Dear investors, In April 1965, an article entitled "Cramming More Components Onto Electronic Circuits" appeared in Electronics Magazine. This publication, whose title can be understood in its full magnitude only by engineering enthusiasts, has become one of the most influential contributions in history. The article had been written by Gordon Moore, an electronics engineer, then director of R&D at Fairchild Semiconductor, one of the future founders of Intel. In his paper, Moore predicted that the number of transistors on an integrated circuit would double on average every two years. This prediction eventually became known as Moore's Law. The prediction was originally made for the next 10 years, but it still holds true today, nearly 60 years later. And it is thanks to her that the number of transistors that fit on a chip went from 4 to more than 16 billion today¹ and made it possible for this technology to become increasingly prevalent in our lives. At the center of the digital universe, chips, or microprocessors, are the brains behind the computers, smartphones, tablets and myriad electronic devices that form the basis of the digital economy. Without them, many of the advances we see in fields such as artificial intelligence, Big Data, Internet of Things (IoT) and cloud computing, for example, would not be possible. Demand for chips is growing in a variety of industries, from auto to healthcare to agriculture and even space exploration. Chip shortages can have dramatic effects on manufacturing and the wider economy, an effect that was evident during the pandemic, when chip shortages had a significant impact on the auto industry. A modern vehicle has, on average, 1,500 chips. Without them, many vehicles went out of production, which is estimated to have caused the industry to lose up to ~USD 200 billion in sales in recent years. This impact is equally noticeable in the sharp increase in car prices that we have witnessed over the same period. Considering that the technology in this industry is owned by very few companies, each one specialized in a stage of the production chain, new bottlenecks are not unthinkable and could be much more severe than those faced during the pandemic – especially considering that the company responsible for the production of almost 90% of the world's most advanced chips² (TSMC) is located in Taiwan. In the next few paragraphs, we briefly explain the history of the industry, how it is set up today and its role in the global geopolitical landscape and implications for our investments. For those interested in going deeper into the subject, we recommend reading the book Chip War, by author Chris Miller.
What exactly is a chip To understand how a chip works, it's helpful to start with the concept of a semiconductor. Semiconductors are materials with electrical properties that fall somewhere between those of conductors (such as copper, which conducts electricity very well) and insulators (such as rubber, which does not conduct electricity). Silicon is the semiconductor most commonly used in chip manufacturing – it is for this element that the US region called Silicon Valley is named. On chips, small components called transistors are created from this semiconductor. Think of the transistor as a small switch that can turn electricity on and off. This ability to control electricity is crucial to how the chip works, as this is how the binary language (code of 1s and 0s) is represented. When the transistor is “on”, a “1” is registered and when it is “off”, a “0” is registered. This series of 1s and 0s is the fundamental language that computers use to process information.
Brief history of the chip industry The semiconductor industry has its roots in the 20th century, when the invention of the transistor at Bell Labs in 1947 changed the course of technology. This small device, which could amplify and switch electrical signals, eventually replaced the vacuum tube, which was larger, consumed more energy and was less reliable. In 1958, Jack Kilby of Texas Instruments and Robert Noyce of Fairchild Semiconductor independently created the first integrated circuit (or chip) that combined multiple transistors into a single device. This invention marked the beginning of the silicon era and the birth of the chip industry. In the early years, the products had no commercial demand and found use in military applications. The fact that the US was lagging behind in the space race provided the necessary impetus for computing demand. Fairchilld Semiconductor received a large order from NASA for the Apollo mission (the mission that landed a man on the moon in 1969). Meanwhile, Texas Instruments received a large order from the US Air Force for a missile guidance system. In the 1970s, companies such as Intel and AMD emerged as major players in the industry, with Intel introducing the first commercially available microprocessor, the Intel 4004, in 1971. The invention of the microprocessor led to significant advances in computing and other technologies , fueling the rise of personal computers in the 1980s. Starting in the 1980s and continuing into the 21st century, the semiconductor industry has expanded beyond computers to include an ever-increasing range of applications, including mobile phones, Internet of Things (IoT) devices, and artificial intelligence systems. . In addition, a global division of labor has emerged, with some companies, such as Intel, designing and manufacturing their own chips, while others, such as Apple and Qualcomm, designing chips but outsourcing manufacturing to companies such as TSMC.
