SOXQ: Strong Growth Outlook But Very Expensive Valuation

Introduction

We last covered Invesco PHLX Semiconductor ETF (NASDAQ:SOXQ) in November 2023. At that time, inventory correction was still not over yet. However, semiconductor stocks have made significant gains since we last covered SOXQ. Is now a good time to invest in SOXQ? In this article, we will provide our analysis and recommendations.

Investment Thesis

SOXQ owns a portfolio of 30 large-cap global semiconductor stocks. The fund has outperformed the S&P 500 index in the past, and it will likely continue to outperform the broader market due to its strong growth characteristics. The semiconductor industry is expected to grow rapidly in the next few years, thanks to strong demand caused by artificial intelligence. However, SOXQ’s valuation is very expensive relative to its past valuations. Since we think a higher margin of safety is necessary, investors may want to wait for a pullback.

Fund Analysis

Impressive return in this bull market

Let us begin with an overview of how SOXQ performed in the past two years. As we know, the broader market suffered a significant decline in the first 9 months of 2022 and SOXQ was no exception. Fortunately, since the cyclical low in mid-October 2022, SOXQ has performed very well. As can be seen from the chart below, SOXQ delivered a total return of 166.3%, much better than the total return of 59.7% of the S&P 500 index.

SOXQ’s outperformance to the S&P 500 index was primarily due to the surge in demand for semiconductor chips caused by growing interest in artificial intelligence and GPTs. In addition, inventory correction post COVID-19 has gradually come to an end, and a new semiconductor growth cycle has gradually emerged.

SOXQ’s portfolio composition

Let us look at SOXQ’s portfolio composition. The fund is passively tracking the PHLX Semiconductor Sector Index and consists of about 30 global large-cap semiconductor stocks. As can be seen from the stock style chart below, SOXQ’s portfolio has a strong tilt towards large-cap growth.

This usually means that it has the potential to outperform blended large-cap funds, such as funds that track the S&P 500 index. This has indeed been the case in the past, as SOXQ’s total return of 82.1% since its inception 3 years ago was much better than the S&P 500 index’s total return of 37.5%.

The semiconductor industry is booming again thanks to AI gold rush

Thanks to the demand for semiconductor chips caused by artificial intelligence, the semiconductor industry has now walked out of the cyclical low in 2022/2023 and is currently in expansion phase. As can be seen from the chart below, net earnings revisions have turned positive in the past two months, a clear sign of the industry booming again after about 1~2 years of inventory correction.

Because net earnings revisions have turned positive, consensus forward earnings per share for semiconductor stocks in the S&P 500 have also returned to growth again. As can be seen from the chart below, consensus forward operating earnings has reached $172.46 per share, more than doubled the amount of about $80 per share in late 2022.

Annual earnings growth forecasts are also expected to be very strong in the next few years. As can be seen from the chart below, annual earnings growth rate is expected to be 47.8% this year. This annual earnings growth rate will decelerate to 39.4% and 18.9% in 2025 and 2026 respectively. While a vast amount of growth will come from AI related demand, other areas of growth also include mobile devices, automobiles, Internet of Things, etc.

Valuation very expensive

Given the semiconductor industry’s strong growth outlook, one may wonder whether this is a good time to invest in SOXQ. It really depends on the valuation of these stocks. As can be seen from the chart below, semiconductor stocks in the S&P 500 index have typically traded at an average forward P/E ratio range of 10x and 20x in the past 2 decades. However, the current average forward P/E ratio of these semiconductor stocks is now 33.1x. This is significantly higher than the range of 10x and 20x that these stocks typically traded before.

As the chart above shows, the industry has experienced multiple expansion in its valuation since the low in October 2022. This multiple expansion is primarily due to a combination of the AI hype and the emergence of a new semiconductor expansion cycle. Given the extremely high valuation, we think the market may have already priced in the strong growth in 2025 and 2026. As we have noted, the projected annual earnings growth rate will decelerate from near 40% projected earnings growth rate in 2025 to only 18.9% in 2026. Therefore, multiple expansion of the valuation will likely be unsustainable.

Investor Takeaway

SOXQ has strong growth potential, but it is trading at an extremely high valuation right now. Although we believe artificial intelligence will continue to result in massive demand for semiconductor contents, especially in edge devices and servers in the upcoming few years, it is better to have some margin of safety. Therefore, we continue to think that a pullback will provide a better buying opportunity.