimate product. And semiconductors are like part of the infrastructure layer supporting all of that. So not the oil, it's the middle layer in between the commodity and the end product. That's how we look at it. Yeah, I like that. I think that's a much better way of putting it. Data would be more comparable to the oil, where the semiconductor is more the base level that everything is built on.

23:29Yeah, I love that. So you mentioned earlier about the idea that semiconductors are in just about everything from toasters to computers and phones. How much of the AI and the leading edge, cutting edge gets a lot of buzz and a lot of press. if you look at the overall industry, how much of that is really, how much is the growth of the, of the industry being driven by that? Or is it more of a larger part of the maybe non-sexier parts of chips that go into the vast majority of products? Like, is there a, is there a mix of those or is that a dumb idea? No, no. Um, yeah, this is another interesting thing about, about the industry is it's gotten so diverse in the type of semiconductor and what it's ultimately used for.

24:27We can probably compare what's sitting in front of us on the desk right now, but I've got a smart speaker, I've got a TV remote, a set of headphones, camera, obviously, obviously the computer. There's a different set of semiconductors in each of these. And in the past, it wasn't so diverse. In the not so distant past even, it wasn't so diverse. And the whole industry was maybe even a decade ago, annual sales were a couple hundred billion dollars per year. Now it's this year going to be over$700 billion in end market semiconductor sales, meaning a finished chip that gets installed into a device.

25:14Over$700 billion, it could reach$800 billion next year. And the broad consensus is this is going to be a$1 trillion industry on average per year by the end of this decade. So it's huge. And of that, AI specifically, whenever I think when you hear the word AI used today, especially on the media, what they're actually saying is accelerated computing. That's really what is meant by that term ai it's accelerated computing a gpu like what nvidia makes and it's accelerated in that it's a different computing technology versus the the traditional cpu that gets you an order of magnitude more compute power uh computing capability per unit of of energy spent uh Basically, that's a very crude way of explaining it, but that's really what's meant by that.

26:18And that is the driving force of the semiconductor industry right now. And because those timelines to manufacture a semiconductor are so long, it's taken a few years for a lot of companies to figure out how to participate in this new accelerated computing movement, how to figure out where they can play some sort of support role and participate alongside Nvidia. Because a lot of the industry actually post pandemic, especially around 2022, when the remember the chip shortage in the first year or two after after all the lockdowns, there was not enough chips, there was empty shelves where there used to be electronics in your local Walmart or whatever.

27:07And then suddenly this wave, this avalanche of chips hit. They caught up with the demand just in time for everybody to stop spending on electronics. And so a lot of these markets actually have not been growing very much at all. The auto industry, huge consumer of semiconductors of power chips and sensors has been in a two-year slump and it's just now starting to show signs of recovery. Lots of industrial markets, everything from manufacturing equipment to healthcare devices, pretty similar story, just now starting to recover. And so for the last three years, the start of this current bull market that we're in, it's been pretty much NVIDIA.

27:56it's been accelerated computing that has been the driving force of the semiconductor industry growth and just like that in just a few years it's become the largest end market of all the different semiconductors out there accelerated computing has uh is on course to overtake mobile computing like smartphones iphones as the largest end market possibly this year yeah i mean like you said the explosion over the last few years has been crazy so one of the things that i've read in the past and i've noticed as i've done more analysis is it seems like this industry is very cyclical and so how you know as somebody that's interested in investing in these types of companies whether it's an nvidia or whether it's something you know more industrial related How do you approach the cyclicality?

28:57It is tough with cyclical businesses in general. For all of you out there that have tried to invest in a cyclical business, meaning one where you can have a great year, record sales, and then the next year, because there's too much supply, your revenue and profit takes a header. Semiconductors are very much like that. How do you invest in them? It's difficult because if you rely on more traditional valuation metrics, like a PE ratio, a lot of cyclical businesses sometimes always look expensive. The value of the business could have been cut in half in a year's time, and it still looks expensive and so you feel like you're not buying a value on the way up when you reach some sort of cyclical top sometimes it still looks expensive sometimes though it likes it looks really cheap because the company has earned so much profit in the last 12 months that it can totally fool you into thinking it's still cheap even after it's like doubled or tripled in a year or two So it's really tough.

30:12And what we do, the massive consumer of our time for Casey and I for the last three years has been, okay, to really understand that, you can't rely just on valuation metrics. you have to understand the supply chain. You have to understand what's driving sales and profit within that supply chain. And then from there, then you can kind of get a handle on, okay, yes, this stock looks expensive. It's down X number of percent in the last year or whatever, but based on the cycle, now might be a good time to allocate a little bit of money to it. So it's with cyclical businesses, I think it's kind of scary because you can't just do shortcut work to arrive at an investment decision.

31:12You have to pair it with an understanding of what's actually happening in the industry and what's moving what's moving these businesses forward or not forward. Yeah, right. Yeah, that makes a lot of sense. So how do you keep on top of that? Is it focusing on particular aspects of the supply chain? Or is it just understanding what broadly is moving the market in general? Yeah, we keep tabs on the supply chain and each little sub-industry within the supply chain. And what is nice about these cycles and especially the semiconductor industry, because so many of the companies have specialized in the last couple of decades, what they do, many of them will focus on one key spot in the supply chain.

32:09And that's all they do. They don't color outside of the lines of that sub-industry. you can get a feel for how product or raw materials and ultimately product is moving through that supply chain. We often use this illustration. Another one that Casey came up with is you may find it familiar is upstream and downstream, like the oil industry, integrated oil companies. You have the upstream companies that are maybe involved with exploration and extraction, and then the downstream companies that refine and sell the end product. You can get a feel for how things are moving through that supply chain by monitoring things like inventory on the balance sheet.

33:01You compare that with changes in revenue for these businesses and compare the different segments of the supply chain to get a feel for what's happening. And then, of course, the companies talk about what products are selling, what's not selling, what technologies are moving things forward. And that helps inform the decision as well as what's a good place to invest in at any given moment in time. It's a messy process. Yeah, it would be. It would be. It's an imperfect process because of all the different moving parts. Would it be fair to say that if you're, just to use AI as the example because it's relevant to today, would the demand that a company like, let's say, Meta is seeing and them ordering a lot of hardware from NVIDIA and then TSMC having to make all that and then other companies in that food chain having to help NVIDIA make those chips?