Taiwan back into gear, can ASML follow suit this quarter?

Key Points

• The semiconductor industry is showing signs of a recovery in its price action and fundamentals.
• Taiwan Semiconductor stock just surprised the markets with its earnings, raising hopes for a follow-through in others.
• ASML could be next in line for an explosive announcement; some analysts saw this coming.

Most investors and most markets had given up on the semiconductor and chip stocks; some of their reasons may have been justified during the COVID-19 pandemic months, considering that raw material shortages and skyrocketing shipping costs decimated margins in the space. Today, that seems to be behind the industry.

Who better to confirm this trend than the VanEck Semiconductor ETF NASDAQ: SMH, particularly in its relative performance against the broader S&P 500 index? This is a massive outperformance of 37.2% as measured by the past twelve months of price action.

Now that earnings season has kicked off, some of the biggest players in this industry are beginning to show the true dynamics affecting the future fundamentals. There is a great deal of evidence for you to pour over and line up your potential investments. ASML NASDAQ: ASML could be following in the rally queue for reasons that will become clear soon.

Are chip stocks poised for a turnaround?

By looking at the trends on a business level, things aren't so pretty today. If you pour over the past quarter or two in the ISM manufacturing PMI index reports, you'll notice that most industries are heading in one common direction: down.

However, the FED could sponsor a new rally in this pocket of the economy, particularly now that it has pivoted its previous interest rate hike campaign, kicking a new path to cutting rates into gear. Analysts at The Goldman Sachs Group NYSE: GS took notice, and here's what they think:

Within their 2024 macro outlook report, the investment bank research points to an expected breakout in the manufacturing sector, which could be sparked by cutting interest rates. You see, lower rates will result in a weakening dollar (since rates drive the value of currency), and a weaker dollar makes American exports all the more attractive.

But, to export these goods, there needs to be goods to export in the first place. A breakout in manufacturing activity, unless running on machinery from the Industrial Revolution, requires chips, lots of chips. Today's factories and assembly lines have been taken over by technology, which is where stocks like ASML come in.

Hopefully, the story starts to make sense at this point, but there needs to be something more concrete than a good old 'connecting of the dots.' Taiwan Semiconductor Manufacturing NYSE: TSM just reported its earnings last week, and that stock is up by as much as 16.0% since the announcement; you can probably guess the results were fantastic.

Quarter-on-quarter, that company saw a 14.4% rise in revenue and a 13.1% advance in net income. The reason? Free cash flow (operating cash flow minus capital expenditures) rose to $224 billion (Taiwan currency) from only $68 billion in the prior quarter, erasing the market's concerns regarding inventory and demand.

The question is: will this be a trend specific to Taiwan alone? Or will companies like ASML join in the party?

Evidence points to this

Reading the market's language can help you translate the gauge behind the sentiment toward ASML stock relative to the rest of the peer group. This time, you will need to keep the forward price-to-earnings ratio, which is how the market places a value today on tomorrow's earnings.

ASML will quickly become the outlier when pinned against other names like Micron Technology NASDAQ: MU and Advanced Micro Devices NASDAQ: AMD. However, the average valuation multiple for the sector, which stands at 21.8x, is the benchmark for you to work around.

What you are looking for here is outliers on the upside, where most value investors would turn back at the fact that they need to look at the more 'expensive' names in the group; you will gain an edge by remembering the saying "It must be expensive for a reason."

Using this metric, ASML's 32.0x forward P/E multiple will place the stock at a 46.8% premium to the rest of the group's average; bingo! Micron and Advanced Micro Devices reflect respective 19.3x and 12.6x multiples, which show subsequent discounts of 11.2% and 42.3% to the group. The flipside of "It must be cheap for a reason" also applies here.

Here's what you may want to hear next: J.P. Morgan Chase & Co. NYSE: JPM analysts have raised the price target on this stock to $878.0 a share, implying a 14.5% upside from where the stock trades today.

With earnings coming out on Wednesday this week, the sentiment could suggest that this stock is ready to surprise some traders and rally.