Who profits from a weak pound?

Thanks to internationally diversified revenue streams many of the largest UK-listed companies had been touted as more solid investments than supposedly domestic-focused mid-caps. This, as argued in a recent Investors Chronicle editorial (IC, 15 July), is rather a sweeping generalisation, with many FTSE 250 (and indeed Aim) companies also conducting significant business overseas. Regardless of size, however, a commonly cited bull point for UK companies since the referendum has been whether they receive the majority of revenues in stronger overseas currencies, with special attention given to US dollar earnings.

At the most basic level, if a company sells its goods and services in one currency and banks its revenues in another, there will be a further gain or loss on the transaction depending on changes in the exchange rate. The transactional effect on profitability is amplified if costs are incurred and revenues received in weaker and stronger currencies, respectively. Thanks to this relationship, the low valuation of sterling could be favourable for the earnings of some companies and our stockpicking expert, Simon Thompson, has identified a number of opportunities since the Brexit vote (see 'Brexit: reality check', 28 June 2016). At the upper end of the capitalisation scale, many FTSE 100 companies have seen their share prices rise on the back of their proportionately high overseas earnings, but are they attractive simply because their profits are less dependent on UK growth or is there a currency benefit, too?

Transaction and translation effects of currency fluctuations

Especially in the case of large multinationals, cost of sales, administrative and distribution costs are often incurred all over the world and in multiple currencies. With the need to manage these expenses, many FTSE 100 companies will conduct operations in one or more 'functional' currencies. Sterling will not necessarily be the most important of these so, for some companies, the weak pound is not significant to their operations. A glance at the best performing FTSE 100 shares between 24 June and 24 July 2016 shows that mining stocks have done particularly well. For most of these companies, output is valued and revenues are earned in US dollars, and the value of commodity currencies such as the Australian and Canadian dollars have a far more material impact on costs than sterling.

As far as UK investors in mining stocks are concerned, the weak pound has a translation, as opposed to a transaction, effect on their returns. Often the ‘presentational’ currency for mining companies’ financial statements is the US dollar. Shareholders’ claim on companies’ profits, earnings per share (EPS), is therefore given in dollars. The shares on the London Stock Exchange are priced in sterling, so there is a translational effect on valuation multiples. An important point to note is that companies will report based on the exchange rate at the time of transactions over the previous year, so reported earnings are not going to be based on the latest price of the pound. Where valuation multiples are affected is in analysts’ forecasts of future earnings if the expectation is for the pound to be lower for longer.

The justification for higher share prices when the pound is weak is that going forward EPS will be higher when converted and hence the forward price/earnings (PE) ratio will be lower. As the market adjusts to reach a fair value and the sterling price of the shares increases, investors make a gain on their holding. The buying of shares in dollar earners is therefore driven by anticipation of profit upgrades, rather than what has already gone before.

As well as a claim on profits, shareholders own the underlying assets of a company. Shares quoted in sterling may be trading at a discount to book value, once the worth of dollar assets is translated into sterling, so again there can be price gains for investors if the market adjusts to reflect the new currency relationship going forward. Of course, many different factors influence share prices; in the case of mining stocks a partial recovery in commodity prices and the covering of short positions by hedge funds are key factors. That acknowledged, it is probably fair to say currency translation plays a part in the rise of sterling denominated share prices.

Another sector that has stood out since the EU referendum is pharmaceuticals. Drug companies are well-known for their defensive qualities and sales are inherently global in nature. Again, with costs international, a weak pound doesn't necessarily mean transactional benefits for operational profit. Conversely, a strong dollar can actually have an adverse impact on sales as products become more expensive in other local currencies. In its pre-Brexit briefing back in April, Liberum Capital said it expected the main currency impact of a leave vote to be translational. It predicted that the earnings of companies like GlaxoSmithKline (GSK), who report in sterling, would be given a boost on paper by the cheaper pound. When it comes to valuation multiples, the share prices of UK-listed companies will be in pence anyway, so it is necessary to translate dollar reported earnings into sterling to work out the PE. So, even though dollar reporters such as AstraZeneca (AZN) may not experience the translation effect line by line in their financial statements, the share price can still be driven higher on account of the translation of EPS.

Where companies report in sterling but conduct significant activity and hold a high proportion of assets in other currencies, there are going to be more translational effects in the financial statements, which can have an obfuscating effect. Non-cash reporting items such as depreciation, inventory, payables and receivables all affect profitability. Understandably, this is an area that international accounting standards monitor closely, and Rule IAS 21 governs how companies should report figures affected by currency movements. Nevertheless, it is still important for investors to consider cash profits, as well as accounting profits, when compiling the full investment case for a company.

Special attention should be given to non-cash items in a company's financial statements, especially when an occurrence like the drastic fall in sterling could affect their value. The accruals concept in accounting means that revenues and expenses are recognised as they occur and not necessarily when they are settled. Having receivables outstanding exposes companies to the risk that when revenues are realised as cash, the exchange rate may have changed and profits are not as stated. This is, however, a common operational risk and many companies will have hedging arrangements in place to mitigate adverse currency swings.

Currency and companies' investment and financing activities

Another contributor to net profit is the returns companies make from investment activities. If interest or dividends get paid in foreign currency, this source of income will be subject to a transaction effect. This is likely to be just a small amount in terms of overall income, so shouldn't be the most important aspect of the investment case for the majority of companies.

