In a few years, you’ll wish you had bought this undervalued stock

Semiconductor stocks are a popular sector for investors, but it’s not always easy to pick winners among chipmakers. These stocks are prone to volatility, and rapid technological developments can shake up market share quite quickly. However, there are attractive stocks in the semiconductor supply chain, with strong long-term catalysts and reasonable valuations that should translate into long-term returns for investors.

Lam Research leads an important market niche

Lam Research (LRCX 2.10%) offers exposure to the microchip industry, but the investment thesis is markedly different from that of typical semiconductor stocks. Lam is a supplier to chip manufacturers and therefore plays a key role in the supply chain.

The company supplies essential equipment and machinery for wafer production and is among the world leaders in this market. Its broad product portfolio includes a wide range of specialty devices that enable chipmakers to produce the small, complex components required for any cutting-edge technology.

Image source: Getty Images.

Lam Research is among the global leaders in the wafer fabrication equipment market. The company has several competitors for different products in its portfolio including Applied materialsHitachi and Tokyo Electron. Lam is widely regarded as the leader of his market. The company’s customer list includes some of the largest chipmakers in the world, and the company claims that its machines currently play a role in the production of almost every semiconductor.

Lam Research’s scale and sophistication create a meaningful economic moat. The research and development budget is approximately $2 billion per year, making it difficult for potential newcomers to close the technology gap needed to create a competitive product.

The company has also built relationships with the most important handful of large enterprise customers around the world. That’s a tough sales channel for smaller companies to crack, and these long-term relationships foster partnerships and communications that will guide the design and implementation of future generations of equipment. As the chip design becomes more complex to support more advanced features, this should increase the strength of Lam’s moat.

Reliable growth and shareholder returns

Lam Research won’t excite growth investors. As a diversified supplier of capital goods, it doesn’t have as much pure upside potential as… Nvidia, Broadcomor other semiconductor stocks that have enjoyed tremendous momentum in recent quarters.

The popular chip makers sell to a wider range of customers and can experience rapid growth as new computer equipment is produced around the world in a relatively short period of time. The replacement cycle for manufacturing equipment is not as dynamic.

It may not be an exotic engine for explosive growth, but Lam Research can still provide investors with reliable exposure to a growth sector at a reasonable valuation. The semiconductor industry has clear long-term demand drivers, which is good news for established leaders across the supply chain.

The company’s operating results have supported this approach in recent years. Lam Research achieved a compound annual growth rate (CAGR) of 12% over the past ten years. Profits and cash flows have grown even faster over the same period.

LRCX Earnings Data (TTM) according to YCharts

Progress is not always linear. Lam Research has faced difficult macroeconomic conditions and its financial results reflect the well-being of its customers. The company’s revenue fell 15% last fiscal year as the semiconductor industry emerged from a recent cyclical downturn.

Fortunately, the long-term trends are impressive and the industry appears to be entering a new boom phase, powered by AI. Lam’s customers will likely have plenty of cash on hand, and some of that will go toward upgrading their manufacturing equipment to support more complicated chip designs. Wall Street expects the company’s revenue to grow nearly 20% over the next year, while earnings per share will rise nearly 30% as conditions improve.

Lam’s attractive valuation

Lam Research has a clear long-term investment thesis and comes with a discounted valuation. The stock’s price chart shows a remarkable correlation with the iShares Semiconductor ETF And Taiwanese semiconductor manufacturing. If history is any indication, Lam’s performance should mirror the performance of the semiconductor industry at large.

LRCX Total Return Level data per YCharts.

That story is even stronger considering the stock’s valuation. Lam’s price-to-earnings (P/E) ratio has fallen to 22 after rising to an abnormally high level of above 35 earlier this year. Economic uncertainty has played a role, and the market also seems a bit distracted by the company’s faster-growing, higher-priced competitor. ASML. That stock shares many of Lam’s attractive qualities, but investors should accept a premium valuation; the forward price-earnings ratio is 29.

Lam’s aggressive share buybacks at the current price imply that the board of directors views the company as undervalued. There is compelling evidence that Lam has the potential to deliver strong financial performance in the coming years, and its valuation does not make it particularly risky. If the company’s next decade comes anywhere close to matching the past decade’s performance, long-term shareholders are likely to see big returns.