How can small business deal with today’s currency fluctuations?

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

Right now it’s no secret that selling merchandise to Americans is pretty lucrative.  We also know that it hasn’t always been this way.  A relative of mine who sells lighting products to customers the U.S. is a case in point.

My brother-in-law built a very successful business with his wife from the ground up.  Their decision to sell to markets in the US worked fine, but the real boost to sales occurred when their son joined the business and talked them into selling on the Internet.  Online sales boomed, but of course so did their company’s vulnerability to exchange rate risk.

A few years ago, he was struggling to make his usual margins (which are not that big at the best of times) when the CAD/USD exchange rate approached par.  In other words, a C$ was pretty much equal to the US$.  Cross-border shoppers from the Canadian side of the border were in heaven (myself included), whereas exporters were beginning to panic.  After all, their costs were still in Canadian dollars, which was an advantage when they received sales revenue in a much stronger $US.  Converting back into Canadian currency provided a substantial bonus to their profits and quality of life.

Things are great once again, but how can a smaller business owner(s) plan ahead to make sure that currency risk doesn’t threaten their livelihood?

The graph below illustrates the impact currency can have on a business.  Imagine a fictional Canadian company that began selling a specialty cheese to the U.S. marketplace in June of 2006. The sale price stays the same (due to competitive pressures) at US$ 2.50.  Costs are steady in C$ 1.98 range.  Sales made in US dollars must be converted back to Canadian dollars.  
USD-CAD sales and profits
It is easy to see how just the exchange rate can wreak havoc on a businesses revenues and profitability.  Is it possible to anticipate or prevent this volatility?  When companies are accustomed to very large orders, it is possible to contact your bank and make arrangements to use the currency forward markets in order to ‘hedge’ your profits.  For instance, if one expects to have to convert a significant amount of foreign currency into one’s domestic currency once the order is delivered, you can arrange to lock in the forward exchange rate today, thereby knowing exactly what your margin is (and will be).

However, the orders for most small businesses aren’t large enough to make hedging a viable option. Can you plan for currency fluctuations?  Experts agree that there is no robust way to forecast exchange rates.  Experts have been frustrated trying to predict exchange rates for years, and the forward markets/futures markets are not very good predictors of the exchange rate that will actually occur in 3 to six months.

One approach that has been around (seems like forever) is the purchasing power parity theory.  The price of a consumer product (same materials, can be sourced locally or at same prices) should be the same in different countries, once adjusting for the exchange rate.  Below, the table compares the price of the rather ubiquitous iPhone in Canada, Europe and Asia.  The price of the iPhone 6s 16GB (unlocked) in the U.S. is about $699, and should be more or less the same in Nanjing, China (their currency (is the remninbi or RMB) adjusting for the exchange rate as it is in Berlin Germany (euros).  As you can see from the table, this is not the case (the prices and exchange rates are not 100% accurate due to rounding).

iPhone intl pricing

Because Germans and the Chinese have to pay an even bigger price, it suggests the the USD is overvalued relative to those currencies.  The Canadian dollar on the other hand, based on this overly simple approach is actually still a bit overvalued compared to our neighbour to the south even at these depressed levels.  Of course, our proximity to the US might simply give Canadians a great deal on iPhones not available in other countries.

We should therefore expect the USD to depreciate relative to both the EUR and RMB in due course – the forces of supply and demand (for products, services and therefore currencies) should cause disparate prices to equilibrate.  The mobile device in theory should cost the same to the consumer no matter where he/she lives.  Should the USD decline significantly (perhaps even compared to the Canadian dollar) then the margin on good and services businesses in those countries are earning today with decline.

When sales are in another currency

The problem, is that historically purchasing power parity is also a poor predictor of exchange rates. The game of international finance is extremely complex.  Not only are exchange rates determined by differing interest rates in countries, balance of payments, trade balance, inflation rates and perceived country risks, the rates are also influenced by expectations associated with these variables and more.  The bottom line for smaller businesses is that when it comes to foreign exchange risk – they are completely exposed.

So what can be done?  Planning.  It is tempting to become overly optimistic when exchange rates have drifted in your favour, encouraging further investment to facilitate more sales in the stronger currency.  Buying equipment, hiring permanent labour and leasing more space introduces higher fixed costs that might dampen or destroy profitability when the tide turns the other way.  It is important to consider ‘what if’ scenarios frequently – and especially before laying out more capital. For entrepreneurs the biggest mistake is to take for granted that the status quo will continue.  All of a sudden, you might be buying yourself a bigger house, a fancier car and sending the kids to private school – all based on current income which is linked to the current prosperity of your business.

