Computer chips may be tiny, but the global stakes for this industry aren’t. The Semiconductor Index (SOX) has fallen nearly 10% since the US announced new restrictions largely aimed at slowing the development of China’s military capabilities. Some downbeat news from two major chipmakers helped to further propel the selloff, underscoring the fact that this high-growth industry is constantly on a knife’s edge. If you’re thinking of investing in this space, it’s important to understand everything that’s at play here. Let’s take a look…

Why are computer chips such a big deal?

It’s almost impossible to talk about the computer chip industry without mentioning Taiwan. Taiwan Semiconductor Manufacturing Company (TSM US) – better known as TSMC – is a giant in this industry as well as Taiwan’s largest company, with a market cap of $327 billion and a weighting of 26% in the key Taiwanese stock index. It makes super-advanced semiconductors that are crucial to its global customers, which include the US military, Apple, Tesla, Nvidia, and Volkswagen. TSMC fell 8% Tuesday as fears grow about how the new US restrictions will impact its business.

The thing is: ever since Russia invaded Ukraine, there’s been increased worry about the risk that China might use military force against Taiwan, which it claims as its own territory, potentially disrupting the global supply of those leading-edge chips. The US National Security Council has estimated that if TSMC went offline, it could cost the world economy more than $1 trillion – not small potatoes. Right now, all of TSMC’s manufacturing is based in Taiwan, but that’s changing. A new $12 billion chip factory is now being built in Arizona, and a deal has been reached to build another new factory in Japan, with sizable subsidies from governments in those countries. There are also ongoing discussions about building additional factories in Singapore and Europe. The facilities will take a few years to complete, so in the meantime, there are risks.

Why would China want to disrupt the industry?

It’s not so much that China would want to disrupt the industry as it is a geopolitical dispute about Taiwan’s presumed autonomy – and the fact that the US wants to maintain its advantage over China’s military capabilities. That said, computer chips are a sticking point for the Chinese government. China’s Huawei was hit hard by US sanctions over the past few years, leading the technology giant to lose its leadership position in network equipment and smartphones. At the time, Huawei’s founder said the sanctions were threatening the company’s very existence. The announcement last week that the Biden administration would impose new restrictions on the way semiconductor chip companies are allowed to do business with China dealt another blow – and prompted a stern rebuke from the Chinese government. For sure, Chinese semiconductor and related companies are set to suffer the most, but companies like Nvidia (NVDA), Applied Materials (AMAT), Lam Research (LCRX), and many global semiconductor companies will also see a hit to their revenues and profits. The exact impact remains unclear as it will depend on exactly how these US restrictions are enforced. There’s also the potential that China will retaliate, which often happens when these two countries get into a dispute.

What’s the solution?

Well, it’s tricky. Even for Elon Musk, though that didn’t stop the Tesla founder and CEO from sharing his views about the recent escalation in the Financial Times late last week. “My recommendation,” he said, “…would be to figure out a special administrative zone for Taiwan that is reasonably palatable”, adding that it “probably won’t make everyone happy”. China heaped praise on the proposal and the idea of a “one country, two systems” framework similar to the one drafted for Hong Kong. But Taiwan’s reaction was not so positive, with its president saying there is no room for compromise on sovereignty and democracy. It probably seemed like it was worth a shot for Musk: Tesla’s production and sales depend significantly on China.

What’s happening with the rest of the world’s chipmakers?

Last week, PC-processor maker Advanced Micro Devices (AMD), and memory-chip leader and smartphone leader Samsung Electronics (005930) reported disappointing quarterly sales and said consumer demand had fallen off for things like smartphones, TVs, and PCs. That news came just after memory-chip companies Micron Technologies (MU) and Kioxia Holdings (not publicly traded) announced spending and output cuts in response to declining demand. It all points in the same direction: consumers are buying less tech.

What’s the opportunity then?

The semiconductor index (SOX) has fallen 42% this year, with its stocks crushed by the impact of higher interest rates, supply-chain snarls, and declining demand. In the short-term, more earnings downgrades could well drive their share prices lower still. And that’s where the opportunities might be.

See, many semiconductor-related firms are high-quality companies, with high market share in their respective areas, enjoying high barriers to entry that keep competition at bay, and providing investors with high financial returns like return on invested capital (ROIC). Starting to buy these high-quality companies on weakness could end up being a profitable long-term strategy. The iShares Semiconductor ETF (ticker: SOXX; expense ratio: 0.43%) tracks the SOX index and includes the top semiconductor companies. Separately, the industry’s leaders like Texas Instruments (TXN), Broadcom (AVGO), Nvidia, and Qualcomm (QCOM) could be worthwhile investments. You could also consider buying shares in TSMC (TSM): it is, after all, the leading global semiconductor company.