PSI: Valuation Not Cheap (NYSEARCA:PSI)

Introduction

We last covered Invesco Semiconductors ETF (NYSEARCA:PSI) back in April 2023. At that time, we were cautious due to economic uncertainty. However, the U.S. economy has proven to be more resilient than we thought, and a recession never happened. It has been over a year since we analyzed PSI, and we thought we should come back and provide our analysis and suggestions again.

ETF Overview

PSI owns a portfolio of about 30 semiconductor stocks in the United States. The semiconductor industry is expected to grow rapidly in 2024 and 2025 and should be able to benefit from several important technological megatrends. PSI can be quite volatile relative to the S&P 500 index. The fund appears to be very expensive relative to its historical average. Given that the industry typically goes through inventory corrections every 3~4 years, we think investors should remain cautious. A pullback will provide a better margin of safety.

Fund Analysis

PSI has outperformed the broader market since October 2022

PSI has enjoyed very strong growth since the broader market reached its cyclical bottom in October 2022. In fact, the fund has delivered a total return of 110.8% since the low. In contrast, the S&P 500 index has only delivered a total return of 53.2%. While PSI enjoyed very strong outperformance relative to the S&P 500 index, it can be quite volatile. In fact, PSI has a 5-year average beta ratio of 1.66 to the S&P 500 index’s beta of 1. This means that for every 10% increase or decrease in the S&P 500 index, PSI’s fund price may in average increase by 16.6% or decrease by 16.6%.

The semiconductor industry is expected to grow rapidly in the next few years

As the title of the fund suggests, PSI owns a portfolio of U.S. semiconductor stocks. These stocks are expected to grow rapidly in the next few years, thanks to strong demand for semiconductors. In fact, semiconductor components are crucial building blocks for many technological megatrends such as artificial intelligence, Internet of Things (IoTs), industrial automation, cloud computing, etc. Therefore, this industry should be able to ride on these tailwinds in the next 5~10 years.

Below is a chart that shows the annual revenue growth forecasts through 2026 for semiconductor stocks in the S&P 500 index. While PSI’s portfolio may not be the same as these stocks, there are significant overlaps. In addition, what is important is to observe the trend, not the exact numbers. As the chart below shows, semiconductor revenue growth is expected to be north of 20% in 2024 and 2025. This strong growth rate is expected to decelerate to mid to low teens in 2026.

We observe similar trends when we look at these semiconductor stocks’ earnings growth forecast. As the chart below shows, consensus earnings growth rates are expected to be very strong in 2024 and 2025, and this rate will also decelerate in 2026 to high teens.

Semiconductor industry typically goes through inventory correction every 3~4 years

However, investors should keep in mind that the semiconductor industry is very cyclical in nature. Unlike the software industry, the semiconductor industry will inevitably face inventory problem. If demand surges, these semiconductor firms will try their best by producing more components and devices to meet the demand, and this can often result in higher inventory, especially when demand diminishes. Below is a chart that shows the earnings and revenue revisions in the past 20 years. Positive revisions mean that the demand is improving. On the other hand, negative revisions are signs that demand is weakening, and the industry is likely going through some forms of inventory correction. As can be seen from the chart below, negative revenues and earnings revisions typically happen every 3~4 years. We are now at a level where these revisions are turning positive, suggesting that inventory correction is likely over.

Valuation expensive relative to historical average

So, is the semiconductor industry as a whole expensive or cheap? As can be seen from the chart below, the semiconductor stocks have usually been trading at a forward P/E ratio of about 15x between 2013 and 2020. During the pandemic, this valuation has been higher, at about 20x. But the recent outperformance of the semiconductor sector means that the valuation is now above 25x. Hence, we think the industry as a whole is quite expensive relative to its historical average.

Investor Takeaway

The semiconductor industry is expected to benefit from many important technological megatrends in the upcoming decade. The growth outlook is also very attractive in the near-term. However, its valuation is quite expensive right now. Since we think it is important to seek higher margin of safety and that these semiconductor stocks can be very volatile, we think investors may want to wait for a pullback before initiating a position.