When Adam Smith met Warren Buffett

This is a story about another time on Wall Street.

Given that we know history rhymes, it’s a story worth recounting here. What people really mean when they say that history rhymes, is that human nature never changes.

The time I’m talking about is 1960s Wall Street. This was the original tech boom — as in the birth of computers. Data became a buzzword. Ross Perot, a boy from Texas, floated his Electronic Data Systems (EDS) at $16.50 a share in 1968. This was at a whopping 118 times earnings. But it was boom times, and, after all, a growth company. It ‘grew’ to $160 a share by early 1970.

The main Wall Street indices (Dow, S&P500) peaked in late 1968. In the prior two years, the S&P500 had surged nearly 50%. But many ‘tech’ stocks, like EDS, continued to rally throughout 1969.

This was the ‘Go-Go era’. ‘Nifty-Fifty’ stocks were all the rage. These were large growth companies like Polaroid and Xerox. They were safe. No price was too high to own them.

As I said, the main indices peaked in 1968. From there, the S&P500 sank 35% into a May 1970 low. The bulls were badly beaten. There were casualties everywhere.

But the market began to rally again. By March 1972 the S&P500 made new all-time highs, up 70% from the lows. The Nifty-Fifty weren’t dead yet.

After a standard seasonal swoon into October 1972, the market then surged more than 12% into a January 1973 high. That was THE high for a long time. It took more than seven years for the S&P500 to get back to that level.

1973 and 1974 were very bad years for the market. The main indices saw their prices cut in half. It was the final denouement of the go-go era. The world experienced an energy crisis, and structurally high inflation for years to come.

But in late 1972 ‘investors’ clearly didn’t see this coming.

This situation rhymes with today’s environment. The S&P500 suffered a 27% drawdown in 2022, after more than doubling from the COVID lows. The bulls were beaten. But not for long. Stocks recovered strongly in 2023. After a seasonal swoon into an October low, the S&P500 is now up over 25%.

No one sees any problems on the horizon. But that is a problem right there. When no one is worried, it’s time to worry.

The Money Game

One of the best books ever written on the markets came from the go-go era. Published in 1968, The Money Game, by Adam Smith, delves deeply into the effect that investor emotions have on the market…and the effect that the market has on investor emotions.

A few quotes stand out:

No matter what role the investor has started with, in a climax on one side or the other the role melts into the crowd role of greed or fear. The only real protection against the vagaries of identify-playing, and against the final role of being part of the crowd when it stampedes, is to have an identity so firm that it is not influenced by all the brouhaha in the marketplace.

…the end object of investment is serenity, and serenity can only be achieved by the avoidance of anxiety, and to avoid anxiety you have to know who you are and what you’re doing.

Related to this:

If you don’t know who you are, this is an expensive place to find out.

'This', of course, was Wall Street. The Money Game was a huge hit. An investment legend from an earlier era, Ben Graham (the ‘Dean of value investing’, as Smith called him) enjoyed it so much that he wrote to the author to thank him for it.

It kicked off a correspondence between the two. Graham had retired to the south of France. But when he came to the States to visit family, he and Smith met for breakfast at the Plaza Hotel in NYC. This must have been around 1969.

Smith recounts the story in his second book, SUPERMONEY, published in 1972:

We talked about events since the last edition of Security Analysis. Benj. Graham had an idea he wanted to talk to me about: a new edition of The Intelligent Investor was forthcoming, that book being more or less a distillation of the textbook, Security Analysis, only for the layman. Graham wanted me to work on it.

“There are only really two people I would want to work on this,” Graham said. You’re one, and the other is Warren Buffett”

“Who’s Warren Buffett?” I asked.

This was around 1969, remember. NO one knew who Warren Buffett was at the time. He’d been managing a private partnership with funds from friends and relatives. He started with $105,000 in 1956 and closed it down in 1969 with $105,000,000. That’s a compounded return of 31%.

And, he’d done it from Omaha, Nebraska.

Before you get mild depression about your own long-term performance, consider that the market threw up some pretty good opportunities back then if you knew what you were doing.

Smith quotes Buffett as saying:

“There was Western Insurance, earning sixteen dollars a share, and selling at sixteen dollars a share. There was National Insurance selling at one times earnings. How could it miss?”

But by the late 1960s, Buffett was getting nervous. He wrote to his partners, as quoted in SUPERMONEY.

I am out of step with present conditions. When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, and so on…on one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean forgoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.

He wasn’t forecasting a bear market. He was merely pointing out that there were no cheap companies around.

Adam Smith passed on Graham’s request to help him write a new edition of The Intelligent Investor. But Graham’s mention of Buffett was fortuitous. Smith and Buffett became friends. They corresponded. Smith went to Omaha to meet Buffett and hang out.

Smith documented these meetings in a chapter of SUPERMONEY. This was the wider investment world’s first introduction to Buffett. Remember, the book was published in 1972.

Smith went on to host a TV show in the 1980s called Adam Smith’s Money World. He got his old mate Buffett on a few times. Check out this profile and interview with Buffett.

Buffett did end up doing some work on the 1973 edition of The Intelligent Investor. He wrote the preface to that edition. Some of the words are particularly useful to remember in the current environment, one that sees The Commonwealth Bank [ASX:CBA] trade on 20 times earnings, ARB Corp [ASX:ARB] 30 times, or Car Group [ASX:CAR] at 40 times.

All great businesses, for sure. But not great prices.

Buffett wrote:

To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions, and the ability to keep emotions from corroding that framework. This book precisely and clearly prescribes the proper framework. You must supply the emotional discipline.

The investing part is easy. Managing your emotions is the hard part. This is why history rhymes. Human behaviour — always under the influence of fear and greed in the market — never changes.

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