Shah Gilani

When specialty-chemicals-maker H.B. Fuller Co. (NYSE: FUL ) announced its third-quarter results earlier this month with earnings and revenue coming in well below expectations company shareholders suffered an 8% haircut in a single day.

Rising raw material costs appeared to be the headline reason for turbulence at the company. But there was another culprit a frequent flier in cases of earnings shortfalls, but one that often remains unseen and misunderstood.

I’m talking about exchange-rate risk.

U.S. investors don’t realize it yet, but the level of exposure to exchange-rate fluctuations facing big American companies as well as those based overseas is steadily increasing. So what happened to H.B. Fuller and its shareholders is going to occur with increasing frequency. And in many cases, the fallout will be much more severe.

Global Gains Spawn Currency Pains

As U .S. investors increase their appetite for global stocks, bonds, mutual funds and even exchange-traded funds (ETFs ), they are simultaneously increasing the exchange-rate risks they face due to fluctuations in foreign currencies.

In H.B. Fuller’s case, unfavorable currency-translation effects reduced revenue growth by 3.1 percentage points. a key reason the company’s $338.6 million in third-quarter revenue was nearly $10 million less than analysts had expected.

It’s a fair wager that the bulk of U.S. individual investors have no idea that most of their investments now expose them to volatile currency swings. And it’s not just from disappointments like H.B. Fuller. In the worst cases, negative currency impacts could wipe out a company’s earnings, undermine the competitiveness of its products, or in extreme cases force a company into bankruptcy.

But the real danger ahead may well stem from situations in which positive changes in exchange rates make a company’s sales, net profits and earnings per share appear much stronger than they actually are. That sets an investor up for a rude awakening and a haircut down the road.

For investors who didn’t previously realize that their portfolio contains huge currency risks, consider this your wake-up call.

Generally speaking, the more active a company is overseas, the more sensitive it will be to currency fluctuations.

In a research study that utilized data from MSCI and Standard and Poor’s. The Charles Schwab Corp. (Nasdaq. SCHW ) concluded that over the past decade when the dollar was down, foreign-market returns were boosted by 7% to 18%; and when the dollar was up, foreign-market returns were reduced by 3% to 16%.

Most of the companies in the Standard & Poor’s 500 Index and all the companies in the Dow Jones Industrial Average do business in the international markets. They buy components from foreign suppliers, sell goods and services to customers abroad, or own overseas affiliates themselves. Some of the biggest U.S. companies derive 30% to 70% of their revenue from outside U.S. borders.

And it’s not just U.S.-based multinationals that face currency-exposure issues. Any company that operates outside its home market is going to have to deal with the effects of shifting exchange rates.

That means that investors who own shares in that company face the same currency risks they probably just don’t realize it.

Understanding Exchange-Rate Risk

Companies face three types of currency exposure:

• Translation Exposure : This is the actual conversion of one currency into another (for accounting and reporting purposes), or the actual translation of one currency into another,which occurs when overseas earnings are converted into the home currency.
• Transaction Exposure . This occurs whenever a transaction,at present, or in the future, has to be settled.
• Business or Economic Exposure : While translation and transaction exposure are more micro (specific) in nature, business or economic exposure is more of a big-picture macro risk. In this case, foreign-currency differentials affect a company’s competitive position in terms of its costs of production, profitability of sales in the markets where it does business, and the value of balance-sheet assets.

In today’s multinational corporations, managing foreign-currency exposure has evolved into one of the key responsibilities of the chief financial officer (CFO). Former Microsoft Corp. (Nasdaq: MSFT ) CFO John Conners recently lamented that foreign-currency management is one of the most-difficult and least-understood jobs in finance. If CFOs struggle with currency exposure, we’re all in trouble.

Take Toyota Motor Co. (NYSE ADR: TM ), for example. While Toyota’s recent negative publicity over safety issues and quality standards sent its stock down, many investors saw value in the company’s fall from grace and bought the stock to play its rebound.

But it’s possible those investors failed to think this move all the way through. Fixing Toyota’s safety and quality issues might be easily accomplished; however, an astute investor would look beyond the recent recalls and examine the currency exposure that’s -part and parcel of an investment in Toyota shares.

The Japanese yen recently reached a 15-year high against the U.S. dollar. That means that it now takes more dollars to buy yen than it did before, which translates into a higher cost to American buyers of Toyotas.

Some of that currency headwind for Toyota can be mitigated through currency management: Toyota can build and sell cars here in America. using this U.S. revenue to pay its American workers and build more U.S. factories (negating the need to exchange any currencies). But that only goes so far: Eventually, the dollars earned here have to be translated back into yen, even if just for financial-reporting purposes.

According to Toyota, for every yen above an assumed dollar rate of 90 yen to the dollar (meaning one dollar can buy 90 yen), Toyota says it loses 30 billion yen ($357 million) in operating profits.

However, the yen has since risen in value, making it more expensive; a dollar now buys only about 84.5 yen. If that exchange rate holds, Toyota’s expected 330 billion yen operating profit for its fiscal year ending in March 2011, will be half of that.

How does that Toyota investment look now?

Then there’s The Coca-Cola Co. (NYSE: KO ). Coke’s second-quarter numbers announced July 22 were really good. In fact, they beat expectations.

But how pure were those numbers? In other words, was Coke’s upbeat report due to higher sales volumes, or did favorable exchange rates make the company’s sales look better that they were in actual volume terms?

If you happened to listen in on Coke’s second-quarter conference call, Gary Fayard. the company’s CFO, actually answered that question when he noted that despite recent volatility and some key currencies, we once again benefited from currency in the second quarter.

