Unsound play & the value of speed

Napkin math vs. thorough in-depth asset valuation

Mikhail Tal

'You must take your opponent into a deep dark forest where 2+2=5, and the path leading out is only wide enough for one.' - Grandmaster Mikhail Tal

My favorite chess player of all time is Grandmaster Mikhail Tal for a multitude of reasons. As an amateur and a fan, chess in its current modern state has limited applicability to investing, but I still thoroughly enjoy it.

Pre-modern chess, where Tal thrived and the theorized optimal move in a given position was not calculated precisely by supercomputers, was much more art than science in the same way public markets investing continues to be. The optimal decision was not clear and not calculated out precisely to depth n=100 (read: all combinations and permutations of the subsequent 100 moves calculated precisely by a supercomputer). Decision-making windows were capped by an analog clock and the limits of the human brain; this mirrors, but not perfectly, the imperfect information public markets investors deal in.

Tal was famous for what modern grandmasters would call “unsound play”. Tal would, based on feel, make a bold move such as a piece sacrifice without precisely calculating out every potential continuation in an effort to corner his opponent into finding the exact perfect sequence that would allow his opponent to escape the trap he laid.

The perfect continuation would have to be unintuitive- the obvious move could not be correct. Tal called this his “deep dark forest” where “the path was only wide enough for one” implying that Tal understood that there most likely existed a subsequent series of moves that could refute his bold decision, but did it anyway under the assumption his opponent would be unable to find it under time pressure and the hindrances of an overthinking mind. Tal’s bold decisions were made on feel: he understood he was not playing a computer and that the human element of the game could be used to his advantage.

Modern computers with perfect hindsight can now show modern grandmasters just how unsound Tal’s sacrifices were (if at all- sometimes the computers agreed with Tal!). Tal’s opponents could have found unintuitive moves to refute his sacrifices (if only they had supercomputers in the 60s!), in the same manner that post-mortems from investment committees can perfectly underwrite the risk of an investment ex post.

Practical applications to modern investing can be seen in (often apocryphal) stories of “napkin math” investments, or deals done without modern Excel models that projected cash flows out to the banker equivalent of n=100. Usually these deals have a time element to them and a price element, where the price is so obviously dislocated that the outcome of the investment must work out in the investor’s favor. A great modern example is Bill Ackman’s GFC-era investment in Wachovia where Ackman details both price and speed being elements in his 4-hour investment process. Ackman understood that Wachovia was in distress but also understood that there must be some merit to owning the securities in question based on his intuition, background knowledge in markets and how the current market were reacting to current news. This “unsound play” might not have been the most in-depth and thorough valuation analysis, but it made money all the same.

Balancing when you can “play unsoundly” and when you must thoroughly know an asset in question (and its value) will forever be a challenge to the generalist. It is very easy to overestimate your own knowledge of an asset and overvalue your own background knowledge when, more often than not, the market knows far more than you.

When handling other peoples’ money, defaulting to a thorough and detailed approach to public markets investment should be the norm. It is my personal default approach. I have tried my hand at playing unsoundly to mixed results. I prefer to understand the ins-and-outs of an asset I’m purchasing, underwrite a downside scenario that’s reasonable, and evaluate the probability of it occurring conservatively. Playing unsoundly can only be done under certain circumstances:

1.) Decades of market experience, knowledge of the ins-and-outs and intricacies of markets, understanding of liquidity and the role of the liquidity provider in distressed situations, understanding who your counterparties are in a given scenario. These opportunities do not present every day, and if you see them in every stock you analyze you’re doing it wrong.

2.) A generalist understanding of the value of the asset in question and the price being paid for it. To paraphrase WEB, one does not want to drive a truck weighing 1,999 lbs. over a bridge where the give is precisely 2,000 lbs. If the truck is a Tonka toy and you can see the other end of the bridge, its fair to say it will make it across nine times in ten. Said more eloquently: it’s gotta be obvious.

3.) The obvious can’t and shouldn’t be obvious to your counterparty. Similar to Tal, we’re counting on our opponents making a mistake in a pressure cooker situation. Your opponent needs to be convinced the piece of paper they’re holding is going to be worth less than what you’ve bid for it. The analogy between Tal’s play on the board and investing in pressure cooker situations is somewhat flawed in this respect: the trap being set must be sprung. Not all of Tal’s sacrifices were accepted, and some were refuted perfectly. Unsound play is unsound for a reason.