Shares digital

The greenback has been dropping like a wounded bandit in a spaghetti western. Carlo Svaluto looks at the reasons behind the decline and some of its potential winners and losers

The fate of the dollar is being watched closely by the world’s financial markets. The currency has lost a big chunk of its value against other currencies over the past few years, with the pound/dollar exchange rate peaking at $2.12 last autumn. This is a reason to worry for many UK-based companies as a vast proportion of international trade is transacted in dollars, and global commodities are exchanged in greenbacks.

A further slowdown for the dollar could spark more dangerous volatility in the markets, and wreck other economies such as the UK and Europe, where companies earn their money in dollars and translate it into local currencies. Sky-high exchange rates for sterling and the euro also threaten to put pressure on export levels from the UK and Europe.

Greenback sings the blues

The reasons for the dollar’s worrisome decline are many. In the past few years the US has run a large current account deficit, which is an economist’s way of saying that Americans spend more than they earn. They have been able to do so because a huge amount of money is poured into the US by foreign investors, and also because the foreign currency reserves of the world’s governments are mostly in dollars.

However, looming prospects of a slowdown in the US economy, partly caused by last summer’s sub-prime mess, saw the dollar embark on a rough downward journey, with investors no longer sure about the worth of their dollar holdings. Last week’s data showing a possible contraction in US manufacturing added to woes about a battered housing market. It doesn’t take an economist to understand that a slumping economy and the chance of falling US interest rates make the greenback less attractive. The prospect of the US government not being able to pay back its borrowing is remote, yet US borrowing is much greater than the country’s earnings.

Recently, forex traders also played an important role in the dollar’s depreciation story. In 2006 they grew richer through ‘carry trading’, a technique that involves borrowing low-yielding currencies (such as the Japanese yen) to buy assets in high-yielding ones (such as greenbacks). However, growing risk for US assets, following growth concerns and worry about the credit crunch, saw them rushing to close their positions in 2007 by selling their dollar holdings, pushing the value of the yen up against the dollar.

Dustin Reid, senior currency strategist at ABN Amro, reckons throughout 2008 the dollar will keep sliding. He gives two main structural reasons behind this. One is that the US current account will see more adjustments this year (as policymakers allow for a weaker dollar to encourage exports). The second, more worrying, is that many global central banks and sovereign wealth funds are already ‘recycling out’ of dollars to G4 or G5 currencies, particularly the euro, sterling and Canadian and Australian dollars.

Governmental responsibility

The role of the world’s governments is crucial. In past years they have been increasing the size of foreign currency reserves, which are mostly in dollars but, as the dollar declines, governments see their reserves fall in value and might consider switching to other currencies. By selling large dollar holdings they could even prompt a crash in the currency’s value.

Reid says that this is not likely, as by doing that governments would be damaging themselves. However, he adds: ‘Another structural reason for a decline is that the flow of global funds into the US, namely in foreign direct investment, will slow down, so the demand for dollar assets will decrease. From the cyclical side, we think there’s a risk that the Fed will need to cut rates a few times. While these issues may be already in the price, the dollar could decline further against the euro, and possibly also against sterling.’

This is a big headache for the Federal Reserve, the institution that decides the cost of borrowing in the US. A looming recession should prompt it to cut interest rates to boost investment and spending. However, sky-high oil prices and other inflationary pressures limit its scope for action. Reid says that this is going to be the other main issue: ‘Oil prices have the potential to curtail central bank intervention globally, and to halt rate cuts a bit earlier than needed. Balancing consumers’ needs with liquidity needs for the investment community will be fundamental.’

A sluggish economy is an argument in favour of rate-cutting action, while inflation risks and a weak dollar are against it. US interest rates falling too quickly would prompt forex traders to buy higher-yielding currencies, and slashing value off the already stricken currency.

More clarity on the legacy of the credit crunch will also influence dollar currency pairs. James Hughes, market analyst at CMC Markets, says the credit mess is still taking its toll: ‘No one is yet sure of the extent of it, and that’s why many think there’s a lot of weakness for the dollar, even though we recently saw a sell-off in the pound/dollar pair after it reached all-time highs.’ He adds that, from a technical point of view, the $1.96 level for the pair is crucial and a bounce back to higher levels is on the cards.

Can China and India take up the US slack?

