The Philadelphia Semiconductor Index, the key indicator of the health of the chipmaking sector, flirted with a record overnight, prompted by growing hopes of a trade deal between Washington and Beijing.

White House economic adviser Larry Kudlow said talks between the US and China have progressed and both sides hope to get closer to a deal this week.

Shares of chipmakers, which rely heavily on China for revenue, especially benefited from the latest developments. The Philadelphia Semiconductor index jumped as much as 3 per cent to a record high. The index ended 2.3 per cent higher.

Semiconductors, a critical component of microprocessor chips, are found in anything that is computerised or uses radio waves. This technology continues to transform every day life. 

The Morningstar Global Technology Index is up 16 per cent year to date in 2019 and outperformed the global equity market, which rose 11 per cent over the same period, notes Brian Colello, director of technology, media, and telecom equity research for Morningstar.

Semiconductors are the most attractive sub-sector of technology, and three names to watch on the global scene are: Baidu, Microchip Technology, and Applied Materials.

Here Colello takes the pulse of the sector and expands on these three names:

Technology snapped back nicely in early 2019 with some optimism that the US and China can reach trade agreements and avoid a full-blown trade war, an issue that caused the markets and the tech sector to fall in the fourth quarter. We continue to believe that tariffs and/or the lack of a trade deal may weigh on the health of the Chinese consumer and disrupt a highly interwoven tech supply chain that would be quite difficult for the US and China to unwind.

Tech stocks have outperformed the global markets

Tech stocks have outperformed the global markets. Source: Morningstar Analysts

The median technology stock is roughly 2 per cent below our fair value estimate today compared with a 15 per cent discount toward the end of the fourth quarter. Despite the recent rally in tech and in semiconductors specifically, we still think semis are the most undervalued subsector in technology, as about 30 per cent of our coverage is 4-star-rated or higher and the median chip stock is about 4 per cent below our fair value estimate. Online media is also an attractive segment, as the median online media stock within our global coverage is about 12 per cent undervalued.

Semiconductors is the most attractive subsector of tech

Semiconductors is the most attractive subsector of tech. Source: Morningstar Analysts

Admittedly, the near-term picture in semis is relatively weak after a couple of years of tremendous growth. However, a good portion of the bounce-back in semis in the first quarter came from optimism about easing trade tensions between the US and China, as well as some commentary suggesting that the March quarter will be a bottom for chip demand. Although we're not expecting strong car sales in 2019, we foresee no slowdown in demand for more processing power, connectivity, and sensing capabilities in a wide variety of cars in order to enable more advanced infotainment and active safety applications, all of which bodes well for long-term chip demand.

We see no signs of automotive chip revenue slowing down

We see no signs of automotive chip revenue slowing down. Source: Morningstar Analysts

Online media stocks are also cheap. In the US, bellwethers like Alphabet and Facebook face data privacy issues, while concerns about the health of the Chinese consumer have made regional champions like Baidu undervalued as well. Ultimately, we still foresee tremendous growth in global digital advertising in the years ahead, outpacing growth in TV and other media vehicles.

Digital advertising growth continues to outpace traditional

Digital advertising growth continues to outpace traditional. Source: Morningstar Analysts

Top Picks

Baidu (BIDU)

  • Star Rating: 4 Stars
  • Economic Moat: Wide
  • Fair Value Estimate: $262
  • Fair Value Uncertainty: High

We believe that Baidu is an undervalued, wide-moat name. Although weaker economic growth in China remains a concern, Baidu is still the largest Internet search engine in China and has built an ecosystem around search and shifted to mobile Internet by releasing various well-received mobile apps, such as Mobile Baidu Search and Baidu Map. Baidu has been evolving from a mobile-first to an artificial-intelligence-first company. In the near term, margins will remain under pressure because of aggressive content spending and talent acquisition costs for AI personnel, but we foresee strong revenue growth for the company thereafter.

Microchip Technology (MCHP)

  • Star Rating: 4 Stars
  • Economic Moat: Wide
  • Fair Value Estimate: $112
  • Fair Value Uncertainty: Medium

We view wide-moat Microchip Technology as one of the highest-quality firms in our semiconductor coverage. It remains a leading supplier of the "brains" needed for a variety of smart devices categorized as the "Internet of Things." We find Microchip under the hood (figuratively and often literally) of the latest cars with the most advanced electronics and think it is poised to profit from rising chip content per vehicle. Microchip is adept at navigating the various industry cycles and, at this point, appears poised to recover well from the downturn in late 2018.

Applied Materials (AMAT)

  • Star Rating: 4 Stars
  • Economic Moat: Wide
  • Fair Value Estimate: $49
  • Fair Value Uncertainty: High

We believe wide-moat Applied Materials' shares are trading at an attractive discount. The company has benefited greatly from the sharp rise in spending by memory and display chipmakers over the past few years, though recent customer commentary suggests a near-term pullback in spending for each subsegment (especially in 3D NAND memory and OLED displays). Although we think total wafer front end spending will be modestly lower in 2019, we foresee Applied leveraging the breadth of its product portfolio and services business to navigate this softer demand.

Brian Colello, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

Lex Hall owns shares in Nvidia

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