Global Currency Wars: Three Ways to Profit From the "Race to the Bottom"

Short of sitting on the sidelines, investors can't escape the global currency wars - a "race to the bottom" shootout that has countries debasing their currencies to boost overseas sales.

But here's the only thing you need to know: As the central banks of the world slug it out in the global currency markets, individual investors who understand the currency-war strategy can reap some extraordinary gains.

Let's take a look.


When Currencies and Stocks Collide

The first step in managing your currency risk is to understand just where that risk is.

Currency Matters
Let's start with stocks.

When you're trying to figure out what currency exposure a company has, first try to determine from which countries a company is getting most of its revenue. It's not always easy to find a breakdown of sources of foreign revenues in consolidated financial statements. Sometimes the numbers are there for you, and sometimes it takes a forensic accountant to uncover them.

But these days, because global business is so important to investors, companies often break down foreign revenues in public announcements about their earnings, and on earnings calls with analysts.

Thanks to the Internet, it's easy to search company announcements and for analysts' opinions of earnings, complete with their breakdown of revenue streams.

Once you know where a company's revenue is coming from, you need to ask yourself a question: Am I comfortable with that particular foreign currency risk?"

To answer this question you need to start with knowing who is winning different currency wars.  We'll look at examples through the eyes of the U.S. dollar.

Take Toyota Motor Corp. (NYSE ADR: TMC), in my second installment in this currency series I noted that according to Toyota, for every yen above an assumed exchange rate of 90 yen to the dollar (meaning one dollar can buy 90 yen), Toyota says it loses 30 billion yen ($357 million) in operating profits.

At the time of that article, a single U.S. dollar could buy 84.5 yen. I explained that if that exchange rate stayed the same, Toyota's expected 330 billion yen operating profit for the fiscal year that ends in March 2011 would be cut in half.

Today, however, the dollar only buys about 81.5 yen. And that makes Toyota's upcoming operating profit look even worse.

If you'd been following this shift in the dollar/yen relationship, you'd have seen how the exchange rates were moving against Toyota and would've understood the bottom-line implications for the Japanese automaker. Armed with that knowledge, you likely would've avoided new purchases of Toyota shares - and perhaps would've decided to sell any shares that you held.

Since my last article, the yen has continued to move higher against the dollar. So it was no coincidence that Toyota's stock fell from $73 to $71.07 this past Friday - a day that the rest of the market rallied.

For a different (albeit, more positive) perspective, consider YUM! Brands Inc. (NYSE: YUM), the seemingly quintessential American company that owns the KFC, Pizza Hut, Taco Bell, Long John Silver's and A&W Restaurants.

If you've been following analysts' reports and news about YUM, you would know that the company is experiencing flat U.S. sales - but is expanding rapidly in China. Since YUM is on track to derive nearly half its revenue from overseas - with the bulk of that coming from China - to make an informed investment decision you'd definitely want to understand who's winning the U.S. dollar/Chinese yuan currency war.

And in that particular currency skirmish, it's China that's right now got the upper hand. Since the yuan isn't appreciating against the dollar - in spite of American yelling, screaming and legislating - YUM looks like it will continue to be a good investment because Beijing's not about to let the yuan appreciate demonstrably against the dollar.

And since YUM gets so much revenue from its China operation, the company's profits in currency terms just keep getting better. The stock is at the top of its range and continues to make new highs and the company should continue to enjoy profit growth until the yuan/dollar battle swings against China.

When you are attempting to analyze a stock, there's a simple rule of thumb that you can use.

If the U.S. dollar is weakening relative to the currency that makes up an important share of a company's overseas revenue, then the stock will realize a positive return from that revenue. When the foreign earnings are converted back into dollars - because the dollar has fallen against that other currency - those foreign earnings will be able to "buy" more dollars when they are "translated" back into the U.S. currency, meaning revenue and profits will get a boost.

The flip side of that rule is when the U.S. dollar is rising against other currencies, it means that U.S. companies that earn a lot of revenue overseas will probably be impacted negatively when their foreign earnings can't buy as many dollars as before.

Exchange Rates and ETFs

You may not realize this, but stocks aren't the only investment that contain exchange-rate risk. Many popular exchange-traded funds (ETFs) have lots of currency exposure that you may not have realized. Investors who see and understand this can emerge victorious from this global currency war. Investors who fail (or just refuse) to take the time to study this will be carried out on their shields - by their broker.

