2 Semiconductor Stocks That Could Outperform the S&P 500 Over the Next 5 Years

If you want to beat the market's average return, you need to find companies with superior growth prospects than the average company. The S&P 500 has delivered median annualized earnings growth of 11% since 1989. One industry that is seeing accelerating demand and is positioned for above-average earnings growth is semiconductors.

Let's look at two chip stocks that could crush the market's return over the next five years.

1. Arm Holdings

Arm Holdings (ARM -1.99%) is a highly profitable business that licenses its chip designs to other semiconductor companies. Nvidia, Apple, and Amazon are some of its more prominent customers. The stock price is up 104% year to date, outperforming the S&P 500's 15% return.

Companies that can deliver strong revenue growth and consistently convert that into growing profits, or free cash flow, usually earn premium valuations over time, and Arm certainly checks those boxes. Over the last year, the business generated $907 million in free cash flow on $3.2 billion of revenue, which is a healthy margin of 28%.

Arm processors are used in almost every smartphone worldwide, but it's seeing booming demand in the data center space. Revenue grew a robust 47% year over year in the most recent quarter. Arm-based chips are highly valued for their cost efficiency and energy savings, which will become important factors for companies to consider as they ramp up investment in data center infrastructure.

With more data centers being optimized for artificial intelligence (AI) workloads, AI training will require huge increases in power consumption. Goldman Sachs estimates data centers will use 8% of all U.S. power by 2030, up from 3% in 2022. This could drive substantial growth for Arm's business.

Alphabet's Google recently announced its new Arm-based central processing unit (CPU) for data centers. Google credited Arm's industry-leading performance and energy efficiency for its implementation in Google Cloud.

New markets like data center and automotive solutions could blossom over the next decade and benefit Arm stock. The Wall Street consensus projects Arm's earnings per share to grow 31% on an annualized basis, which would be more than enough to outperform the S&P 500.

2. Broadcom

Broadcom (AVGO 1.19%) shares spiked following its latest earnings report. Investors are sensing a massive opportunity for this leading supplier of networking and software solutions for data centers. Revenue grew 43% year over year in the most recent quarter, which is a sharp acceleration over its previous single-digit rates of growth. This above-average growth pushed the stock up 43% this year, nearly tripling the return of the S&P 500.

Broadcom provides the nuts and bolts of data centers, such as Ethernet switches and high-performance interconnects. These components are in high demand as part of the broader buildout of AI infrastructure. Broadcom said its networking revenue grew 44% year over year in the quarter.

Broadcom also offers software solutions, which adds to the breadth of its product offering and competitive advantage. The addition of VMware's software revenue following the acquisition last year could benefit the company's growth prospects. The company said the addition of VMware was largely responsible for boosting its software infrastructure revenue by 175% year over year last quarter.

Broadcom has been around for many years supplying smartphones, electronic displays, and servers. It particularly targets new markets that are profitable and can increase margins over time, which means the opportunity unfolding from AI could significantly pad its profits and send the stock soaring.

Revenue from AI surged 280% year over year last quarter, and management now expects this revenue to comprise one-fifth of its total business, but it will probably grow much larger in the coming years.

Analysts expect Broadcom's earnings to grow at an annualized rate of nearly 17% over the long term. Investors can expect the stock to perform roughly in line with its future earnings growth. Assuming it performs in line with those estimates, the stock should outperform the S&P 500.