The Law of Large Numbers

By Chad Langager | August 07, 2005 AAA
Over the last year Exxon Mobil (XOM) has become the world's largest publicly traded company. The integrated oil and gas player sports a market capitalization of $375B which is roughly equal to Citigroup (C) and Intel (INTC) combined.

Exxon provides us with an opportunity to focus on a very important idea in the stock market - the law of large numbers. The idea, at its most basic, is that as a company grows larger and larger the more difficult it becomes for it to continue to grow.

For example, well Exxon has provided a decent return for investors for the year - currently up around 16% year to date - it pales into comparison to some of the smaller companies within the industry. For example take Encana (ECA) - up 61% for the year or Able Energy (ABLE), up nearly 500%. One reason for this, yet not the only reason, is the shear size of the company.

Let's assume that from today (August 8, 2005) Exxon provides investors with 15% capital appreciation over the next year (August 8, 2006) - a respectable return. If Exxon were to gain 15% this would translate into the addition of $56.25B in market cap, bringing the company's total size to just over $431B! Think about that for a second. $56B is approximately equivalent to the size of eBay (EBAY), Boeing (BA), or Goldman Sachs (GS) at the time of this writing.

OK, perhaps you still don't think that is all that unrealistic (in fact it isn't very unrealistic, it could very well happen) and you are already noticing that we have not taken into account dividends, but please bear with us as we try to make this point.

Let's take a far more 'out-there' example to demonstrate the concept.

Imagine Exxon grew 100% over the next year. This means that in one year's time the company would be worth $750B! Now let's say you invested in a company worth $2B. Isn't it a lot more feasible that the $2B company could grow to become a $4B company? See what we are trying to say? Either way your stock goes up 100%, but in the latter example only $2B in market cap is created.

The point is, the ability for a company to continue to grow at rates of 25%, 50%, and 100% are greatly diminished as they get larger and larger. They just become too big. Now please do not misinterpret us, we are not saying "all big companies are bad". Not by any means. Many large companies are great businesses, but the fact of the matter is they are not necessarily good stocks to own if you are looking for capital appreciation.

To find another good example look no further than the Oracle of Omaha, Warren Buffett himself who has stated in the past, "It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

Although Buffett is referring to growing money for an investor, not growing a company, the same principle applies. When numbers get larger it is becomes increasingly difficult to grow them. Just like Exxon will have a hard time doubling from $375B to $750B so too does Warren Buffett's Berkshire Hathaway (BRK.A) (currently valued at approximately $130B).

This is one of the reasons why at the Investopedia Advisor we examine companies in the $1B-$25B the range for our Core Portfolio. This allows us to invest in companies with good opportunity for price appreciation. Put simply, we feel that in many cases a $10B company has a heck of a lot better chance to grow to $30B than a $100B company does to balloon to $300B.

Although we are not going to pull out any examples of the numerous research papers done on this topic, rest assured this is not a totally new concept, rather it is one that we feel is over looked all too often. Also, even more importantly, please note that we are not discounting the importance of good research. There are plenty of companies in the $1B-$25B range that are absolute dogs and have no hope of ever doubling or tripling, just like there are in the larger market cap ranges. The point is that given "ceteris paribus" (all else equal) we will invest in the smaller company due to the larger upside capital appreciation potential.

At the Advisor we have a very stringent process for selecting stocks and one very important element is where we look. For us, there is simply not enough room for mega-cap ($200B +) companies to appreciate (by this we mean double, triple or even quadruple).

And that's just one of the reasons we steer clear of this group....stay tuned for more on this subject in future writings.

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