Recycling Investment Capital
Should we or should we not do it?
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I’ve often described our investment approach of “Investing in Mavericks” as applying the Venture Capital mindset to the Public Markets.
In Short:
We are looking for companies poised to become the best companies of our time. Think Amazon or Netflix in the early days. Companies that, if successful, have the potential to 10X in 10 years or less.
This approach really comes down to envisioning what the world MAY be like in the future, and investing in companies who can make that proposition a reality.
We want these companies to be run by visionaries, and we will aim to own these stocks for long periods of time.
I’ve also married the above with the notion of Coffee Can Portfolios. The idea is simple: Try to find the best investments you can and let them sit for years. You incur no costs with such a portfolio, and it is simple to manage.
One of my fundamental beliefs is that the biggest driver of investment performance is finding the right opportunities and holding them for long periods of time (and therefore ignoring volatility). That said, another tool at our disposal is portfolio management. Things like “seeking liquidity” to recycle investment capital, diversification, position sizing etc.
Today we will discuss Capital Recycling, and whether I’m a fan of this.
Recycling Investment Capital
Venture Capital funds have a “recycling” provision that allows them to sell some percentage of their investments and reinvest those funds back into new investments instead of distributing that capital to their limited partners.
Recycling investment capital, if done correctly and opportunistically can make a big difference in returns. For example: Let’s say you are able to double your $1mm portfolio, your outcome is $2mm. But, if during the same time, you could also redeploy, say 20% of your capital, your outcome could then be $2.4mm, a meaningful improvement.
One might argue that since public markets are liquid, we can switch from one investment to another anytime (and therefore recycle capital) based on price fluctuations, valuations, upcoming catalysts etc. To me, even thinking about doing this feels terribly exhausting. I am just not a fan of such an approach. I am not interested in re-evaluating every decision I make everyday based on near term price movements. Instead, in general, I would rather make a 3-5 year bet and wait. If I am unwilling to wait, then it’s probably better to (a) build more conviction (b) wait for a better price or (c) find something else to bet on instead.
When it comes to venture capital, most VC funds have investments where they “get their money back or a bit more.” This could be an early exit where the founders got a great offer they could not refuse, or it could be an investment that only kind-of worked. These can be great opportunities to recycle capital for VCs.
Similarly, in public markets, there are some circumstances where it might make sense to seriously consider recycling investment capital:
When You’ve Made Options or other Leveraged Bets
Options provide a natural reason for us to recycle capital: expiration dates.
As far as I am aware, publicly traded options do not have expiry dates more than 2-2.5 years out into the future. For the purpose of my Scorecard, since our holding/tracking period is 3 years, if we buy options, as we get closer to expiration, we must naturally decide whether to recycle this capital.
We have the following choices:
Do nothing (ie. Don’t recycle capital)
Re-deploy the capital into new option contract(s) for the same underlying investment idea
Re-deploy the capital into a new investment idea
When an investment only kind-of worked (or didn’t work)
Redeploying capital in this scenario comes with a high opportunity cost, the most obvious being taxes.
Redeploying capital in this scenario is also at odds with the Coffee Can approach. The reason I am a fan of the coffee can approach is because I have found that many of my regretful investment mistakes have come from selling too early, and as a result forgoing investment returns I should have captured.
So I hesitate to recycle capital before a good amount of time has passed from my buy date.
Of course, one of the benefits of investing in liquid public markets is that we don't have to make an “either-or” decision. Instead, we can choose to sell only a portion of our investment in order to recycle the investment capital.
That said, I don’t do much of this. For 2 reasons:
I think the psychological benefits of forcing myself to buy investments only if I am willing to hold them for a minimum of 3 years far outweigh the potential benefits of recycling our investment capital in the near term. Just take a look at the “Max Drawdown” column in the Scorecard. It is unlikely one could endure such drawdowns without some way of stopping themselves from selling when the world disagrees with them.
As I mentioned above, the biggest driver of performance is finding the right opportunities, especially over long time periods, much more so than recycling capital. So there is no need to be penny-wise pound foolish trying to optimize the recycling of capital.
Of course, I caveat this by saying that if an obvious investment opportunity presents itself, then yes, recycling is not out of the question. As I have written before, there are no rules when it comes to investing.
Where there is a broad market selloff
When this happens, correlation among stocks tends to increase exponentially, and it feels like everything is going down.
It may be difficult to remain positive in such an environment. But history is on the side of the optimist. If you’re a long term investor, the bet you need to make is on the resiliency of capitalism.
What does that mean? During such times, it might pay to recycle the whole portfolio (or at least evaluate the need to do so), as compelling opportunities that weren’t available when you first started building your portfolio may now be available.
This can be tough to do, and is once again at odds with the Coffee Can Portfolio mindset.
In Conclusion
So, in conclusion, recycling investment capital, if done correctly and opportunistically can make a big difference in returns. But it comes with a high potential opportunity cost: You need to be right twice, first about the sell decision and second about the new buy decision.
More importantly, the biggest driver of performance is finding the right opportunities, much more so than recycling capital. So in my opinion, there is no need to be penny-wise pound foolish trying to optimize the recycling of capital.
That said, every now and then recycling should be taken under serious consideration, particularly during broad market sell-offs and when making leveraged or options bets.
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