The Dollar and Stocks- Don't Confuse 'em

The US dollar’s downtrend appears to have reached a point that it has entered the public’s consciousness, judging from the media’s attention. Such level of interest often seems to come after a protracted trend is in place, rather than in anticipation of a significant move. The dollar’s move has also captured the imagination of many equity traders who now appear to add a currency component to their investment strategies. While a weaker dollar may help boost the value of foreign earnings for US-based companies, turning one’s dollar view into an equity strategy may be more difficult than many pundits would suggest.

Some commentators focus on how a weaker dollar will make US exports more competitive. While this claim is intuitively reasonable, there are several mitigating factors. The most important consideration for US exports does not appear to be the exchange rate of the dollar, but rather, the strength of the export markets. Exports in February rose 9.3% in February from year ago levels. That is actually the slowest pace since October 2005. Moreover, this export growth is measured in dollars which is bolstered by the greenback’s decline. Indeed real exports (i.e., adjusted for price) stood at $78 bln in Feb, the weakest since July of last year.

Recall the US dollar put in its last cyclical low in the spring of 1995 and proceeded to appreciate for the next five years. The 12-month moving average of the year-over-year rate of export growth was above 11% in late 2000 after a five year dollar rally. In February the comparable rate was about 12.5%. And this is after the dollar has generally declined since 2000-2001 with the lone exception being 2005.

Consider that companies pursue different strategies relative to currency fluctuations. European and Japanese companies, which rely to a greater extent than US companies on bank loans, have the luxury of being more patient and seek to preserve market share by not passing through, or at least minimizing the pass through of currency fluctuations. In contrast, US companies, more dependent on the capital markets than banks, do not have that luxury. Their strategy often requires preserving profit-margins rather than market share. This means that, on one hand, European producers are not about to raise their prices to offset the more than 9% appreciation of the euro over the past 12-months. Nor, on the other hand, should US companies be expected to cut the price of their goods.

However, there also seems to be a conceptual problem. US companies do not primarily service foreign markets by exporting. This little recognized fact has been true since the early 1960s when the Commerce Department first began keeping track of it. The most recent disaggregated data is for 2004 and then the sales made by the majority owned affiliates of US multinationals outstripped US exports by a function of nearly 3 to 1.

The focus then should not be on exports per se but foreign sales. Roughly speaking, foreign sales account for about 40% of the sales of the Dow Jones Industrial companies, a little less than 30% of the sales of the S&P 500 companies and a little more than 15% of the sales of Russell 2000. Foreign sales are important because those earnings get translated back into dollars for accounting purposes and boost revenue.

The depreciation of the dollar boosts the value of those foreign currency earnings for the US parent. Corporate treasurers view foreign exchange exposure as a risk that needs to be managed. Hedging policies vary from company to company. Some companies hedge a currency exposure as soon as they send out an invoice. Some companies hedge anticipated receivables. Generally speaking though most US corporations don’t hedge the sales of foreign subsidiaries, in large part because they often have local currency costs related to operating the business (e.g. supplies, wages, rent). Companies do typically hedge export sales from the US.

Consider Caterpillar and Deere. Observers who emphasize the currency considerations tend to like the former over the latter because of the greater international exposure. Caterpillar’s foreign sales exceeded domestic sales by about 10% in 2006. Deere’s foreign sales, in contrast were a little more than a third of its US sales. Year-to-date, shares of Caterpillar have risen by about 20.5% compared with Deere’s 18.1%. However, over the past 12-months’ Deere shares have returned more than 33% while Caterpillar’s has had a negligible return of less than 0.25%, which includes a dividend yield of 1.6% (at current prices).

Consider PepsiCo and Coca-Cola. Coca-Cola’s foreign sales are more significant than Pepsi’s. For Coke, foreign sales surpass domestic sales. For Pepsi, foreign sales are about a third of domestic sales. Since the start of the year, Coke shares have gained about 7.6%, while Pepsi’s shares are up about 5.6%. Over the past 12-months, Coke has generated a total return of 27% compared with Pepsi’s return of less then 16%.

One other example would suffice to illustrate that it is difficult to go from international sales to stock performance, even in a weak dollar environment. Consider McDonalds and Wendy’s. Even though Wendy’s has international, as part of its name, it is significantly less international than McDonalds. International sales accounted for about 10% of its overall sales in 2006 and according to Bloomberg data, Wendy’s average two-year sales growth rate has fallen by about 38.5% in Canada and 11.5% in ROW (rest of the world), while its US sales have fallen by about 5.7%. In contrast, McDonald’s European sales exceed US sales and Asia-Pacific, Latam, and Canadian sales are more than ¾ of its US sales. Moreover its sales growth rate (two-year average) is positive. According to Bloomberg data, McDonald’s US sales growth exceeds sales growth in Europe and Asia-Pacific. McDonald’s sales growth is, though more than 4 times stronger in Latam than the US.

Despite the apparent focus on the impact of a falling dollar on earnings, Wendy’s shares have outperformed McDonald’s shares 13.4% to 10.4% this year. McDonald’s superior return is evident on a 12-month view, where the total return has been more than 44% compared with just less than 30% for Wendy’s.

If the dollar’s weakness is good for the share prices of US multinationals, one would expect major US indices to outperform the bourse of countries with strong currencies. Yet an American investor would be better off to have invested in Germany. In euro terms the Dax gained 11.8% this year compared with the 5.25% rise in the S&P 500. The Germany ETF (EWG) has gained 16.6% year-to-date.

The Swedish krona has gained 2.1% against the dollar this year, compared with the euro’s 3.3%. Sweden’s main index (OMX Stockholm 30) has gained 10.2% year to date in krona terms. The Swedish ETF (EWD) has appreciated by 14.4% thus far this year.

The larger point here is that there is no short cut to investing. One cannot deduce the performance of the US stock market, let alone an individual company, on the basis of the vagaries of the US dollar. Often companies that have large foreign revenue also have large foreign expenditures. If an investor has a view on the dollar, there are numerous vehicles, to express the view directly and efficiently. But don’t simply take a dollar view and express it by buying shares of a particular company. The same factor that is weighing on the US dollar, slow growth, undermines earnings growth in general. There is no substitute for doing one’s homework. Sorry.
The Dollar and Stocks- Don't Confuse 'em The Dollar and Stocks- Don't Confuse 'em Reviewed by magonomics on April 27, 2007 Rating: 5
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