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Stock Strategist

Six Books for Summer

Increasing returns, economic moats, investing formulas, and more.

If you're looking for good books related to investing, you're in luck. There have been a number of good ones published over the past year or so. Now, I'm interpreting "related to investing" pretty broadly, encompassing books on economics and psychology as well as books you'd find in the business/investing section of the bookstore. But in one way or another, all touch on themes familiar to readers of Morningstar research. Below, I picked six books published in 2005 or 2006 that I found worth the time invested in them.

Knowledge and the Wealth of Nations, by David Warsh
The first two books on my list focus on a topic dear to our hearts here at Morningstar--returns on capital and competitive advantage.

The theme of David Warsh's book is how the topic of increasing--as opposed to diminishing--returns managed to escape the notice of most economists for 200 years. It had actually been there in Adam Smith, who wrote eloquently in The Wealth of Nations about a pin factory where the division of labor enabled production to expand dramatically and per-unit cost to drop--otherwise known as economies of scale. But soon after Smith, economists focused almost exclusively on diminishing returns: Through either competition or lack of new opportunities, returns regress to a mediocre level. But while diminishing returns are a sad fact of life--and pity on those investors who think otherwise--they aren't the whole story.

The first half of Warsh's book takes us from Smith to the 20th century and succeeds in making the history of economic thought much more interesting than the original works ever were. The second half focuses on a seminal 1990 paper by Paul Romer, in which the concept of increasing returns finally made its way back into the economics mainstream. As a painless way to learn a great deal about economics, I'd highly recommend the book.

Competition Demystified, by Bruce Greenwald and Judd Kahn
Whereas Warsh's book focuses on the theory, Competition Demystified focuses on the practice: how companies actually generate increasing returns, or at least keep their returns from diminishing. Greenwald wrote a wonderful book a few years back on valuing companies (Value Investing: From Graham to Buffett and Beyond). With Competition Demystified he summarizes his thoughts on competitive advantage, which grew out of his lectures to MBA students at Columbia.

In this book you'll find one of my favorite aphorisms, which I first heard Greenwald utter several years ago at an investing conference (at which he debated Legg Mason's Bill Miller on the merits of investing in Amazon): "In the long run, everything is a toaster�."

His point is that building a better product won't win you a competitive advantage; others can copy you. Investing in your brand won't, either; your competitors can invest in their brands as much as you invest in yours. No, the only way to form a competitive advantage is to erect a barrier to entry--something to keep a rival firm from knocking your returns on capital back down to normal levels. And as he points out, even when companies establish competitive advantages, such as scale economies in a regional market, those advantages often dissipate as a company expands. Wal-Mart (WMT) may still be a great company today, but its returns on capital are a fraction of what they were in the mid-1980s.

Fortune's Formula, by William Poundstone
The formula of the book's title is the so-called Kelly criterion, which was worked out in the 1950s by a physicist at Bell Labs named John Kelly. In contrast to modern portfolio theory, which preaches diversification and the efficiency of the market, the Kelly formula has appealed to active investors--including poker player turned hedge-fund manager Ed Thorpe and Bill Miller--who want to exploit an edge they think they have over the rest of the market. In a nutshell, the formula guides active investors as to how much to bet on a particular investment in order to maximize long-term, compounded returns.

Poundstone details the history behind the formula, as well as its cool reception by mainstream economists like MIT's Paul Samuelson. This is a fascinating story, and along with Greenwald's book, probably the one on my list with the most direct applicability to running a portfolio.

Vienna and Chicago: Friends or Foes? By Mark Skousen
If you've ever been puzzled about why some economists favor a gold standard and some don't, why they can't agree on what causes recessions, or what the role of government should be, this book is a fun way to learn some economics. The title of the book refers to two schools of thought in economics: the Austrian School, of which Friedrich Hayek is the most famous representative, and the Chicago School based around the University of Chicago, of which Milton Friedman and George Stigler are the most well-known members (and from which today's Steven Levitt--of Freakonomics fame--is a descendant).

The two schools agree on many things, but disagree on some of the key questions of economics. Take the Great Depression. The Chicago School, following Friedman, sees the depression as the result of misguided moves by the Federal Reserve in the early 1930s--moves that turned a recession into a decade-long depression. The Austrian School, by contrast, emphasizes loose monetary policy in the 1920s and a subsequent overinvestment by businesses as the key factor. Skousen walks through such debates and gives his own opinion on which side makes the better case.

Stumbling on Happiness, by Daniel Gilbert
Students of investing are of necessity students of human psychology, both their own and that of other market participants. Gilbert, a professor of psychology at Harvard, summarizes much recent research in psychology, tying it all together with the theme of happiness. If you like reading about behavioral finance, I think you'll enjoy this book.

Gilbert's starting point is that evolution has left human beings with a rather unique attribute: the ability to think about the future. Unfortunately, we're often not very good at it; the way our brains work is not always conducive to a rational assessment of what will make us happy. For example, just as our memories are notoriously bad--and bad in systematic ways--so is the way we tend to imagine the future. We oversimplify, or we assume the future will be like our (misimagined) past. Such errors mean the future often doesn't live up to our expectations. Confirming once again Charlie Munger's advice on the best way to lead a happy life: low expectations.

Fischer Black and the Revolutionary Idea of Finance, by Perry Mehrling
My last recommendation will appeal to anyone interested in the development of modern finance theory and the investment products it has spawned.

Perry Mehrling is a professor at Columbia specializing in financial history. His biography of Fischer Black, who among other things helped develop the Black-Scholes option-pricing formula, is fascinating on many levels. First of all, there is Black's obsession with the concept of equilibrium (and in particular, the capital asset pricing model), which led him to do original work in one topic after another; there's the intellectual story of Black's shift from physics to finance; there's the Black-Scholes formula and how it came to be; and Mehrling sets it all against the backdrop of the intellectual battles of economics and finance in the latter half of the 20th century. Great stuff.

Other Reading Ideas
I would be remiss if I didn't mention Morningstar's own series of books on stocks and funds that appeared in 2005. Aimed at people wanting to get a firm grounding in investments, the books start with the basics and work steadily up though more advanced topics. And for more non-Morningstar books focused on investing, check out "The Ultimate Investment Reading List" or "Last-Minute Gift Ideas for Investing Bookworms."