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I’m Matt Reynolds and this is Capital Ideas, your connection with the minds and insights helping to shape the world of investments.

Today on Capital Ideas we’re talking about the semiconductor industry - the outlook for the business of making computer chips, and how it has been fundamentally transformed by the pandemic.

Like many things post pandemic, a lot of things have changed for the semiconductor industry.

So, let’s start off with a big picture outlook for the semiconductor industry, both near-term, say the next one to three years, and also, since we're long-term investors here, the long-term outlook for this key industry.

In short there have been some pretty dramatic changes happening in the semiconductor industry and, to put it in perspective, we have not seen changes of this magnitude and significance in over 15 years.

In the short to intermediate term, we are now finishing the period of changes due to COVID. These changes affected demand as well as the supply chain. And now that we're kind of flushing those things out, we are seeing some normalizing.

So, we should see growth rates probably cool down a little bit in the next short to intermediate term and returning to the levels that we have seen historically.

However, there are some significant changes that have been transforming the industry.

Some examples of these are.

Firstly - we’re seeing the two main sources of demand that are relatively new.

One of them is electric vehicles including autonomous driving. Those two things are somewhat separate and they're driving demand that we did not have before.

I think the second change is the upgrade of computing infrastructure around the world.

And the words that we are hearing about are artificial intelligence, and more recently, ChatGPT. These are large language models, which are a segment of artificial intelligence.

And these are additional sources of growth for semiconductors.

And let me add the third one in that bucket, and that is a continued change towards electrification. Now part of this is electrical vehicles, but there is also demand being created at the industrial level and at the consumer level driven by more awareness of power consumption and the environment.

So, these demand drivers are very positive for the semiconductor industry.

Let’s spend a moment on ChatGPT and why its development is important for chip makers.

Now in the near term we are probably still in a hype period about artificial intelligence in general and ChatGPT in particular. There is a lot of hype in the media and there is no doubt AI will  have a far-reaching effect on our lives but the effect of ChatGPT on semiconductor demand will probably be less than from EVs and autonomous driving.

It’s fairly clear that artificial intelligence in general and large language models in particular, or GPT, require a different compute infrastructure.

And let me give you an analogy.

We are all now very familiar with cloud computing. This is where companies like Amazon providing AWS services. And Microsoft providing Azure.

These are a different compute infrastructure than we used to have. Every company used to own their own compute infrastructure. And now, through cloud computing, we have created a new way of having compute as a service.

This is another computing infrastructure. And that's going to require an upgrade. And that upgrade requires additional and different types of chips – both smaller chips and more powerful one’s.

This is why some of the stocks that have the kind of semiconductors that are particularly effective in performing these large language model computations have done so well.

Both, not only as a stock, but the fundamentals of the company. The sales are growing, and this is why. They are the solution that is needed now.

So, whilst semiconductor stocks are enjoying a very strong rally this year, investors have historically seen big swings in semiconductor stock prices.

The semiconductor industry is a very cyclical industry. It's a capital-intensive industry with several segments that are commodities, and this is just a recipe for cyclicality.

One company in particular, NVIDIA, has been in the news a lot and it’s getting a lot of attention because of parallel computing.

Let me explain by taking us back to artificial intelligence in general and ChatGPT, or GPT models in particular.

The type of problems that artificial intelligence present are more effectively solved with an architecture called parallel computing.

As it turns out, gaming and graphics are also solved more efficiently with parallel computing.

So, if a company had that architecture, suddenly, there is another problem that is ideal for that architecture to solve. And guess what? NVIDIA was a gaming company, developed chips for gaming, for graphics.

So NVDIA in effect had a solution waiting for a problem.

The problem came up, and they were at the right place at the right time.

Now I am simplifying things, because they did recognize early on that they were going to be the architecture of choice for this new technology. So, they did a lot of work to get ready for that intersection. And that is why the company is in the news these days. Because their architecture is the most efficient to solve these types of problems.

There are obviously many other companies involved in the semiconductor industry and broadly we have the designers of the products and the manufacturers of the products. There also companies that do both design and manufacture.

