How does the falling pound affect UK companies?

Yet that was the reaction to a growth plan featuring so many unfunded tax cuts that it requires the Treasury to borrow an extra £161bn over the next five years, on top of the estimated £60bn it will cost to hold down energy prices over the next six months, according to MUFG.

The pound fell to as low as $1.035 on Monday before recovering to around $1.08 by Tuesday, still down 20 per cent year to date.

Yields on 10-year gilts soared from just below 3.5 per cent at Friday’s opening to a peak of over 4.3 per cent earlier this week. 

Although higher borrowing rates are generally bad for equities, the outward-looking nature of the FTSE 100 meant the fall in value of the UK’s main market index was not quite as severe as the reaction on currency and bond markets. After a drop of almost 2 per cent on Friday, the benchmark has been largely flat this week.

One saving grace is that UK equities were already valued at a significant discount to peers. The FTSE 100 trades off a forward price-to-earnings ratio of 8.8, compared with 15.7 for the S&P500 and 12.3 for the Euro Stoxx 50 indices.

International rescue

Another is the global nature of the UK’s main benchmark. Around 40 per cent of the companies that make up the FTSE 100 are based overseas. Overall, the FTSE 100 has a strong inverse correlation to the pound given that its constituents generate almost 80 per cent of their revenues outside the UK, as Thomas McGarrity, head of equities for RBC Wealth Management in the British Isles, noted

For companies that report in dollars (roughly 40 per cent of the index), there will be no significant change to earnings or balance sheet strength but the dividends they offer will be of more value to UK investors. Moreover, when cash flow or earnings per share in cents is translated into the weaker pound to value shares, it could justify a higher rating, said Investec Wealth’s head of UK equities Guy Ellison.

Companies that earn large amounts in dollars but present their results in pounds are likely to see significant uplifts in reported numbers as the year progresses, agreed Vivek Raja, an analyst at Shore Capital.

The pound fell by 3 per cent against the dollar in the first quarter of the year. This accelerated to 8 per cent in the second quarter and to around 11 per cent so far this quarter. 

As a result, “the propensity to beat” earnings expectations for such firms is likely to increase, he said.

“For those default dollar earners reporting in sterling, Q3 and Q4 [are] really, really important,” Raja said. “This is going to be a massive source of potential beats and upgrades.”

Screening UK-listed companies based on how much of their revenue is earned internationally throws up plenty of potential winners and losers – both in terms of sectors and individual companies – but currency movements need to be considered within a broader investment context.

For instance, many energy companies earn almost exclusively in dollars. However, the strength of the greenback has proved to be a drag on oil prices, with Brent crude futures down 27 per cent over the past three months.

Also in the upper echelons of international earners are manufacturers like Weir Group (WEIR), Spirax Sarco Engineering (SPX) and Halma (HLMA), which generated North American revenues of 32 per cent, 35 per cent and 36 per cent respectively in their most recent reporting periods.

Most companies typically don’t break down costs geographically, but as long as they are “commensurate” with the amount of business generated within each market they should make gains if a significant chunk of overheads such as head office and listing costs are in pounds.

Other major foreign currency earners worth considering include consumer staples companies like Unilever (ULVR), Reckitt Benckiser (RKT), Diageo (DGE) and British American Tobacco (BATS), said Josh Mahoney, senior market analyst at IG Group. These have the added advantage of being “largely recession-proof” in terms of demand outlook, he argued. The big UK healthcare firms possess the same qualities, RBC Wealth Management’s McGarrity said.

The main losers from the decline in sterling are the domestically-focused retailers, particularly non-food operators such as Next (NXT) or B&M European Value Retail (BME) that often buy and ship in dollars but sell in pounds. Shares in both are down by more than 7 per cent since Thursday’s close. 

In the short term, many retailers will be insulated from currency swings as stock for the key Christmas period will already have been bought and shipped, and hedging practices will also help. But if the weakness in sterling persists this will feed into higher input costs next year, Ellison said.

Bargain hunt

The other major consideration for equity markets is a potential resurgence in bids for UK companies. Although the uncertain economic environment and rising finance costs “reduce the propensity to do deals”, the discounts on offer for dollar-denominated buyers may prove too tempting, said David Cumming, head of UK equities at Newton Investment Management.

Besides, overseas acquirers "are buying into corporate UK, not the government", WH Ireland's chief investment officer Ian Brady added.

The share prices of Spirax Sarco and Halma are down 37 per cent and 36 per cent respectively this year, but in dollar terms they have slipped by 50 per cent and 43 per cent.

Both would be attractive targets to a private equity buyer, given their “very strong” balance sheets, Ellison said. Other businesses that look cheap include Greggs (GRG), Dunelm (DNLM), Dr Martens (DOCS) and Travis Perkins (TPK), he added.

“There’s definitely going to be private equity still kicking around in terms of M&A opportunities and I suspect they’ll be looking at sterling assets right now,” Raja said.

Although raising debt could prove tricker for PE firms as interest rates rise, the industry is still sitting on several years’ worth of “dry powder” they need to deploy, he added.