According to Fayard, on a year-to-date basis, operating income was up 16%. However, shifting exchange rates provided Coke with a nice tailwind: Six percentage points of that 16% gain came to the company courtesy of positive currency-translation shifts.

On a year-to-date basis, gross profit was up 9% with a full four percentage points of that gain due to currency translation.

So while Coke’s numbers were good, the posted gains weren’t solely due to improvements in the company’s business and the results wouldn’t have been nearly as good without the benefit of positive currency translations.

Coke shares which closed at $54.08 the day before the announcement rose 1.6% the day of the earnings release (even more impressive given that the Dow got trounced). And the shares have been on a roll ever since, closing yesterday (Tuesday) at $59.10, which is just below their 52-week high of $59.45.

That’s all well and good. But the exchange-rate pendulum swings both ways and, given that Coke is a global brand, the company could just as easily see its earnings get trounced by a negative currency swing.

Fayard, the Coke CFO, tried to placate such concerns about future earnings by stating that the company would expect currency to have [only] a low-single-digit negative impact on operating income starting in the third quarter.

But here’s the real question: Does he know for sure?

Absolutely not. Assumptions about currency translations are just that assumptions. What’s noteworthy for investors is that analysts and CFOs make assumptions about currency translations in the future based on things like internal models, and something that’s known as the unbiased forward currency rate , which is derived from actual forward hedging transactions conducted by banks on behalf of big corporations.

There are literally thousands of examples we could illustrate these points with. The name of the company doesn’t matter. But here’s the reality: If a company has foreign-currency exposure and you invest in that company then you face exposure to the foreign-currency markets that you very likely don’t even realize.

As the H.B. Fuller example shows us, in today’s stock-market environment, with its short-term-trading bias, any company missing its numbers because of negative currency translations will be hammered. And it won’t matter a bit if the CFO tries to placate investors by saying that the company sold record amounts of goods, or booked record revenue for its services.

Investors want to know that management has control over currency exposure.

Unfortunately, most companies do not.

You Can Run, But

The closest an investor might come to having no foreign currency exposure would be if he or she bought shares in a U.S.-based company that only uses U.S.-made parts in its products and that only sells its wares here in the U.S. market.

While that’s theoretically possible, it’s not very likely: For instance, even if the parts supplier is American, the odds are good that somewhere back in its supply chain you’ll find a foreign raw-materials provider, or an overseas component-maker for semiconductors, or electronic components, for example.

But even a U.S.-only company faces currency risks.

Why? Because if the U.S. dollar is stronger than the currency of a foreign manufacturer of the same goods as our theoretical all-American company, imports of the relatively cheaper foreign-made product can challenge the U.S. maker’s dominance at home. If imports can be brought in cheaper, they can also be sold cheaper over here, allowing importers to increase their market share.

If the exchange-rate differential is large enough over a long-enough period of time, all other things being equal, your investment in the American company may not be as profitable as investing in its foreign competitor.

While things like comparative advantage, which stems from labor cost differentials and proximity to raw materials, gives some manufacturers of components or finished goods a leg up on their competitors, differences in foreign exchange, or forex, rates have even greater overall impact.

Any comparative advantage that a foreign manufacturer has can very quickly be cancelled out by a rise in that manufacturer’s home currency, relative to the currency of the buyers of its products. Even a country such as China that has cheap labor and access to plentiful raw materials which it buys with the foreign currency reserves it has built up from its massive exports -would find it tough to sell its products on world markets if the cost of converting buyers’ currencies into the Chinese yuan made Chinese exports expensive.

Right now, because it’s enjoying an export bonanza. China is determined to keep its currency cheap relative to the U.S. dollar and other world currencies. The United States isn’t happy about having to compete with China’s cheap exports and wants the country to increase the value of its currency relative to our dollar.

So, now ask yourself, will China still be a good investment if the dollar drops and the yuan appreciates?

Action to Take . There are two points that we repeatedly return to here in Money Morning :

• Now, more than ever, investors must understand that we operate in a global economy. Some of the biggest profit opportunities will come from beyond the U.S. borders.
• And investors who really want to succeed must learn to follow the money to watch for the liquidity flows that can pump up the markets they flow into, while dropping those the waves of capital move out of.

The global currency markets are perhaps the most-clear embodiment of those two points. Investors who wish to truly succeed today must understand at least the basics of the currency markets, since that’s a key to global money flows.

But there’s a catch: The increasingly global nature of the financial markets U.S. investors now invest in as well as the investment choices the face mean that exchange-rate risk is something individual investors need to learn about, to understand and to take steps to mitigate.

There are steps U.S. investors can take in order to mitigate currency exposure in their portfolios.

Indeed, understanding how and when to protect yourself from volatile currency moves will be the subject of next week’s installment of this Currency Matters series, in which we’ll look at navigating the ever-increasing currency risks that U.S. investors fail to realize they’re taking on.

Now that you get the big picture, next and final installment of our Currency Matters series will focus on some of the specific steps you’ll need to take to mitigate these risks.

[Editor’s Note. Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready — and so were subscribers to his new advisory service: The Capital Wave Forecast . The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster capital waves now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani’s capital-wave-investing strategy — and the profit opportunities that he’s watching as a result. And take a look at some of his most-recent essays, which are available free of charge. Those essays can be accessed by clicking here .]

News and Related Story Links :

• Money Morning Currency Matters Series:

Currency Exchange Rates and Your Investments: What You Don’t Know Can Hurt You