A final key question, according to Reid, is what effect a blip in US growth would have on the global economy. If global growth holds up, with China and India making up for the decline in US growth, the dollar could keep falling, as other currencies become more attractive. If global growth turns out to be more dependent on the US, the dollar could make some gains, making its sell-off look overdone.

That said, how will the greenback’s destiny in 2008 drive the performance of UK companies, and ultimately their share prices? A large numbers of UK firms are exposed to the American currency in a number of different ways, and this exposure affects their profits, their dividend payouts and, in turn, the perception of the value of their shares.

The current exchange rate of $1.98:£1 surely keeps CEOs of British companies awake at night. To mitigate this, some financial hedging strategies can be adopted. Rod Weaver, finance director of electronic car parts maker TT Electronics (TTG), says: ‘There is a range of derivative-type products available, which can hedge the effect of changes in the exchange rate, but these are only short to medium-term hedges. It is very difficult to hedge against permanent structural changes in the exchange rate.’ These can be fixed-time, fixed-rate forward currency contracts or complex options arrangements, but structuring them can also be quite expensive.

Aside from financial engineering tricks, the main currency-related risks are two-fold, according to Weaver: transaction risk, where margins are exposed to adverse currency movements until revenues and costs are all actually determined in the operative currency of the company; and translation risk, where both balance sheet values (in terms of shareholders’ funds and liabilities) and translation of profits are affected.

Weaver says that the best way to offset transaction risk is to have a natural hedge by matching costs and revenues in each currency, and, where possible, making sure that revenues are in the same currency as the cost base. The latter is more difficult to achieve when production is moved to low-cost locations such as China, India and Malaysia, as not all customers are keen to pay in yuan, rupees or ringgits. Wherever manufacturing operations are, though, it can be arranged for the supply of materials to be in the same currency as the revenue stream.

For a few dollars more

Therefore, companies that source their costs in dollars as well as selling their goods in dollars have less to worry about. Duncan Penny, chief executive of electronic goods manufacturer and distributor XP Power (XPP), says this is the case for his firm. ‘We are naturally hedged against currency movements. A big part of our revenues are in dollars, even when we sell to Europe, but at the same time almost all of our costs are in dollars. So when the dollar goes down, costs actually go down quicker than revenues, and the and lower revenues are offset by lower costs, with a slight improvement in margin.’

Penny highlights that with a company such as XP Power, that has both revenues and costs in dollars but reports in sterling, the decline in operating profit is purely the result of the translational effect, rather than an economic issue. Such companies may even benefit a little if sterling loses ground against the greenback in 2008, which is what many expect, and if the Fed’s hopes for a slow rebound of the US economy are realised, amid lower interest rates for businesses.

As for the translation risk, Weaver says that the risk of translating shareholders’ funds, which are accounted for through the reserves, can be offset by having liabilities in the same currency. If a subsidiary’s balance sheet is in dollars, it would make sense that it borrowed dollars. This way, if the income statement is in sterling, and the interest cost in dollars, a company can end up paying less and hedging against other translational effect. However, there are some tax rules that regulate how much debt a company’s subsidiaries can have on their balance sheets.

Weaver concludes that, while hedging the translation of profits by using derivative instruments can be effective, balance sheet hedges only work for the duration of each derivative instrument and should be viewed as a delaying tactic rather than a solution.

Falling with the dollar

A number of UK companies have seen their share prices take a battering over the past year following announcements that profits will be short of expectations due to adverse dollar movements. One eminent example is electronic components maker Morgan Crucible (MGCR), which saw its shares plunge almost 29% to 171p in the first three weeks of December after it said profits would be £6 million lower than hoped for 2007. Another electrical components maker, E2V Technologies (E2V), warned as early as October that dollar weakness would hit earnings, and the shares have lost 10% since then.

Dozens more British firms are exposed to the dollar. The most heavily exposed are engineering stocks such as Rolls Royce (RR.) or industrials such as can maker Rexam (REX), which saw its shares tank 27% to 394p since November last year, and reported problems caused by high oil prices and the weak dollar.

Some food and tobacco stocks are also exposed, most notably British American Tobacco (BATS), Diageo (DGE) and Cadbury Schweppes (CBRY), all of which have major interests in the US but haven’t warned about profitability yet.

