How Weak Currencies Can Create Big Opportunities For Brave Investors by Andrew Hunt, Better Value Investing: A Simple Guide to Improving Your Results as a Value Investor
Stories of collapsing currencies have been making the headlines recently as emerging markets struggle with high debts and tumbling commodity prices. The Turkish Lira, Brazilian Real and Russian Ruble have been hit particularly hard, with those currencies depreciating by 50 to 60% since 2010.
Anyone invested in these countries will have taken some very painful hits. However, history suggests that weak currencies often present incredible opportunities for long-term equity investors.
This very issue was explored by economists Dimson, Marsh and Staunton in the 2012 Credit Suisse Global Returns Yearbook. And here is the chart illustrating what they found:
Just look at the difference in dollar returns! It turns out that weak currency equities thrash strong currency stocks, with real returns as much as two to three times higher! The data is less clear for bonds.
These findings are pretty robust, working across different samples and periods, and using long data sets.
Why is this?
When you invest in a stock you’re buying a real asset – a combination of land, labour and capital. Investing in a real asset provides a natural hedge against currency volatility. For example, a factory in Brazil may become more competitive and more profitable as the currency falls, while the replacement cost of that factory is likely to carry on rising in relation to the local currency.
In investing terms, a falling currency (when combined with a falling or stagnant stock market) simply exacerbates the discount between the replacement cost of the real assets and their market price.
In the long run, those real assets have to make a worthwhile long run return, so pricing and profitability must eventually catch up, albeit with a lag.
As well as cheap real assets, wider economic crashes often set things up for an even better recovery. They take out competition, raise barriers to entry, and drive corporate restructuring and efficiency improvements alongside structural reforms at the macro level.
|A hypothetical example illustrating how extreme opportunities may be created|
Let’s imagine a Brazilian manufacturing company called Buggins do Brasil (BDB)
It’s 2010, and BDB goes and builds a BRL1bn factory.
The company is valued at BRL 1bn (i.e. book value = replacement cost), with investors assuming a 10% RoE, a real cost of equity of 10%, and earnings growing in line with inflation.
Fast forward to 2015, the currency has collapsed by 60% and the economy is in a mess.
But these are real assets: the replacement cost of the factory is now BRL2.5bn, even though it’s still on the books at BRL1bn.
Moreover, all the volatility, economic and geopolitical problems, and tightening capital availability have changed the real cost of equity to 15%.
In other words, no one’s going to up their capex or fund new competition till prospective returns get above that 15% real hurdle.
The result is that normalized expected earnings have gone from BRL100m (i.e. 1bn replacement cost x 10% cost of equity) in 2010, to BRL375m (i.e. 2.5bn x 15%) in 2015.
If the market cap has stayed at BRL1bn in the meantime, Buggins has gone from a normalized P/E of 10 to a normalized P/E of 2.7x!!
If (as is more likely), the equity has sold off as well, say to BRL500m, then Buggins is now on a normalised P/E of 1.3x!
When things turn, that could easily be the making of a ten-bagger.
Note that all of this happens with a lag. It takes a long time for economies to recover and for companies to implement reforms and pass through cost increases. That’s probably not much comfort for most investors, but for long-term investors the current macro troubles may be setting up some once-in-a-generation opportunities.
It is striking to compare Brazil’s current travails with the UK or the US in the 70’s – i.e. democracies with desperate and dysfunctional governments, rising debts, falling currencies, rising real interest rates, high inflation, violent cities, protests, and the worst recession in living memory.
Of course, if you’d invested in some of the best real estate bargains or a deep value fund back in the day, you’d have made a hundred times your money or more by now. But you would have needed nerves of steel.
Andrew Hunt is a portfolio manager with one of the UK’s leading investment managers. His new book, “Better Value Investing: A Simple Guide to Improving Your Results as a Value Investor” is available from Amazon.com and in good bookshops.