The making and miniaturizing of microchips has been among the world’s greatest engineering challenges. The semiconductor trade—along with that of an ever-broadening array of electronics enabled by these chips—has been essential to our globalized economy. What should investors focus on now that the United States has begun ambitiously putting more funding and muscle into domestic chip production and industrial policy?
I discussed these themes recently during a conversation with economic historian and Tufts University professor Dr. Chris Miller, who examines the industry’s complex evolution in his new book, Chip War: The Fight for the World’s Most Critical Technology, and with Franklin Equity Group Portfolio Manager JP Scandalios, who has spent more than 20 years researching the semiconductor industry. Here are some key takeaways:
- The world’s economy is reliant upon semiconductor chips. Far beyond just data centers and smartphones, the computing power accessed through microchips is required for all parts of our economy. Cars are increasingly embedded with thousands of microchips, whereas even just a decade ago, they had just a few dozen. We now use chips for credit and debit cards, dishwashers, microwaves—virtually anything with an on/off switch. Advanced microchips are also vital to the defense industry. “Last year, the chip industry produced more transistors than the combined quantity of all goods produced by all other companies, in all other industries, in all human history. Nothing else comes close,” according to Miller. The global chip industry has historically been quite cyclical because of its dependency on personal computers (PCs) and smartphones. With this proliferation, we’ve seen cyclicality begin to dampen and profitability increase significantly. Select semiconductor companies are among the most profitable in the global technology sector, and with cyclicality lessening, this could help drive strong long-term investor returns.
- The process of designing and manufacturing chips is bifurcating. The industry’s trend toward a fabless (without fabrication) model means the users of semiconductors (i.e., Apple) design for their specific needs, while outsourcing the fabrication of the hardware to chip foundries, the largest of which is Taiwan’s Taiwan Semiconductor Manufacturing Company (TSMC). Increasingly, companies running large cloud-computing infrastructures are also building their own chips, including Amazon, Microsoft and Google. The benefit of this is that their application-specific integrated circuits (custom-designed chips) become perfectly honed to their data centers, which will reduce costs. Intel, which has historically designed its own chips, has missed some key shifts in the industry. There is a famous story about how Intel snubbed Apple co-founder Steve Jobs when he asked the firm to produce chips, designed by Apple, for its first iPhone.
- The potential for making chips smaller is itself shrinking. Already measured in billionths of a meter, transistors have been reduced to the size of DNA and virus molecules. Moore’s law of doubling the number of transistors on microchips every two years has become more difficult, forcing companies to be more creative to make chips more effective. Customer demand for new uses and capabilities is propelling that process forward. What we expect to see is a greater share of advances coming from creative chip design versus a continuation of size reduction. A key issue facing the industry is how to package chips so that they can be arranged and assembled in new and innovative ways.
- Today’s underlying competition is largely structured around a differentiated global supply chain. US prowess lies in chip design and the manufacturing of certain machine tools. Japan is quite skilled at producing ultra-purified chemicals used in manufacturing semiconductors. The Netherlands produces the most advanced lithography machines, and Taiwan is unparalleled in its fabrication of the most advanced processor chips. A single company, TSMC, manufactures 90% of the world’s most advanced processor chips.
- Chinese chipmakers rely on manufacturing equipment imported from the United States and the Netherlands. That has left China vulnerable to the type of import restrictions imposed last October. Chips are important to the Chinese economy, which consumes about 25% of all chips made globally, but Chinese producers only manufacture about 8%.1 China, quite remarkably, spends as much to import semiconductors as it spends importing oil.
- The United States is determined to maintain its leadership in semiconductors. The US government’s first goal is to preserve its leadership in research and advanced chip design. Around 20% of the CHIPS Act is dedicated to research.2 It also aims to have the most advanced processor production located domestically. Currently, only three firms in the world can manufacture the most advanced logic semiconductors—Samsung (South Korea), TSMC (Taiwan) and Intel (United States).
- The US government’s drive for new domestic fabrication comes with hefty upfront costs and a complexity that is perhaps second only to the development of nuclear reactors.
We continue to monitor industry developments closely as our economy and everyday lives are more and more dependent on semiconductors.
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1. Source: Macquarie Research, “Tech decoupling and China,” March 10, 2023.
2. The CHIPS and Science Act of 2022 is a legislation signed into law that invests billions in semiconductor and scientific research and development over the next five years to help the United States regain a leading position in semiconductor chip manufacturing.