Of greater significance to shareholders will be the impact of currency on financing activities. The overall cost of capital will dictate expenditure plans and movements in exchange rates may reduce the cost of debt interest, relative to the currency revenue is earned in. The Trader made an important point recently, that interest rates are the cost of money and exchange rates are the value of money. Companies will tap a number of capital markets, seeking arbitrage opportunities between interest and exchange rates, to secure the most efficient sources of funding.

Looking at the trade-off between equity and debt, if borrowing is cheap and payments are further offset by benign exchange rate conditions, then the capital structure of a company may alter. This means that investors need to think about how they evaluate company performance. The return on capital employed (ROCE) is a full measure that gives operating profit as a percentage of debt plus equity. Such fundamental analysis shows how well the company is doing without prejudice to capital structure and reflects the quality of an investment.

Quality indicators remain the same

Ultimately, currency movements are just one of a number of macro factors that need to be considered. Momentous events such as Britain's decision to quit the EU are bound to have an immediate impact. The market's revaluation of the pound has provided part of the impetus for the increase in share prices, especially for companies with an international focus. As is the case with mining stocks, however, there are often other factors at play and it is an oversimplification to assume companies making most of their revenues in dollars will outperform.

If the view is taken that a weaker pound is more than a short-term reaction to the Brexit vote, some of the increase in FTSE 100 share prices can be taken as a one-off adjustment of valuations to reflect the translational effect on earnings and assets. Going forward, when picking companies for which a cheap pound is a definite bull point, the focus should be on those businesses that enjoy transactional benefits. As ever, the distinction needs to be drawn between cash and accounting profits and there is a quality checklist that investors should apply to companies, regardless of the source of revenues.

Cash check-up: The translational effect of the pound's fall in value affects payables, receivables, depreciation and inventories. Deducting non-cash profits and adding back non-cash expenses will really show up whether transactional currency benefits are occurring in business operations.

Watch out for operational gearing: The operational gearing ratio subtracts variable costs from revenue and divides by profit. This shows how vulnerable a company is to increases in fixed operating costs. If these costs occur proportionately in a weaker currency, giving a transactional benefit to profits from overseas sales, this will show up in a lower ratio.

The acid test: Another ratio that shows up the benefits to a company of favourable currency transactions, the acid test subtracts inventory from current assets and divides by current liabilities. Ignoring inventory, it shifts focus to only the most liquid of companies' assets and gives a truer reflection of solvency. Currency changes may affect the value of current assets and current liabilities, so this is a good measure for assessing the health of a business.

Ability to meet obligations: Unhedged currency exposures can also affect the ability of companies to pay loans. The value of debt minus cash and current investments relative to shareholders' equity (the net debt to equity ratio) can be altered by currency translations. Also of concern to investors will be the interest cover on loans. This is operating profit plus receivables, divided by interest payable. If there are transactional effects on profits and the cost of debt repayments, this will have an impact on profitability and net cash position.

How well covered is that dividend? As we have seen, currency movements can have a translation effect on accounting profits, which means higher earnings per share; on paper, signalling greater dividend cover. This can be misleading, however, if there has not been significantly more cash generated with which to fund payouts. Of course, where there is a transactional boost to profits, this is going to have a positive cash impact. This, in turn, begs the question of whether shareholders are happy to see such a gain recycled into the business or would prefer an increased dividend.

Check out the consensus on future growth: With the pound worth less than in the past, there is some justification for the re-rating of share prices to reflect the value of dollar-denominated assets or earnings. The immediate impact of sterling's post-referendum drubbing aside, in the longer term the fundamental justification for a share price is the expectation of future cash flows. This means the anticipation of earnings growth and possibly higher dividends. A useful ratio to monitor here is the price/earnings growth (PEG), which divides normal PE by the consensus expected growth rate in earnings. Companies expected to benefit in the long term from transactional gains thanks to the weaker pound may, in the absence of other offsetting factors, have a better (lower) PEG.

Watch out for a dilution of earnings: Some companies may have had outstanding options or warrants on their equity stock, which have been triggered by higher share prices. Companies will, of course, recognise this in published financial statements as it is prudent to assume outstanding claims on stock will be exercised. For investors, it is worth monitoring the dilution effect on EPS and dividends, as without the fillip of a genuine transactional boost to cash profit, returns will suffer.

Of the best and worst FTSE 100 performers in the first month since the referendum, dollar earners are doing well.

Topping the list of best performers is ARM Holdings, thanks to the impending takeover by SoftBank. Otherwise, the most significant risers have been miners, which have notably low sterling exposure - although the sector is also rebounding after last year's dismal lows. Similarly, energy companies, buoyed by crude's recovery in 2016, benefit from their products being dollar-denominated. Pharmaceuticals, notable for their high proportion of overseas earnings, have performed well too.

On the downside, companies with a heavy sales focus on the UK have seen their share prices fall. The FTSE 100's worst performing share since 24 June 2016, easyJet (EZJ), appears caught in a perfect Brexit storm. Most of its revenues are in sterling, while fuel costs are in dollars; its customers are sensitive to a weaker pound; and then there are the potential recessionary consequences of Brexit.

Housebuilders, banks and home improvers were also heavily discounted in the past month, on fears that the UK's house price boom is being derailed. Food and general retailers such as Marks and Spencer (MKS) and WM Morrison (MRW) have suffered too. The latter two cases could in part be because of the increased sterling cost of sourcing goods from suppliers, although given the power supermarkets have over their suppliers the true impact of this will not be known right away.

The FTSE 100's best and worst performers 24 June to 24 July 2016

Source: Bloomberg