Recycling and Reallocating Capital

As investors, it is important to regularly review our shareholdings and to ensure our money is being put to productive use. This is because the enemy of inflation is always out there and will constantly and consistently erode the value of your cash holdings, making them worth about 3-5% less than the previous year. The insidious effects of inflation have been discussed in many economic textbooks and therefore one cannot afford to leave their money idle in bank accounts earning a very miserable and paltry 0.5% per annum. This brings me to the topic of recycling and reallocating capital, and I shall touch on each in the following paragraphs.

Recycling capital is one method whereby one can ensure one’s capital is always growing and put to productive use. This method involves selling shares which one feels has not much further potential for capital gains, and moving the capital to an undervalued investment with more potential for capital gains in future. Of course, this is predicated on the fact that one will be able and willing to look for undervalued gems to park his money in, and to adopt a patient attitude to be able to recycle his capital. One also has to be able to determine (according to his own personal prescribed philosophy), what is meant by “over-valued” and “under-valued”. Thus, this method of recycling capital may sound easy but is in fact fraught with considerable risk. Take for example an investor who invests $1,000 in Company A. Company A grows over the years and his investment becomes $2,000 over 4 years. The investor then recycles the new capital of $2,000 into Company B which he feels has a growth rate of 20%, compared to say 10% for Company A as its period of rapid growth is over. Thus, the investor wishes to grow his capital by 20% to $2,400 instead of being content with $2,200. Capital additions along the way can also assist to grow one’s portfolio and ensure one has a larger “base” with which to compound; and this is why the savings habit is of critical importance to building financial stability. Only when your capital base is significant does compounding start to work its magic; hence recycling of capital should be done on an adequately large capital base (of say 6-figures). What one can do early on in his investing days is to aggressively add to his capital base through savings (from salary) and bonuses (one-off windfalls) rather than through gains from investing.

Reallocation of capital is different in the sense that I am segregating the two terms based on capital gains and dividend yield. I use the term “reallocate” to mean shifting capital from one low dividend yield company to one which is paying a higher, sustainable dividend yield. For example, one may wish to reallocate some capital from REIT A (paying 5% yield per annum) to REIT B (which is paying 10%), thus effectively doubling your yield. Of course, it’s never so simple on paper and one has to evaluate the salient aspects of both REITs including the probability of capital loss should one decide to conduct the reallocation. In contemplating the merits or demerits of this kind of exercise, one has to also investigate the underlying fundamentals behind the high yield and to justify to oneself that it is sustainable and that the risk-return trade-off is favourable. No use exposing yourself to 4x the risk just to double your yield.

I can give two personal examples of the above using my own portfolio to illustrate. In August and more recently in October, I had divested Swiber and Ezra and recycled the capital from those investments into MTQ, as I believed that the growth prospects for these two companies were limited due to their heavily-geared nature, and their propensity for raising capital through financing activities rather than through operations. In addition, the two companies were (I felt) richly valued and thus appeared to be risky, because if growth failed to materialize there might be a collapse in valuation metrics and I could suffer a permanent loss of my capital. Hence the decision to recycle the capital to MTQ which has a much better Balance Sheet, a steady business generating positive operating cash flows, and which is valued at just 4-5x PER and which has potential to grow further in the medium-term due to initiatives undertaken by Management (Bahrain investment and Bosch superstores in Australia).

During October 2009 itself, I reallocated some of my capital from the previously mentioned divestments into GRP Limited, as the latter was paying an attractive dividend yield of 10% and was supported by a stable business, good cash flows and a strong Balance Sheet. The reason for the reallocation was because Ezra was paying a paltry dividend, and Swiber and Pacific Andes are probably going to suck up more cash than pay it out. Therefore, rather than keeping the money in a bank account earning a miserable 0.5% per annum, I chose to park it in GRP over the long-term to enjoy the higher yield. Of course, one can argue that there are also correspondingly higher risks involved, but this is to be mitigated through a prudent and thorough analysis of the business of the company to ensure no substantial permanent loss of capital occurs.

It is important for the investor to constantly seek better investment opportunities and to do portfolio re-balancing and review from time to time. Recycling and reallocating capital is vital to ensuring one gets a steady return on their investment; and not to let any investment sit idle and erode over time. This, of course, also involves cutting losses decisively on companies which are below par and shifting the capital to a more worthwhile company. This process necessarily entails painful decisions and determination and is thus easier said than done. But it must be done in order to ensure one’s portfolio does not become cluttered with last season’s “duds”, where useful capital simply wastes away from inflation and share price erosion.