Pabrai's Law of Large Numbers

By Joe Ponzio on October 22, 2007  |  6 comments

Thanks all for the well wishes. Everyone is doing great! Now, back to business as usual (with a hint of less sleep).

In 1939, Sir John Templeton borrowed money to buy stock in 104 companies selling under $1, 34 of which were in bankruptcy. In time, four of those stocks ended up worthless, but Templeton turned massive profits on the portfolio as a whole.

Should we be looking at small- and mid-cap stocks? Pabrai thinks so.

The S&P 500 vs. The Big Boy

In this 2002 article, Mohnish Pabrai examines the effect of buying the biggest and brightest Fortune 500 company (the most valuable business by market cap) each year from 1987 to 2002. The result: You would have earned just 3.3% vs. 10% for the S&P 500 during that time.

In his study, Pabrai points out that there seems to be a glass ceiling on revenues—none of the top companies got much beyond $100 billion. And so he asks the question...

Is There A Natural Upper Limit On Revenue Or Profitability Of A Business?

According to Pabrai, the answer is yes. From constant attacks by competitors to management's ability to handle only so much input, the largest companies can only grow so much. According to Clay Christiansen in The Innovator's Dilemma, this is a disruptive innovation phenomenon—and the big companies can't possibly overcome it with speed and great success time and time again.

Pabrai's Law

From where does the best growth come? Pabrai says you should stick with companies generating no more than $3 to $4 billion in annual cash flow—particularly if that company is considered a blue-chip.

"Indeed, cash flows are most likely to tread water or start dropping almost immediately after your investment. A few companies will buck the trend, but they're probably not the ones that end up in your portfolio. Over the years, I've taken a pass on many supposedly stellar businesses purely on the basis of the Law of Large Numbers, and I've never regretted it.

Taking insurance while playing Blackjack seems very logical, but it's a sucker's bet. Investing in the most valuable businesses around is no different.

Low-Risk, High-Uncertainty: Another Pabrai Law

Is Mohnish saying we should run out and buy every stock under $1? I doubt it. Instead, look for businesses that have been "punished" by Wall Street—stocks that have had their prices beat down or that have experienced massive business growth without a commensurate rise in stock price.

Then, Keep It Simple

Don't forget: Stick with simple, easy-to-understand businesses. Your sphere of competence and confidence is built into you, and it is likely different than mine (or anyone else's sphere). Going back to Pabrai—when I asked him how he determines a company is in (or out of) his sphere of competence, he meandered a bit before answering. Then, he gave me the "you just kind of know" answer.

When you find a business, it will click. If you aren't sure, let the prospective (and potentially mouth watering) profits go...and start looking for another opportunity.

Investing is one of those games where it pays to be a quitter. If something seems too difficult, walk away. Just don't translate that into your personal life and you'll be fine.

Also Filed Under "How to Think About Investing"

• What Is The Best Asset Allocation Strategy?
• When To Watch Out For Insider Selling
• Let Me Tell You About Patience
• Should I Reinvest Dividends? WWWD?