Current industry overview Considering the industry's importance, it's surprising how concentrated it is. Companies like Apple, Nvidia and AMD play an important role, but they are only responsible for designing the chip. To develop this project, these companies depend on software whose technology is dominated by only 4 companies (3 Americans and 1 German) that, together, hold 90% of the global market: Synopsis, Cadence, Ansys and Siemens. When the design is completed, it is sent to one of the chip makers. Depending on the complexity of the product, there are only 2 or 3 companies in the world capable of producing them: TSMC (Taiwan), Samsung (South Korea) and Intel (USA)³. For chips with inferior technology, other companies start to act, such as the American Global Foundries (former spin-off of AMD), the also Taiwanese UMC and the Chinese SMIC. The dominance that TSMC exercises in this market is noteworthy – for the most advanced chips, with nodes smaller than 10 nm, it has 90% of market share. And even for lower nodes, the company has a dominant position, with a market share greater than 50%. Details in the chart below.
Graph 1 – Market share of non-integrated chipmakers by node, 2020 data 
Source: Bain/IC Insights/Gartner Note: In the graph, the bars on the right represent the most advanced chips (with the smallest distance between elements) Companies like Apple and Nvidia ended up becoming more famous, the first for being the most valuable in the world, and the second for being the best prepared to surf the AI wave (which made its shares jump an incredible 175% in 2023), but both are extremely dependent on TSMC – 100% of both chips are manufactured by the Taiwanese company. TSMC is able to design its customers' designs in silicon using some of the most precise machines in the world, which record, deposit and measure layers of materials in nanometer dimensions (20,000 times smaller than a strand of hair). These machines are mainly produced by 5 companies: one Dutch (ASML), one Japanese (Tokyo Electron), and three American (Applied Materials, Lam Research and KLA), each one focused on one step of the process. ASML in particular (the largest company in the Netherlands by market cap) is the sole owner of EUV lithography technology
4, which is essential for designing the chip design into the silicon layers. Each of these machines has an average cost of USD 150 million (few companies are able to make such an investment – only TSMC, Samsung, Intel and memory chip makers such as SK Hynix and Micron), and is the product of an investment of 3 decades by ASML. Today, the company reaps the benefits, as it is essential for the production of the most advanced chips and there are no substitutes – it is said that ASML has been free of competitors for this technology for a few decades. And how did we end up in this situation? How is such an important industry dominated by so few companies? Across the chip industry, the last few decades are stories of consolidation. And there are two reasons for this: the first is that many parts of the chip-making process are brutally capital intensive, with very expensive machines. This discourages competition, as a new entrant has to invest billions of dollars before knowing if your product will even work. The second is that the level of knowledge needed to manufacture this equipment is very specific and requires practical experience, it is not something that can be taught theoretically in colleges. This means that the companies that own the technologies have in their staff the vast majority of people in the world with the necessary knowledge, and it makes it very difficult for a new entrant to emerge in the industry.
