International Investing & Currency Hedging
US investors in non-US stocks have a choice when considering the impact of currency movements on returns ‐ to hedge or not to hedge currency risk. As long-term, intrinsic value investors, we carefully evaluate the impact of currency when estimating the intrinsic values of our holdings in the International strategy. However, we choose not to hedge currencies because the costs do not seem to justify the benefits for investors with long time horizons.
We recently discussed currency hedging in some detail with members of our international research team. Here are their perspectives.
As investors in non-US markets, do you hedge currencies? If not, why?
Yiting Liu, CFA: For the Diamond Hill International strategy, we do not hedge currency exposure. We have made a conscious decision to leave the hedging decision to our end clients for several reasons.
First, studies have shown that over the short term, currency movement is extremely difficult to forecast accurately and consistently.
Second, over long periods of time, studies have shown that the return difference between a currency hedged portfolio versus an unhedged portfolio in the international equity asset class is marginal.
Finally, currency hedging is not free and the costs, in our view, do not justify the marginal benefits.
How are companies impacted by currency movements?
Chris Piel, CFA: Companies are impacted in several ways by currency movements. Most common are translation and transaction effects.
For translation, take a company that is domiciled in Europe and has operations in the US, for example. At the end of a reporting period, the company will take the sales and earnings generated in the US and translate those US dollars back into euros. Depending on the exchange rate at the time of reporting, this translation can have a positive or negative effect on the company’s financial statements.
Transaction effects arise due to the lag period between the timing of invoice and the actual physical delivery of payment for goods and services completed. Using the same example from above, the USD/EUR FX movement — that occurs between when the US customer was billed and when payment was received — will add either a positive or negative impact on this individual transaction by the time the US dollars can be converted back into euros.
Some companies choose to hedge their currency exposure, for both translation and transaction effects, and others decide not to hedge.
At Diamond Hill, we try to assess our currency exposure at the overall portfolio level. As US-based investors, we’re making a collection of US dollar investments in companies in different countries with different currencies that trade on different exchanges. For example, one of our portfolio holdings is Tesco, a UK retail grocery store chain. To buy shares of Tesco, which trade on the London Stock Exchange (LSE), we have to covert our US dollars into British pounds and purchase shares on the LSE in British pounds. When it comes time to exit the position or sell shares of Tesco, we need to unwind our position and translate our British pounds back into US dollars. This translation effect will add an extra positive or negative impact on this investment based solely on the movement between the US dollar and the British pound over the course of our holding period.
Under this backdrop we have a decision to make. We can decide to hedge our portfolio currency exposures — and there are various ways to do so — or we can choose not to. As Yiting mentioned, hedging is not free, and it can be quite costly to do it right, especially with those currencies that pose the greatest potential risk, whether because of liquidity constraints, political instability or a less transparent monetary authority. We have decided as a team that we add more value finding businesses that trade at attractive discounts to our estimate of intrinsic value than we do trying to predict foreign currency fluctuations. In addition, we have learned that currency impacts on stock returns tend to be de minimis over long enough periods of time within a diversified portfolio; and for these reasons, we've decided to not hedge currency exposure for the international strategy.
If you don’t hedge currency, how do you incorporate risks associated with currency volatility?
Yiting Liu, CFA: At the end of the day, it's about a company's ability to compensate for or offset currency headwinds. For example, I cover some of the global luxury goods companies in the portfolio. Businesses like LVMH or Richemont have been able to offset currency headwinds in select markets through price increases for certain brands where demand is relatively strong.
There are also business models out there that offer a natural hedge against currency depreciation. For example, we used to own a Mexican airport operator that owns the concession rights to run the Cancun airport. When the underlying currency (Mexican peso) of that airport operator depreciates, this is usually not a good thing for US investors due to the translation effect Chris mentioned previously. However, there are some natural offsets built into the business model. When peso depreciates, foreign tourists will take advantage of the depreciation because it’s cheaper to travel. In turn, passenger traffic or volume rises, which drives top line revenue growth for the airport operator. Moreover, duty-free sales to passengers at airports are transacted in US dollars, which translates into more revenue when the local currency depreciates.
Chendhore Veerappan, PhD, CFA: Another example is on the health care side. We own several global pharmaceutical companies — GSK, Roche and Novartis. In examining these companies’ annual reports, they operate dozens of subsidiaries in different countries. These companies try to balance out the receivables and payables in the local or foreign currencies. Given the volume of these transactions, it is nearly impossible to model their currency transactions on a practical basis quarter over quarter. With large companies such as these that are earning revenues in excess of $30 billion to $40 billion, the small revenue streams coming from different markets makes it pretty tricky to model even if you try to do so.
5 Currency Risk Considerations
Choosing not to hedge currencies doesn’t mean we ignore the impact of currency. How currencies may impact the strength of a balance sheet or could alter a company’s competitive position, cash flow generation potential or cost structures — among other factors — can often impact our long-term estimate of intrinsic value. Here are five ways we take currency risk into consideration for each individual investment opportunity.
- Be cognizant of currency risk and why that risk exists.
- Be selective in countries where you take a direct investment exposure.
- Understand natural hedges that exist within a business.
- Build currency risk into your valuation assessment and apply an appropriate discount.
- If necessary, demand a higher margin of safety (i.e., discount to intrinsic value).
As of 30 September 2022, Diamond Hill owned shares of Tesco plc, LVMH Moet Hennessy Louis Vuitton SE, Compagnie Financiere Richemont SA, GSK, Roche Holdings AG and Novartis AG.
The views expressed are those of the authors as of October 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal.