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Investing Specialists

American Funds' Insights on Managing Currency Fluctuations

Don't get lost in translation.

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Fluctuations in foreign currencies can be a big driver of returns, for better and worse, over short periods of time in investment portfolios. However, determining how currency fluctuations may affect a portfolio over the long haul is more complicated than initially meets the eye, especially in a global economy where goods and services move quickly and companies sell their products in many countries. It may not always be enough to explain multiyear outperformance of international or global funds by simply pointing to a weakening dollar or strengthening foreign currencies. Here, using information from its most recent annual report, I'll discuss how  American Funds New Perspective (ANWPX) considers currencies when buying and selling foreign stocks. I'll also discuss why individual investors should leave currency bets to the pros.

First, some background on what causes currencies to change value: Currencies are backed by government credit and fluctuate in value against each other now, whereas they used to be based on an exchange rate for a commodity such as gold. Currency values change for some of the reasons that individual securities do. American argues that it's helpful to think of a currency as the stock of the country issuing it, which means the currency's value will be influenced by the country's growth rate, balance sheet (how much it owns--its assets--and how much it owes-its liabilities), and political stability. Another factor influencing currencies is the prevailing interest rate of the country issuing the currency. If a country's bonds are paying a high interest rate, demand for them will likely increase, and the currency in which the bonds are denominated will appreciate in value. An extremely high interest rate, however, can also mean rampant inflation, where the currency has lost or is losing much of its purchasing power.

Just like foreigners who travel to the United States and buy up a storm when their currencies are strong versus the dollar, investors may be tempted to make similar currency plays in their portfolios. They want to benefit from the "translation effect." In other words, owning securities denominated in foreign currencies can be beneficial when the dollar is falling and foreign currencies are rising and rising. Having your money in the security denominated in the currency that's increasing in value will boost your purchasing power. So it can help Americans to own securities denominated in foreign currencies when the dollar is weak and help foreigners to hold securities denominated in dollars when their currencies are weak.

Don't Emphasize the "Translation Effect"
While this translation effect is important, it's not the whole story by any means. Given the global nature of many businesses today, it's not enough to anticipate future strength in a currency and purchase stocks denominated in that currency, because the companies you own may derive revenues and profits from other currencies than the one their stock is denominated in. They may also incur expenses in multiple currencies. American Funds software analyst Paul Benjamin points out, "Every company that I cover does business in more countries and currencies today than it did five to 10 years ago--and by a considerable margin."

If foreign companies derive a significant portion of their revenues from the U.S. in dollars, then the result of a falling dollar is more complex than the translation effect would imply because the company is getting paid in a weakening currency despite its stock being denominated in a strengthening currency. Additionally, if the company's expenses are in a strengthening foreign currency and the company is generating revenues in weakening dollars, its profit margins can deteriorate. An effect such as this can be even more important than the translation effect.

Alternatively, a strengthening dollar and weakening foreign currency can lead to a translation effect disadvantageous to an investor in the U.S. who is transferring his dollars for a weaker currency. However, if the foreign company derives a significant portion of its revenues from dollars and pays its expenses mostly in foreign currency, the overall effect can be positive, despite the stock of the company being denominated in the weakening foreign currency.

Don't Try This at Home
It can be very difficult for an analyst to respond to this complexity. The New Perspective annual report notes that American's auto analyst, Justin Toner, prefers to build financial models of his companies initially assuming no currency fluctuations. So we can infer that he tries to estimate future sales, expenses, profits, and the cost of capital assuming a stable currency at first. Then, after the model is built, he can tinker with it, adjusting for shifts in currencies. An auto analyst must be especially adept at accounting for currency fluctuations because most auto companies sell their cars all over the world, and many of them build cars outside of the country in which they are domiciled and in whose currency their stock is denominated. So both revenues and expenses (especially in the form of wages to workers) can be affected in significant ways by currency fluctuations.

It's important for analysts to go through this exercise because favorable currency winds could mask some performance problems at a company. Conversely, the companies may be performing better than they seem to be when currency factors provide head winds. An analyst may gain deeper insight into a business by backing out or adjusting for currency fluctuations if he thinks they are temporary. Alternatively, if an analyst has a strong conviction about currency movements, such as the weakening of the dollar, for example, he may penalize a company that sells lots of products to the U.S. in his estimate of its intrinsic value.

Analysts must also consider that companies themselves employ strategies to manage currency fluctuations. For example, a London-based portfolio counselor for American Funds remarks that Japanese automakers have factories in the U.S. so that they can match up U.S. revenues in dollars with dollar-based expenses. Moreover, another American analyst reports that the majority of a U.S.-based sportswear manufacturer's expenses are in Asian countries that peg their currency to the dollar, which would ordinarily make their margins increase as the dollar weakened. However, in lieu of showing excess profits that would evaporate once the dollar strengthened again, the firm chose to deploy them into technology and research that could provide benefits in the future. Finally, companies use financial instruments such as futures contracts to buy or sell a currency in the future at a predetermined price in order to protect against disadvantageous fluctuations.

The bottom line for individual investors is that currency movements and their effects on investments are more difficult to take into account than just assuming a "translation effect." Fund managers are much better equipped to position their portfolios for currency fluctuations. In fact, the American Funds themselves can hedge their currency exposure. The Statement of Additional Information of the New Perspective fund allows the fund's counselors to enter into currency contracts or obligations to buy or sell a specific currency at a future date. However, like many mutual funds that invest in foreign stocks, it hasn't been the style of the fund to make use of these capabilities and engage in direct currency bets. Mostly, the fund evaluates businesses one by one based on their individual prospects, with currency considerations contemplated on the individual business level. That approach has served the fund well since its inception in 1973, and we think it will continue to do so.

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John Coumarianos has a position in the following securities mentioned above: ANWPX. Find out about Morningstar’s editorial policies.