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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.

Written by Joe Ponzio on October 22, 2007

Joe Ponzio is the managing partner of the Ponzio Investors Funds and owner of Ponzio Capital Inc, a registered investment advisory and deep value portfolio management firm. The author of F Wall Street (the book and the website), his articles have appeared in hundreds of financial media, including Financial Planning Magazine, CNBC.com, Yahoo! Finance, and Reuters. He has appeared numerous times nationally on both radio and television, and has presented at universities and seminars across the United States.

Read more articles like this online at www.fwallstreet.com.
To learn more about Joe's portfolio management services, visit www.ponziocapital.com.
The Discussion
Babui' gravatar

Babui
Oct 22nd, 2007
8 comments

I don' think it really matters if a company is large cap, mid-cap etc. All that matters is that the company stock price is selling at a significant MOS to intrinsic value and that the company's numbers are solid and it is doing business in the same fundamental way, it has always done its business. The only time it matters if you buy small cap vs large cap is if you plan to buy and hold forever (or at least for 20 yrs). Even then, some long term CAGR for large caps can put many a small cap to shame (e.g., MMM).
Casey Mattson' gravatar

Casey Mattson
Oct 22nd, 2007
26 comments

I agree with your assesment, but over a certain amount of time, I believe the "small-cap" has a means to grow more rapidly, thereby giving one the chance to find bargains more often. Which is what I think Mr. Pabrai is contending. The large cap arena, is good for Plan A stocks, but Plan B stocks are more likely small cap in a nature. Lack of analyst coverage etc etc.
I agree with both of you. $1 worth of a business, selling for $0.50, is still a great deal. The problem with the smallest companies is that they have more fierce competition, with less means to ward it off. Then again, they can fly under the radar and get some good growth in the process.
Nelson' gravatar

Nelson
Oct 24th, 2007

In one of his recent speeches Buffet said if he was a small investor he wouldn't care whether he company was large or small cap.

However a study (Arie De Geus) referenced in Pabrai's Dhandho book found that the average Fortune 500 company has a life expectancy of 40 - 50 years and it took 25 - 30 years from formation to get on the Fortune 500. This implies large cap companies are well past middle age. This brings raises questions about Buffet's permanent holdings - how permanent are they?

Charlie Munger also referenced in Dhandho says "Of the fifty most important stocks on the NYSE in 1911, today only one, GE, remains in business.."

My take is, whether investing in large or small cap, keep reviewing their moat and be prepared to sell.
Great point!
LC' gravatar

LC
Dec 6th, 2007

I have a ton of respect for Pabrai. However, he seemed to forget Buffett's "law" of preserving capital at all cost when he went big into DFC even after the initial phase of the credit crises. They filed for bankruptcy yesterday.
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