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

Semiconductor stocks are a popular industry for investors, but picking winners among chipmakers isn’t always easy. These stocks are prone to volatility, and rapid technological developments can change market share quite quickly. However, there are compelling stocks in the semiconductor supply chain with strong long-term catalysts and reasonable valuations that should translate into long-term investor returns.

Lam Research leads an important market niche

Lam Research (LRCX 2.10%) provides exposure to the microchip industry, but the investment thesis is distinctly different from that of typical semiconductor stocks. Lam is a supplier to chipmakers, so it plays a key role in the supply chain.

The company supplies equipment and machinery vital to wafer manufacturing and is among the world leaders in this market. Its broad product portfolio includes a wide variety of specialized devices that enable chipmakers to produce the small, complex components that are required for every advanced technology.

Image source: Getty Images.

Lam Research is among the world leaders in the wafer manufacturing equipment market. The company has several competitors for various products in its portfolio, including Applied materialsHitachi and Tokyo Electron. Lam is considered the leader in its market. The company’s client list includes some of the biggest chipmakers on the planet, and it claims its machines play a role in the production of nearly every semiconductor right now.

Lam Research’s scale and sophistication creates a significant economic moat. Its research and development budget is about $2 billion annually, making it difficult for potential new entrants to close the technology gap needed to create a competitive product.

The company has also established relationships with the most important handful of major customers worldwide. This is a difficult sales channel for smaller businesses to crack, and these long-term relationships foster partnerships and communication that will guide the design and implementation of future generations of equipment. As the chip design becomes more complicated to support more advanced functions, it should increase the strength of Lam’s trench.

Increased confidence and return for shareholders

Lam Research won’t excite growth investors. As a diversified provider of capital equipment, it does not have as much pure growth potential as Nvidia, Broadcomor other semiconductor stocks that have enjoyed booming momentum in recent quarters.

Popular chipmakers sell to a wider range of customers and can experience rapid growth as new computing equipment is produced around the world in a relatively short time frame. The replacement cycle of manufacturing equipment is not that dynamic.

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

The company’s operating results have supported this approach in recent years. Lam Research provided a 12% compound annual growth rate (CAGR) for sales over the past decade. Its earnings and cash flows expanded at an even faster rate over the same period.

LRCX Revenue (TTM) data by YCharts

Progress is not always linear. Lam Research has faced challenging macroeconomic conditions and its financial results reflect the well-being of its clients. The company’s sales fell 15% in its most recent fiscal year as the semiconductor emerged from a recent cyclical downturn.

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

Lam’s attractive assessment

Lam Research has a simple long-term investment thesis and comes with a discounted valuation. The stock price chart shows a remarkable correlation with iShares Semiconductor ETF and Taiwan Semiconductor Manufacturing. If history is any good indication, Lam’s performance should mirror the performance of the semiconductor industry in general.

LRCX Total Return Level data by YCharts.

This narrative is even stronger given the stock’s valuation. Lam’s forward price-to-earnings (P/E) ratio fell to 22 after climbing to an abnormally high level of more than 35 earlier this year. Economic uncertainty has played a role, and the market also seems a bit distracted by the higher-growth, more expensive company. ASML. That stock shares many of Lam’s attractive qualities, but investors should accept a premium valuation — the forward P/E ratio is 29.

Lam’s aggressive share buyback at the current price implies that its board sees it as undervalued. There is compelling evidence that Lam has the potential for strong financial performance over the next few years, and its valuation does not make it particularly risky. If the company’s next decade comes close to replicating its performance over the past 10 years, then long-term shareholders will likely enjoy big returns.