💵 Betting On The Value Chain

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Sometimes things seem obvious. You bet money on these things. It turns out they weren't so obvious.You lose money. The pure joy of markets...

Entire encyclopaedias have been written on the topic of 'how to lose money in markets'. It's all filed in the economic history section...

The message still doesn't sink in. People still make the same market mistakes that every prior generation made.

Confusing contradictions are permanently embedded in financial markets. Is this what trips us up? The fact that we're so determined to solve the puzzle or beat the market... Do we miss the wood for the trees?

Take thinking for example. Everyone thinks. But there are huge differences between first order and second order thinking.

We're told that first order thinkers are dumb. A trap to avoid. Howard Marks often features on these pages as one of the clearest minds in the biz. He says 👇

Second level thinking is the domain of the superior-minded. Or so we're told.

In this beautiful world of financial markets though, first-order thinking is often all that's required. When everyone's a genius in a bull market, second order thinkers can easily get left behind, refusing to participate in the insanity...

The oil price plunge to negative pricing was the perfect example. Anyone could see that wasn't sustainable. People still need oil, therefore the price will go up.

Add in a tiny bit of technical knowledge to satisfy the ego. It's as simple as:

Oil is below the cost of production, therefore the price will go up. Or... Germany will no longer buy gas from Russia, therefore the price of gas will increase.

All pretty simple. First order thinking is sufficient. Second order thinking isn't required.

Over time, the first-order thinkers will usually get caught out though. As Marks says, it's hard to outperform when 'just about everyone can do it'.

Answer this question 👇

There's a Semiconductor boom: Which stock do you buy?

Quick! Choose one!

If you said anything other than ASML, you're wrong.

OK. Maybe not wrong, just thinking in the first order. Here's a spaghetti chart of ASML, TSMC, Apple & Intel to illustrate the point.

At first glance, those relationships might not be obvious. It's all a matter of perspective. Let's start with why ASML is the 'correct' answer.

Because they're highest in the value chain. If there's going to be a semiconductor boom, why buy Intel? What's special about them?

Which balance sheet benefits most?

ASML does something unique, and they'll be doing more of it as companies and countries push to diversify their production locations... 👇

One of ASML's main customers is TSMC, the leading global chip manufacturer. Back in April 2021, the firm announced plans for a huge capacity expansion.

Who receives a chunk of that cash? ASML.

Why is TSMC expanding capacity? US-China trade tensions, supply chain concentration risks that were laid bare in the pandemic, and the tail risk that China could invade Taiwan.

None of those reasons are likely to improve TSMC's profitability, but they're definitely good for ASML's bottom line.

That doesn't mean it's a disaster for the chipmaker. When it comes to smartphones, TSMC is dominant too 👇  

Taking it a step further. Who's a major TSMC customer?

Apple.

Who's pushing TSMC to make more advanced chips in the US?

Also Apple...

We've built a simple chain here.

ASML builds the machinery that allows TSMC to make the cutting edge chips for iPhones that Apple can market as superior/leading tech.

Which company do you bet on?

Most value chains focus on a single company. Something like this 👇

Which is fine. It's good to understand the business. For investors & traders, the key question is one of value add along the chains. Who are you backing to outperform, add undeniable value, and ultimately grow their bottom line?

• The silicon wafer manufacturer

• ASML whose machines adds lithography to the wafers...

• TSMC who combines both to make advanced chips which are then supplied to...

• Apple, who then use them in iPhones which we all buy because of...

• Marketing...

You can keep going until you tie yourself in knots. Which is where the second-order thinkers often come unstuck.

Too much thinking can leave you drowning in complexity, turn you into this guy 👇

The joys of financial markets and their contradictions. There's always a balance to be found. The interplay between these dependencies, constraints and sector dominance (competitive advantages & pricing power) is an excellent place to focus without getting too complex...

Call it one and a half order thinking.