Lost In Translation – More Than Just A Strong Dollar? by Tom West, Columbia Management
- The strong U.S. dollar has weighed on the results of global firms that report in dollars. But investors think there may be some end-market weakness hiding in the currency translation effects.
- Following years of impressive pricing discipline and upside profit surprises due to cost cutting, it seems that more and more companies are describing a need to invest in the business.
- In the long run, that’s not all bad. One company’s investment expense is another’s revenue.
As of this past Friday, a little over 75% of the S&P 500 companies will have reported results for the last quarter of calendar 2014. With the U.S. dollar up strongly over the past several months, there was concern that currency translation effects, “FX,” would cause disappointing results, and indeed it did. But I think investors detected some end market softness and profit margin strain hidden amongst the currency effects.
A little background: A global, U.S.-based company sells products at home and around the world. It may export products, or it may have foreign subsidiaries that produce and sell in those markets, other foreign markets or even back to the U.S. Whatever its global footprint, it reports the sum total of its financial results in U.S. dollars. These are big complex companies. And while their basic flows are known to investors, outsiders can never pinpoint the precise effects of hedges, cost footprints, supplier arrangement and timing differences. While investors would like more details, we also have the view that we should not be unnerved or excited by currency-related moves. So with the dollar up sharply against other currencies, the market should have been prepared for weakness in the form of foreign revenues translating into fewer dollars, and foreign profits down, but to a lesser extent than revenues due to hedging and foreign costs also being lower when measured in dollars.
Still, more often than not, the shares of companies with these profiles often went down when results were reported. It is said that bad news is never fully priced in until it actually hits. But I think there have been a few other factors at work. In some cases, it seemed like there was some end-market weakness hiding in the numbers. If foreign profits are lower than expected, was it due to hedging and timing differences? Or were those end markets experiencing softer sales and pricing? Some global tech and consumer companies seemed like they might be experiencing this. Also, some companies have enjoyed higher profits and lower taxes outside the U.S. than at home. With the U.S. economy doing relatively well, this is an adverse “mix shift” in the business, and it’s harder to dismiss than currency moves.
I think the angst over FX is an acute symptom of a broader issue that I have become more worried about over the past year. Following years of impressive pricing discipline and upside profit surprises due to cost cutting, it seems that more and more companies are doing just fine – but, in one form or another, they are describing a need to “invest in the business.” This can take the form of passing cost savings to the customer rather than the shareholder, completing some needed hiring or investing in various systems. In the long run, that’s not all bad. One company’s investment expense is another’s revenue. So, at least in the U.S., I would be lowering my expectations for profit margin growth, but feeling better about investment spending and hiring. This is not necessarily bad for equities. Limited progress on profit margins may be offset by a better outlook for jobs and investment.