In today’s investment world, there is only limited thought given to opportunity cost. That is, the cost of missing out on the next best alternative when a decision is made. For example, you may be happy with a gain of 10% in one of your holdings, but if you had bought a different stock then you could have made 20%.
Similarly, there is relatively little discussion of the idea of selling a good stock for an even better stock. Certainly, you may be happy with your portfolio and believe that it can outperform the index (and hopefully it does). But, there could be other stocks that are an even better place to invest, with your capital therefore not being deployed as efficiently or as effectively as it could be.
Clear Examples
Clearly, when considering opportunity costs and the efficient allocation of capital, Gulf Keystone Petroleum (LSE: GSK) (NASDAQOTH: GFKSY.US) and Afren (LSE: AFR) have been hugely poor places to invest in the last year. That’s because their share prices have slumped by 65% and 98% respectively in the last twelve months, with a declining oil price exacerbating problems that have led to the two companies facing hugely uncertain futures.
For example, in the case of Gulf Keystone Petroleum, its operations have thus far not been affected by the conflict in Iraq, with it producing over 40,000 barrels of oil per day. However, and despite a cash windfall recently, a permanent solution for regular payment for the oil it produces seems to be no nearer. This situation has been in place for a number of months and, as a consequence, the company’s financial outlook has been called into question, which has caused investor sentiment to decline.
Meanwhile, Afren’s financial outlook is also hugely troubling. Its debts are weighing the company down and, while it is in the process of restructuring its debts, a lack of working capital as well as various claims against the company mean that even if it does give itself some breathing space, Afren’s medium to long term future looks to be hugely challenging. And, as with Gulf Keystone, little help from the oil price should be anticipated, since it is expected that we are now in a ‘new normal’ period of sub-$60 oil.
The Wider Sector
Of course, if the situation for the entire oil sector were the same, then it could be argued that sticking with Gulf Keystone and Afren is a good move. However, it is not. There are a number of hugely profitable, diversified oil stocks with sound balance sheets, strong cash flow and, crucially, wide margins of safety that offer far more scope for capital gains than either Gulf Keystone or Afren.
Furthermore, they come with less risk, which makes the opportunity cost of investing in Gulf Keystone and Afren appear to be significant. As a result, selling Gulf Keystone and Afren and investing elsewhere within the oil sector could prove to be a sound move – even if it does mean crystallising vast losses in the meantime.