geopolitical dilemma The importance of chips goes beyond economic aspects, they have also played a key role in military applications, contributing to technological advancement in areas such as communications, surveillance, intelligence and weapons. During the Cold War, for example, the pioneering spirit of the USA in the use of this technology was a decisive factor for them to win over the Soviet Union. In today's world, chips play an even more important role, especially given that military and intelligence systems will be increasingly dependent on artificial intelligence. AI systems are trained in data centers full of sophisticated chips. If a country doesn't have the technology to manufacture such chips, it won't be able to train AI systems. And that is what the US is betting on in its conflict with China. In this context, the US has taken measures to restrict China's access to advanced semiconductor technologies. For example, several Chinese companies have been placed on a US Department of Commerce list with restrictions on buying US semiconductor technology. At the same time, US companies and those from allied countries (such as ASML, Tokyo Electron, Applied Materials, Lam Research, KLA and even TSMC) are facing a series of restrictions that prevent them from selling their most advanced products to China. In response, China has been investing heavily in developing its own semiconductor manufacturing capacity, although it still has a long way to go to reach the technology level of major chip makers. In addition, there is still the question of Taiwan. China has claimed Taiwan as part of its territory, which has been an ongoing source of tensions between China, Taiwan and the US, which is an important supporter of Taiwan. Any conflict in Taiwan or China's attempt to exert more direct control over the region would have significant implications for TSMC and, consequently, the global semiconductor supply chain. To protect itself from an eventual escalation of the conflict in Taiwan, the US passed the Chips Act in 2022. The law establishes the allocation of USD 280 Bi for investments in research and chip manufacturing in the US, and aims to reduce American dependence on chips manufactured in East Asia, especially the most advanced ones. The passage of the law has already attracted investments from companies such as Intel, Global Foundries, Samsung and even TSMC – all intend to build factories in the US in the coming years. Despite the hefty check, there are many who are skeptical about the impacts these investments will actually have on changing the global structure of production, given that each factory is incredibly expensive (a state-of-the-art factory costs between USD 20-25 Billion to build , and it's only had cutting-edge technology for a few years), and the fact that production in the US is naturally more expensive than Taiwan, especially due to higher costs on key resources like personnel, land, water and electricity, tougher environmental legislation rigid, and a more severe tax regime. The unfolding of all this dynamic is something to be closely monitored in the coming years.
Impact on investments From an investment point of view, there are two ways to think about how to act. The first is to identify potential opportunities in the industry itself, since it certainly has very attractive characteristics: it is an essential product for the global economy, with clear growth trends and full of dominant companies in their respective segments. Given these characteristics, we analyze companies and are tracking share prices in order to potentially invest at a time of appropriate prices. One company that particularly catches the eye is TSMC. As we have seen, it has a dominant competitive position and, looking at its track record of growth and profitability (it has been growing at a rate of 22% per year for the last 30 years, with an ROE consistently in the range of 20-30%), one would expect it to trade at high multiples. However, it is currently valued at USD 465 Bi
5 and trades at a multiple of 14x the earnings of the last 12 months – low considering the quality of the company. However, its presence in Taiwan puts the company in a fragile position given the constant threat of Chinese invasion, which could pose a threat to investment in TSMC. Megainvestor Warren Buffett invested in the company, but sold his shares in early 2023. When asked why, Buffett replied that he considers TSMC to be one of the best managed companies in the world, but he does not like the company's location. The second way is to think about second-order impacts, especially how the evolution of this industry's dynamics can impact the global economy. A major point of concern is an eventual war or blockade in Taiwan, which could have near-catastrophic impacts on the global economy. If the shortage of chips seen during the pandemic serves as an example, it is likely that we would not change cars for 1 or 2 years, and the same level of disruption would be seen in several other industries such as cell phones, computers and home appliances. In addition to seeking new investment opportunities in this industry, we are also attentive to the impacts that changes in the semiconductor chain may have on the companies we have in our portfolio. Given the importance of the issue for the global economy, we will continue to monitor it closely in the coming years.
On the 06/06th we will do a live via Youtube commenting on this month's letter. sign up clicking here. ¹ Apple A16 transistor count, iPhone 14 Pro microprocessor ² Data from 2020 show that TSMC has a market share of 90% in chips with nodes smaller than 10 nm ³ Intel is the only company that still designs and manufactures its own chips. Given its dual focus, it ended up losing the race to pure manufacturers (especially TSMC), and was able to launch the most technologically advanced products only several years after competitors.
4 extreme ultraviolet lithography
5 Considering the closing prices of 06/02/2023
