Companies that make the equipment used to make semiconductors have lagged behind the stock market during the last three years, but their shares could climb sharply if investors decide that a strong economic recovery is finally under way.
In previous economic cycles, stocks like Applied Materials, Novellus, Lam Research and KLA-Tencor outperformed the overall stock market and most other technology stocks when worldwide demand for electronics products was strong. Analysts expect that to happen again.
"In prior upturns, equipment companies have recovered faster than other related industries, and investors in the next upturn should look to these stocks to outperform the rest of the technology sector," said Edward C. White Jr., a chip-equipment analyst at Lehman Brothers.
The chip-equipment companies are easy to overlook because they reside at the bottom of the production chain for both consumer and industrial electronics. While their equipment is indispensable in the chip-making process, they are far removed from the end products that rely on silicon chips.
The companies are not only less prominent than many other technology concerns, they are also extremely volatile. Since April 7, 2000, when the S&P index of semiconductor equipment makers reached a peak, the sector has fallen 73 percent.
But from Jan. 1, 1997 to April 7, 2000, the S&P semiconductor equipment-maker index gained 1,042 percent. In that period, the NASDAQ gained 244 percent, and the S&P 500-stock index rose 106 percent.
During weak times, chip makers are generally cautious about spending on new equipment, but when a recovery begins, they scramble to add production capacity, and equipment makers can benefit mightily, several analysts said.
The challenge, of course, is knowing when spending in consumer and corporate electronics goods is likely to rise. While the stocks in the sector are considered fairly cheap right now, there is a consensus among analysts that they could languish for months, given the disappointing pace of recovery so far in a wide range of electronics goods.
"I would sum up the current market for chips and chip equipment as a nascent recovery that is at risk," said Richard Tortoriello, an analyst at S&P who has a neutral rating on the sector. Though sales of chip equipment are expected grow this year for the first time in three years, the gain will probably be a modest 5 percent to 10 percent, less than the average gains of 17 percent in past recovery years, according to industry analysts.
Some analysts see buying opportunities even now among a few niche chip-equipment makers, including KLA-Tencor of San Jose, California, and ASML Holding of the Netherlands.
Kevin Landis, a portfolio manager at Firsthand Funds, a technology-oriented fund company in San Jose, for example, said that he would minimize his overall holdings in the chip-equipment sector until he saw clear signs that chip makers "need both additional capacity and new technology."
But Landis is bullish on ASML. It competes with Canon and Nikon in the market for specialized photo-lithography systems used to imprint microscopic circuitry patterns onto silicon wafers.
"This is one specialized area that Applied Materials won't even touch," Landis said.
He said ASML would gain market share from Canon and Nikon in the next production recovery in chip making. "I am patient with this stock because I think they are an excellent candidate in the next cycle to pick up share," he said.
White favors KLA-Tencor, which makes inspection tools.
"Their inspection tools are so critical for the research and development, that it allows them to do well at a time when chip companies aren't adding manufacturing capacity but still investing in research and development," White said. "Their level of profitability is higher than almost any other company in the industry right now."
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