When you invest in ETFs that track the stock or bond markets of other developed economies, or that mimic one or more emerging markets, you're taking on two kinds of risk. You've taken on:

  • Market risk, or the risk that is created when the other market or markets go up or down.
  • And currency risk, because you've made an investment outside U.S. borders.

Let's assume, for example, that you've invested in an ETF that tracks only euro-denominated European stocks. While each of the stocks or benchmarks may have their own additional dynamics, the stocks themselves are all denominated in euros. Not only are you exposed to whether those stocks or benchmark indexes go up or down, you are also simultaneously taking a position on the European currency, the euro. If your European ETF goes up 10%, that's good.

But if the euro falls 10% against the dollar, when it comes time to sell your ETF, the depreciation of the euro offsets the appreciation of your European stock portfolio.

The bottom line: Sorry, no gain.

If you want to understand how to avoid, mitigate or tackle exchange-rate risk, you always have to answer the same two questions:

  • With any given investment, what currencies are we talking about?
  • And what are the relevant exchange-rate trends.

Moves to Make Now

As an investor, when it comes to FX exposure, you do have choices. You can do nothing to hedge your currency exposure, and perhaps then gain or lose on currency movements in the future. Or you can actually hedge part - or all - of your exposure to currency fluctuations.

Let's say you think European stocks are going to rally. And you also believe that the euro is going to appreciate against the dollar (don't forget, from now on you need to make a determination on exchange rates any time your investment or trade exposes you to currency movements).

If you'd invested in the iShares MSCI EMU Index ETF (NYSE: EZU) (which only invests in eruo-denominated country stocks) back on July 1, and sold your shares in that ETF last Friday (Oct. 8), you'd have reaped a 23% gain - even though European stocks haven't risen anywhere near that much. That's because you were on the right side of the shift in the euro/dollar exchange rate.

In fact, of the 23% gain in your ETF, almost 12 percentage points was due to the euro appreciating against the dollar during that short holding period. In the future, if you believe European stocks are going higher - and expect that the euro is going higher against the dollar - EZU might be a good investment choice.

Hedging currency exposure used to be done exclusively with currency "forwards," currency futures and currency options, and institutional investors still use those often-complex instruments. But today investors at all levels - including retail investors - also have the option of using currency ETFs as speculative investment vehicles that enable investors bet on the direction of currencies.

Make no mistake about it, hedging foreign currency risk is a risky business. Besides knowing how much risk you actually have, you still have to get the timing right when you put on a hedge. Putting on a hedge amounts to putting on another speculative position, which if not executed properly can actually expose you to greater losses.

The truth about unforeseen currency exposure facing investors is that it is a wake-up call. By understanding that currency wars and exchange-rate movements that expose investors to currency risk - especially during this intense "race to the bottoms" - investors can better arm themselves and protect their own investment spoils.

Action to Take: Since we're still talking in dollar terms and you know the rule of thumb that investing overseas is better when the dollar is falling than when it's rising, here's how you hedge against a broad dollar movement.

As always, first try and understand the currency risks that you face in your portfolio. If you get good at following the currency wars and determining the likely trend in different exchange rates, you can execute specific hedges to protect a carefully defined currency-rate exposure. But if you just want to hedge based on that afore-mentioned "rule of thumb" - as well as on the prevailing direction of the dollar (whether the dollar is rising or falling), you can essentially rely on just two exchange-traded funds (ETFs).

Those two ETFs - and the situations in which they are best deployed - are as follows:

  • The PowerShares DB U.S. Dollar Index Bearish (NYSE: UDN) rises in price if the U.S. dollar falls against a basket of major currencies. Having the dollar fall against the currencies of countries where your investments are generating revenue is good for you. If the dollar continues to fall, you wouldn't need to hedge. But if you can actually make a wager that the dollar will continue to fall in the currency wars, then you might want to buy some UDN.
  • The Powershares DB U.S. Dollar Index Bullish (NYSE: UUP) rises in price if the U.S. dollar rises against the same basket of major currencies. If you have a lot of foreign investment exposure and the dollar starts to gain strength in the currency wars, you might want to hedge your exchange rate exposure and buy UUP.

Finally, if you're looking for an individual stock with a decent risk profile that's poised to benefit from the trends and rules that I've articulated here, take a close look at YUM! Brands Inc. (NYSE: YUM), the seemingly quintessential American company that owns the KFC, Pizza Hut, Taco Bell, Long John Silver's and A&W Restaurants.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. Those essays can be accessed by clicking here.]

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