Currency Fluctuations

Currency Fluctuations (also known as Foreign Exchange Fluctuations) are the continuous and often unpredictable changes in the value of one currency relative to another. Think of the world's currencies on a giant, interconnected seesaw. When the U.S. Dollar goes up, the Euro, Yen, or Pound Sterling might go down in comparison, and vice versa. These movements happen in the foreign exchange market (Forex), the largest financial market in the world, where trillions of dollars' worth of currencies are traded every day. The price, or exchange rate, is determined by the classic forces of supply and demand, which are influenced by a cocktail of factors including national interest rates, inflation, political stability, economic health, and trade balances. For a global investor, understanding these fluctuations is crucial, as they can significantly impact the real returns on your international investments.

As a value investor, your goal is to buy wonderful businesses at fair prices. You might think currency movements are just noise, a distraction from analyzing balance sheets and competitive advantages. And you'd be partly right. But ignoring them completely can lead to some unpleasant surprises. Currency fluctuations can affect your portfolio in two main ways:

This is the most obvious impact. Let's say you're an American investor and you buy shares in a fantastic German car company listed on the Frankfurt Stock Exchange. You'll buy the shares in Euros (€).

• Scenario 1: The Euro Strengthens. You buy €10,000 worth of stock when €1 = $1.10. A year later, the stock is still worth €10,000, but the Euro has strengthened, and now €1 = $1.20. If you sell, your €10,000 is now worth $12,000. You've made a $1,000 profit from the currency movement alone, even with a flat stock price!
• Scenario 2: The Euro Weakens. Same situation, but this time the Euro weakens, and €1 = $1.00. Your €10,000 investment is now only worth $10,000 in your home currency. The currency fluctuation has erased $1,000 of your capital, creating a loss.

Your total return is always a combination of the stock's performance and the currency's performance.

You don't have to buy foreign stocks to be exposed to currency risk. Many of the biggest companies in your home country are massive multinationals. Think of a company like Apple or McDonald's. They earn a huge chunk of their revenue in Euros, Yen, and dozens of other currencies. When these companies report their earnings, they must convert all that foreign revenue back into their home currency (e.g., U.S. Dollars). If the U.S. Dollar is strong, each Euro or Yen they've earned translates into fewer dollars. This can make their revenue and profit growth look weaker than it actually is on a “constant currency” basis, which can sometimes spook the market and put pressure on the stock price. Conversely, a weak dollar can flatter the earnings of these multinationals.

So, what's a prudent investor to do? Panic? Start day-trading currencies? Absolutely not. The key is to be aware, not obsessive. As the legendary Warren Buffett has often said, if you have to worry about a 10% currency swing, you've likely paid too much for the asset in the first place.

Your primary job is to find high-quality companies with durable competitive advantages and strong management. Trying to predict short-term currency movements is a speculator's game, not an investor's. Over the long run, a great business will create far more value than what is gained or lost through currency wiggles.

When you analyze a company, take a quick look at its geographic revenue breakdown, which is almost always included in its annual report. This tells you where its sales come from. If a U.S. company earns 50% of its revenue in Europe, you know it has significant exposure to the EUR/USD exchange rate. This isn't necessarily bad; it's just a risk factor to be aware of.

Great multinational companies aren't sitting ducks. They actively manage their currency risk.

• Natural Hedges: A company might build factories and pay local workers in the same country where it sells its products. This way, its costs and revenues are in the same currency, creating a “natural hedge” that neutralizes much of the risk.
• Financial Hedging: Companies also use financial instruments like currency forwards and options to lock in exchange rates for future transactions, providing certainty for their cash flows. A management team that discusses its hedging strategy intelligently is often a sign of quality.

This is the value investor's ultimate defense. Buying a company at a significant discount to its intrinsic value provides a buffer against all sorts of unforeseen problems, including unfavorable currency swings. If a business is fundamentally strong and you bought it cheaply, it can easily withstand a period of currency headwinds and still deliver excellent long-term returns.

Currency fluctuations are a permanent feature of the global economic landscape. For the long-term investor, they are neither a friend to be courted nor a foe to be feared, but simply a variable to be acknowledged. Over decades, these fluctuations tend to even out. The real driver of your investment success will always be the fundamental performance of the businesses you own. Focus on finding those wonderful companies, buy them with a Margin of Safety, and let the currency markets do their chaotic dance. Your portfolio will be just fine.