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The cyclopean rise and reach of big tech appears unstoppable.
The technology sector holds a larger proportion of the US market cap than any sector ever has, and it’s not even close. While the software side of the sector appears well insulated for the long haul, the semis are showing several “warning signals” according to a report by UBS.
One signal is the extreme price momentum of semis, which means they are being overbought.
“On a six to 12 month basis this has been a warning signal,” said UBS analyst Andrew Garthwaite and others. “This is at a time when, as we warned recently, price momentum as a style is vulnerable.”
However, simply removing Nvidia (NVDA) and Advanced Micro Devices (AMD) from the formula greatly reduces the overall price momentum, UBS notes.
Another warning signal in the semis sector is overvaluation as price to sales revenue relative to the market are at record highs, according to UBS data.
Semis are also much more exposed to geopolitical risks as 20% of the sector’s revenue comes from China.
Earlier this week, China indicated it wants to ban purchases of Intel (INTC) and AMD chips for government use. On a nominal basis, Intel had roughly 27% of its sales in China in 2023, or $15B, while AMD had 15%, which was $3.4B. Government purchases comprised approximately 10%.
In comparison, Microsoft (NASDAQ:MSFT), the largest player in the software sphere, has less than 2% of its revenue tied to China sales, UBS finds.
UBS has also noticed semis decoupling from earnings revisions.
“Earnings revisions have been very strong, but there has been a big decoupling with performance,” UBS said. “Even if we exclude Gen-AI companies, we can see a reasonable decoupling. This is a warning that valuations are getting expensive.”
Meanwhile, software stocks are not overbought or overvalued. There also appears to be more room for software companies to expand the total addressable market. Even labor shortage issues are a boon for software sales.
“We can see that there is still a labour shortage on the National Federation of Independent Business data, and normally this is associated with higher software spending implying that a higher TAM number might be appropriate,” UBS notes.
Microsoft’s edge
The current market advantages for software companies are particularly helpful for Microsoft, which is why UBS considers it a “critical long.”
What’s more, with such a large current user base Microsoft has the ability to routinely raise prices as software is such a “low proportion of total corporate or household costs.”
With the integration of generative AI, CoPilot’s pricing strategy seems much clearer than competitors’ attempts to monetize AI, UBS finds.
Nvidia in league of its own
Despite some warnings signs, the semiconductor sector remains in great shape. It’s the highest growth sector in terms of earnings per share and UBS still gives it a top ranking on the quality scorecard.
There is also not over-investment in the sector, meaning capital expenditures to sales and capital expenditures to depreciation are not extended, UBS said. Additionally, semis do not have much debt, with many remaining debt free over the last few years.
Nvidia stands out as one of the strongest players in this sector. UBS has called it “the only chip company that can create its own market.”
It maintains its Buy rating and a price target of $1,100.
Nvidia’s share value has increased nearly 2,000% in the past five years and more than 80% year to date.
TSM rising
Taiwan Semiconductor Manufacturing Company (TSM) is also well positioned for the future.
“TSMC is five years ahead of its Chinese rivals and two years ahead of its US rivals,” USB said. “It controls most of the leading-edge foundry production and has the ecosystem to continue to be the No. 1 foundry provider.”
The company expects 13% of its revenue to be derived from high-end AI chips by 2025.
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