However, it is not easy to work out how much of the dollar worries are already in the price of these shares, and how much of their decline is due to the general nervousness. Some bargains might be out there as investors have heavily sold off many shares due to dollar worries. Here is a list of what Shares believes are the five best oversold buying opportunities, with five to avoid (or short) if the dollar continues to slip.

The good...

Five buying opportunities

Diageo (DGE) £10.79

EPS growth: 21.5% 2008 PE: 18.3

Three-month relative strength: 0.8%

Sector: Food & Beverages

The shares of the maker of spirits, wine and beer have held up reasonably well this year, despite the general nervousness about retailers. Strong sales in the US, especially of scotch and gin, should keep up too, along with demand and, while the company admitted currency will affect 2007 results, it should be only marginally.

Shire (SHP) £11.19

EPS growth: 122% 2008 PE: 29.4

Three-month relative strength: -7.7%

Sector: Pharmaceuticals & Biotechnology

Shire’s large exposure to the US is in a sector where demand is unlikely to contract all of a sudden. The outlook for the company’s portfolio is promising, with new launches and deals due, and the share performance suggests that dollar worries may have been factored in. Bid rumours can lift this share as well.

Micro Focus (MCRO) 256p

EPS growth: 19.7% 2008 PE: 18.1

Three-month relative strength: -14%

Sector: Software & Computer Services

The company’s products and services allow firms to upgrade old IT systems without replacing the hardware. A lot of revenue is generated from recurring maintenance deals, which provides earnings visibility. Micro Focus reports in dollars, so a weak dollar doesn’t worry it much, and will also help it buy businesses in the US.

Ashtead (AHT) 80.8p

EPS growth: 447% 2008 PE: 6.04

Three-month relative strength: -26.9%

Sector: Support Services

Dollar woes and the fear of an exposure to the beleaguered US housing market have made Ashtead’s share price tank last year despite solid earnings prospects. The group, one of the world’s largest equipment rental firms, integrated some acquisitions and is happily profitable now, and the housing exposure is small.

Datong (DTE:AIM) 101p

EPS growth: 0.2% 2008 PE: 11.6

Three-month relative strength: -4.6%

Sector: Electronic & Electrical Equipment

While the weaker dollar dampened profitability at the interims in December, Datong is on track with its strong organic growth programme, as well as looking at acquisitions. New products are being launched and the specialist in surveillance systems is growing revenues steadily. The low valuation makes the shares good value.

...the bad and the ugly

Five to avoid or short

Electrocomponents (ECM) 202p

EPS growth: 11.2% 2008 PE: 14

Three-month relative strength: -22.9%

Sector: Support Services

The shares of the distributor of electrical components slumped last autumn as it posted slowing earnings both in the US and UK. This put the dividend under threat and the management recognises that trading in the US is not growing. With US exports pushed over imports expect more downside for companies like Electrocomponents.

Intercontinental Hotels (IHG) 861p

EPS growth: 23% 2008 PE: 18.7

Three-month relative strength: -13.8%

Sector: Travel & Leisure

The company maintains that it hasn’t seen a slowdown in demand from US customers, but the US exchange rate is reducing earnings, and Cazenove has downgraded its forecasts. In terms of demand, US consumers are not rolling in money and hotels bookings are the first thing to be cut in tough times.

Whatman (WHM) 194p

EPS growth: -4.13% 2008 PE: 15.9

Three-month relative strength: 0.1%

Sector: Healthcare Equipment & Services

Despite saying that it would buy back 10 million shares, the shares of the membrane specialist plunged at the interims last September, as the company flagged up currency issues and a lower order book. The full-year results should see little improvement. Lower earnings and the chairman’s departure in December added to concerns.

Reed Elsevier (REL) 672p

EPS growth: -28.3% 2008 PE: 19

Three-month relative strength: 10.9%

Sector: Media

The media giant enjoyed a rally recently amid news that it would return cash to shareholders. The business, however, is not exempt from the painful currency movements, as Reed Elsevier sources 55% of its sales from the US. Another dollar decline should prompt many investors to take profits from the recent massive gains.

Wolseley (WOS) 711p

EPS growth: 6.81% 2008 PE: 9.1

Three-month relative strength: -17%

Sector: Support Services

The plumbing merchant is massively exposed to the wrecked US housing market, as well as the weak dollar and high financing costs rising from acquisitions. The valuation may look attractive, but the sector has yet to reach the bottom, which makes the shares highly sensitive to any bad news coming from across the pond.