Bottom's up? Falling earnings estimates hurt Intel last year but profit forecasts have been on the rise lately. Month  2005 EPS Est.  June '04  $1.45  July '04  $1.38  Aug. '04  $1.37  Sept. '04  $1.18  Oct. '04  $1.12  Nov. '04  $1.11  Dec. '04  $1.18  Jan. '05  $1.24   Source:  Thomson/First Call

NEW YORK (CNN/Money) - Forgive investors in semiconductor stocks if they had, well, a bit of a chip on their shoulder heading into this year.

Chip sales hit a record in 2004, but revenues began to slow in the latter half of the year and Wall Street worried that the cycle had peaked.

As a result, the Philadelphia Semiconductor Index, or SOX, which includes 20 chip and semiconductor equipment stocks, plunged nearly 15 percent last year.

But since Intel's better-than-expected earnings report in early January, the SOX has surged 10 percent while the Nasdaq has been flat.

Why the excitement?

Inventory levels at many chip companies, including bellwether Intel (Research), declined in the fourth quarter. That's a good sign since one of the bigger issues holding back semiconductor stocks last year was a fear that chip companies had built up their inventories too aggressively and would be faced with a glut. And that could hurt profits.

That is no longer a major concern.

"Inventories were getting burned down heavily in January and February and that should continue into March," said Eric Ross, an analyst with ThinkEquity Partners. "Chip shipments should be reflecting true demand in the second quarter."

And demand for devices that use semiconductors is actually looking quite healthy. Sales of notebook computers are booming and so are sales of consumer electronics devices like digital televisions, MP3 players and cell phones.

"The adoption of semiconductors appears to be broadening. This should be a good, strong year," said Richard Whittington, an analyst with Caris & Co.

In addition, chip-equipment industry leader Applied Materials (Research) raised hopes earlier this week that the sector has bottomed out by issuing sales and earnings guidance for its second quarter that was ahead of Wall Street forecasts.

Chip-equipment companies sell gear to major semiconductor manufacturers. So if they are doing well, that is typically viewed as a sign that their customers are too.

But how much of this is already baked into semiconductor stocks?

Adam Parker, an analyst with Bernstein, thinks investors need to be cautious.

"Our belief is that evidence of improving demand or inventory reduction will be positive, but that some of this is already discounted into the stocks given the recent rally," wrote Parker in a report earlier this week. Nonetheless, Parker likes Intel, Microchip Technology (Research) and Linear Technology (Research) at these levels.

Still, even as chip stocks continue to rise, this is probably the right time to be buying them, said Ross. The main reason, he argues, is that semiconductor earnings estimates for this year have finally started to trend up again after declining steadily throughout 2004. Estimates for 2006 are heading higher as well.

Ross said the next quarter could be choppy and that the second half of this year should be relatively robust. But if you wait until the companies actually report stronger results, you might be too late.

"The worst of the news is behind us and if people think the sector will bounce back, investors will buy stocks ahead of that," Ross said. He thinks investors should be looking at stocks that have the most exposure to the hottest devices.

Ross likes Intel, which should benefit not just from increased sales of wireless laptops but also from burgeoning corporate demand for servers. He also likes MIPS Technologies (Research), which makes processors for digital televisions, as well as SanDisk (Research), which makes flash memory storage cards used in MP3 players and digital cameras.

Whittington also sees a bright future ahead for chip stocks, despite the recent surge. He thinks chip stocks could climb another 15 percent to 20 percent this year. As such, he said the SOX, currently trading at about 430, should wind up back at about 500 by no later than this fall. The SOX hasn't traded above 500 since last April.

Like Ross, Whittington said investors should be looking at companies that can capitalize on the expected health of the notebook and digital television markets. He also likes Intel and adds that Broadcom (Research), Analog Devices (Research) and International Rectifier (Research) should profit from strong sales of laptops.

On the TV side, Whittington said his favorite is ATI Technologies (Research), which makes graphics chips that are also used in video game consoles.

Analysts quoted in this story do not personally own shares of the companies mentioned and their firms have no investment banking relationships with the companies.

Sign up to receive the Tech Investor column by e-mail.

Plus, see more tech commentary and get the latest tech news.