Danesh Ranchhod, equity analyst at Truffle Asset Management combines skill and passion to identify compelling global investment opportunities. Leveraging more than a decade of experience in researching equities, Danesh knows that through focusing on identifying information that materially impacts intrinsic value, we can find attractive valuations offshore. Danesh shares brief insights on why the global semi-conductor value chain is currently offering compelling opportunities, particularly a company called ASML (Advanced Semiconductor Materials Lithography).
Generating good global ideas
Given the size of the global equity universe, Truffle uses a quantitative multi-factor filter to reduce the opportunity set and help target our fundamental research process.
We look for solid companies that are going through a temporary setback – whether it is in their earnings or share price. These companies typically have the following characteristics:
- Above average returns on invested capital
- Strong free cash flow conversion, with a focus on valuing businesses based on cash generation rather than accounting earnings
- Appropriate financial leverage
- Sustainable economic moats that provide long-term competitive advantages
- Trading below our assessment of intrinsic value
We also focus on understanding and assessing potential downside risk. We aim to understand what could go wrong with our investment thesis and evaluate the potential impairment to intrinsic value if the investment case does not materialise as expected.
Identifying attractive opportunities in the semi-conductor industry
Through our research framework, we identified ASML (Advanced Semiconductor Materials Lithography) and TSMC (Taiwan Semiconductor Manufacturing Company), two companies in the semiconductor value chain as particularly compelling. These companies are benefiting from secular growth trends and offer a mix of monopoly power with leading edge technology, scale advantages, recurring revenue, and strong economic moats.
A growing market
ASML, an equipment tool supplier to the semi-conductor industry, plays an important role in microchip production.
Most electronic devices contain microchips or semi-conductors which are essential for computing power. Having smaller microchips with higher computing power and lower energy usage is allowing devices to become smaller, faster, and smarter.
These factors are driving the modernization and advancement of technology particularly in devices such as smartphones, and across many home appliances and cars. More importantly, the advancing tech trend is fueling a broader digital transformation affecting artificial intelligence, data centres, autonomous cars, humanoid robotics, and internet-connected devices. We believe a structural demand for smaller, faster and more energy efficient microchips will therefore remain robust for the near future due to the continued evolution of the digital economy.
The investment case for ASML
While it is likely that the semiconductor ecosystem in total will benefit from increased microchip demand, we believe ASML holds specific and unique characteristics that enable the company to stand out within its value chain.
ASML makes lithography tools, which are one of the most vital pieces of equipment in microchip production. A lithography tool uses a laser beam to print an integrated circuit onto a silicon wafer before it becomes a microchip. The ability to etch smaller circuits is driving microchip shrinkage and improved performance. ASML’s technology is being used to create the most advanced chips used in AI and other high-performance computing devices.
ASML’s monopoly on this innovative technology is well entrenched. The fact that it took 17 years to develop the latest technology provides the company with a strong competitive edge. Another key division for the business is ASML’s maintenance, service, and upgrades division, which helps customers improve the yield or productivity of microchips. Continued growth of this division is adding a high margin, recurring revenue stream. Importantly, customers are heavily reliant on ASML, given the specialised nature of its equipment and the high switching costs.
In our view there are many factors driving a compelling investment case for ASML which are outlined below:
- A strong global demand pipeline for microchips.
- A medium-to-long-term monopoly position in a critical segment.
- The integral role ASML plays in driving chip shrinkage and increasing computing power which enhances the pricing power for its products.
- A growing annuity revenue stream relating to maintenance and upgrades – a high margin.
A compelling investment case does not come without risks. We are aware that a Chinese company is considering expansion into lithography tools, however current indications suggest that they are at least 10 years behind ASML. For now this risk is relatively low.
In summary, we anticipate ASML will experience free cash flow growth in the mid-teens, driven by its expanding share of the growing semiconductor market and improved margins from its newer technologies, as well as its maintenance and upgrades business.
