The Danger in Buying the Biggest

Nature provides some possible answers. Mammals rule the world, but the largest land-based mammal is the elephant. There is no evidence that shows that we've ever had land mammals much bigger than modern-day elephants. Why? Being warm-blooded, mammals are energy hogs.

Mammals have to eat a lot to generate energy. As a result, mammal size is bounded by the energy a given area of land can consistently supply. It is also bounded by internal organs like the heart, which have to pump blood to the body's extremities. Thus, these extremities are physically constrained from being too far from the heart, and that imposes another size constraint.

Lumbering

Large businesses have their own extremities. There is a critical need to rapidly get data back and forth between the central organizational heart (CEO) and all the extremities (customers and foot soldiers). Over the last 100 years, the speed and breadth of these arteries have increased dramatically, and with them has grown the size of our largest companies.

There is, however, an upper limit to senior management's ability to accurately process the various inputs regardless of the size or speed of the arteries. This limitation translates into a size constraint on most businesses.

In addition, the most valued business is under constant attack from the marauding invaders who want to unseat it. This leads to what Clay Christensen, author of The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail, described as the disruptive innovation phenomenon -- against which the incumbent is virtually powerless.

The Law

All of this leads to Pabrai's Law of Large Numbers. The ultimate principle of this law is that one would be best off never making an investment in any business that generates more than $3 billion to $4 billion in annual cash flow and is considered a blue-chip. These businesses are very unlikely to be able to endlessly grow cash flow.

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.

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Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-based value-centric group of investment funds. At time of publication, Pabrai held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback at [e-mail]. You can access his Web site at www.pabraifunds.com.

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