Four things investors need to know about currency fluctuations

currency-fluctuations

You may think that changes in the value of the dollar, euro, or yen only concern tourists sipping lattes on the Left Bank or riding the bullet train to Osaka. But in fact, US-based investors in mutual fund that invest in companies headquartered outside the United States need never cross the border to experience the effects of currency fluctuations on their finances. That’s because shifting currency values can affect them in a variety of ways, many of which may not be apparent to the average investor.

If you are invested in mutual funds whose portfolios include companies such as Nokia, Toyota, Samsung, or Bank of Nova Scotia, here are four things to consider when fluctuating currencies are in the headlines.

1. The “translation effect” can impact investment returns.

The most obvious impacts that currency fluctuations have on investments is known as the “translation effect.” To invest in an overseas company, a U.S.-based investor generally uses dollars to purchase shares of stock denominated in other currencies, such as the euro. If the dollar is strong relative to the euro, it takes fewer dollars to make such purchases. If the dollar is weak, it takes more dollars to do so. The same logic holds true when it comes to selling those shares. If the dollar is strong, the proceeds from the euro-denominated stock will convert it to fewer dollars than if the dollar is weak. Thus, a falling dollar will bolster returns while a rising one will diminish them.

2.  Look out for fluctuating currencies

Fluctuating currencies affect the revenue and profitability of global companies. Certain scenarios – including a rising dollar scenario – can actually shape corporate operations and profitability in a way that benefits U.S.-based investors. Consider the case of two software companies, one based in U.S., the other headquartered in Germany. “Conventional wisdom would suggest that a strengthening dollar would be bad for U.S.-based investors and the German company, since gains or losses on the company’s stock would be amplified when translated back to U.S. dollars. Yet the reality is more complex. If, for instance, the German company pays much of its cost – labor, administration, research and development, and materials – in euros, but has considerable revenues in dollars, a rising dollar scenario may mean its profit margins are effectively increasing. That’s because the dollar-based revenue it generates in the U.S. now translates into more euros and therefore goes further towards paying its euro-based expenses. For U.S. investors, the potential benefit to the stock price as a result of this added profitability may more than offset the loss in return caused by a stronger dollar.

Consider too the case of a European aerospace manufacturer whose products, priced in euros, suddenly become more affordable to a U.S. purchaser because it takes fewer dollars to buy them. Again, a fortified dollar may be a headwind when translating the stocks return into U.S. dollars, but the overall sales benefit to the company may offset the negative impact.

3. Currency issues have become a bigger factor in evaluating investments.

Global companies have costs and revenues in multiple currencies. A company like Starbucks, for example, has outposts in Tokyo and revenues in yen; Toyota manufactures Camrys in the Midwest and pays wages in dollars.

To help manage the exposures that come with this way of operating, many businesses seek to keep their revenues and costs in various currencies fairly well matched to avoid being overly susceptible to fluctuations in a particular currency.  Because a company’s success at controlling this aspect of its business may be indicative of its overall strategic know-how, investment analysts will study a company’s currency exposure and its effectiveness at managing it.

Understanding the repercussions of currency fluctuation is an important part of my analysis, as companies manage their exposure in different ways. Yet I believe our principal goal as analysts is to cultivate a comprehensive picture of a company and then determine whether it offers long-term opportunity regardless of currency movements. To that end, I attempt to take a ‘currency neutral’ approach to evaluating companies; I build financial models that assume currency values are going to remain the same. Of course we all know that’s not going to be the case, so once I establish a baseline, I adjust my models to see how various shifts in currency might affect the results of companies I follow.

For me, it’s not important to predict currency changes or to invest in a company ahead of a move in a particular currency. Instead, I want to be aware of how much currency has helped or hindered a company and then think about what that company looks like minus any currency impacts.

4. Currency issues are not generally the primary driver of investment returns.

For all the effort that companies and investment professionals put into evaluating the impact of currency volatility, the reality is that certain environments do present headwinds. While that can cause yearly swings to be significant, currency tends to move in cycles encompassing periods of strength and weakness. Over the length of these cycles, the impact of any particular currency movement on investments tends to get offset or neutralized by any other movements or factors.

When it comes right down to it, currency is a headwind or a tailwind, but it’s not the driver of our decision to invest in companies. The reality is that many of the factors that cause a country’s or region’s currency to strengthen – which could weaken dollar-based returns – are signals that the underlying economy of those countries or regions is robust and growing. And that generally means we will find attractive investment opportunities with the potential to benefit shareholders over the long-term.

Why do currencies change in value?

The value of currency rises and falls for many of the same reasons that individual stocks gain and lose value. Thus, it may be helpful to think of currency as the stock of the country that issued it. The direction of that stock is, to a large degree, dependent on the conditions and prospects of that country. For instance, if a nation is politically and economically stable, with a healthy balance sheet and solid economic growth prospects, this currency will often reflect that by retaining value or appreciating against other currencies. Another significant influence is the prevailing interest rates of the country issuing that currency. If global investors can earn a relatively high rate of interest by buying a country’s bonds, demand for those bonds will increase, and that country’s currency will strengthen as investors in other parts of the world exchange their native currency for the currency in which the bond is denominated.

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