In terms of sizes, if we think of the larger players here, of course, now we're talking about NVIDIA. NVIDIA is a designer of chips. They don't actually manufacture anything. Then another company is Taiwan Semiconductors. This is a company based in Taiwan, and all they do is manufacture. They don't do any design. In fact, TSMC makes the chips that NVIDIA designs.

In between these two, we have companies like Intel, another large player. Intel does both. They design the chips, and they manufacture the chips. Another company that does both is Samsung Electronics. They design and they manufacture. These are probably the four largest players in the semiconductor industry right now.

These companies are all over the world and this global element of the semiconductor is one of the reasons why I think the industry is changing in ways that we haven't seen in decades.

Let’s change gears a little and look at the most recent cycle a bit more closely.

There was a time not that long ago when we were reading a lot in the news about a chip shortage - to the point where certain cars weren't being sold because they couldn't get the computer chips that they needed to just do the basic technological functions that are in a car now.

That shortage is over now, and the industry is normalizing, but it’s normalizing to a new normal.

Looking back - COVID was a tremendous shock to the system. And like all shocks, they tend to have ripples. And the ripples were actually quite big. Let’s dig into the automotive industry to illustrate that. The semiconductors that go into automotive are very unique. First of all, they are custom. Most of them are designed just for that particular product. And sometimes they are designed for a particular car.

Second, they are manufactured in special ways. This is because they have to withstand a lot of tough environmental conditions. Heat, vibration, water, cold temperature. And so, the manufacturing process is unique.

So, what happened was that as COVID took off, the demand for these chips plummeted. And the semiconductor companies then reacted to that lower demand, and at the same time, they were having problems with their own supply chains.

Unfortunately, the automakers in the second half of 2020 realized that this was going to be temporary. There was this huge demand for cars, particularly EVs. So, they reversed course in orders, but because of everything I just explained, how particular the supply chain is, the semiconductor companies could not react and start replenishing the inventories and getting the factories going again.

It took a long time. And this cascaded, this changed the entire industry. And only now – some 3 years later - are we recovering from that. But something happened along the way. As the car makers suddenly started putting in orders again, and the chip guys did not have enough supply, the chip guys said I wonder if we can increase prices.

And guess what? They started increasing prices.

So, this is a shock to the system that allowed them to do something they haven't done in almost 20 years.

So, these changes have continued to today, and there's some normalization going on.

But what we have not seen is a normalization in pricing. The chip suppliers have taken advantage of these conditions, to keep supply tight, so that it can keep prices high. And that's why we're seeing normalization happening very slowly.

So, the chip shortage we experienced in 2021 is over now but the supply chain is still tight. And it's purposely tight in certain areas.

Finally, lets touch on some investment themes going forward.

The main category is the continuation of the electrification of society. And what I mean by that is the focus on reducing power consumption and at the same time providing functionality through semiconductors. Those two things go together.

This is particularly the case in alternative energy. In alternative energy, we’re adding intelligence to devices that already have semiconductors, but not much intelligence.

The typical example is a thermostat.

Obviously, a thermostat has had microcontrollers for a long time. It has had semiconductors in it for a long time. It's nothing new. But now we can add additional content to make it more functional. We can add connectivity, meaning that we can access that device from anywhere. We can add intelligence. It can make decisions that it couldn't make before. You can control it via your phone. You can do all these things that you couldn't do before. So, that's what I mean when I say electrification.

And this trend is going to permeate everywhere. Not only consumer, but industrial applications and medical applications.

And this will take a long time, and it's not going to be immediate.

This is really the “Internet of Things.” This is what the term “Internet of Things” refers to. Adding connectivity and intelligence everywhere and this will likely underpin demand for semiconductors for many years to come.

We're always trying to get better, so if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@capgroup.com. And if you like what you heard today, please follow us on your favorite podcast platform.

For Capital Ideas, this is Matt Reynolds reminding you that the most valuable asset is a long-term perspective.

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