Currency instability is a fact of life, and the best way to be prepared is to expect the inevitable. Rather than rush to spend more on expanding the business put aside a ‘safety’ cushion during good times that can be drawn upon during bad times.  If your commitment to the US, European or other markets is firm, then park the cushion into currencies you are vulnerable too.  For example, invest your cushion in US dollar denominated assets – U.S. Treasury bills will provide a natural hedge for your sales.  Similarly, if a significant volume of your sales are in Europe and the company borrows funds for operations, borrow some funds in euros as a hedge – then if the euro appreciates you’re able to pay those obligations in the same stronger currency thanks you your euro receivables.

It is widely believed today that the USD is likely to depreciate relative to a number of other currencies, and perhaps imminently.  Today might indeed be the ideal time to begin considering ‘what if’ scenarios and the actions you can take to plan ahead.

 

 

How to Tell the Difference Between Investing and Gambling!

gamblingI saw a question posted on a popular social network. The question was: ‘What is the difference between gambling and investing?” I’m inspired to reproduce (edited with permission) the following excerpt from A Maverick Investor’s Guidebook (Insomniac Press, 2011) which I believe provides as good an answer as one might find.

How to Tell the Difference Between Investing and Gambling!

“How do you develop ‘smart thinking’ and when do you know you’ve got ‘avarice’?”

My instinctive response would be: “You always know when you’re being greedy. You just want someone else to say that your greed is okay.” Well, I’ll say it then: greed is okay. The proviso is that you fully understand when greed is motivating your decision and live with the consequences. Avarice is driven by desire, which is not a trait of an investor.

Remember, it’s best if investment decisions are rational and stripped of emotion. Greed is associated with elation on the one hand, and anger (usually directed at oneself) on the other hand.

When decisions are motivated by greed, I call it gambling. In my mind, there are different sorts of gamblers. Some gamblers place modest bets, and if they win, they move along to another game. For me this might be roulette. There are those who enjoy playing one game they’re good at, such as blackjack or craps, hoping for a big score. Finally, there are those who are addicts. I can’t help those folks, so let’s assume we’re just discussing the first two types.

It’s okay to do a bit of gambling with a modest part of your disposable income. In fact, investors can apply some of what they know and have fun too. Unlike the casinos, financial markets have no limits or games stacked in favour of the house. It’s the Wild West, and if an investor understands herd behaviour and the merits of contrarian thinking, and does some research, the results can be quite lucrative. Whether using stocks, bonds, options, hedge funds, domestic mutual funds, foreign equity or debt funds, or commodity exchange-traded funds (if you don’t know what these things are and want to know, buy a book that introduces investment theory and the various types of securities), applying investment principles will help you be more successful.

gamblerTo put it plainly: counting cards may not be allowed in a casino, but anything goes when it comes to markets. Just don’t forget that most of the financial industry is trying to make your money their money. There’s a reason why a cowboy sleeps with his boots on and his gun within reach.

The fine line between gambling and investing is hard even for old cowhands to pinpoint. Investing also involves bets, but the bets are calculated. Every decision an investor makes involves a calculated bet—whether it’s to be in the market or not at all, biasing a portfolio in favour of stocks versus bonds, skewing stock selection in favour of one or several industry groups, or picking individual stocks or other types of securities.

I met a lady once in line at a convenience store. She bought a handful of lottery tickets, and I asked her, “Aren’t the odds of winning pretty remote for those lotteries?” Her reply was, “The odds are good. There’s a fifty/fifty chance of me winning.” Confused, I asked, “How do you figure?” I laughed aloud when she said, “Either I win or I lose; that’s fifty/fifty, isn’t it?”

A maverick investor knows there’s always a probability that any decision to buy or sell or hold can prove to be incorrect. The objective is to minimize that probability as much as is feasible. It’s impossible to make it zero. This is why financial firms have sold so many “guaranteed” funds lately. People love the idea, however impossible, of being allowed to gamble with no chance of losing. Whenever there’s a promise that you won’t lose or some other similar guarantee, my senses fire up a warning flare.

There’s usually a promise of significant upside potential and a guarantee that at worst you’ll get all (or a portion) of your original investment back. Many investors a few years ago bought so-called guaranteed funds only to find that the best they ever did receive was the guaranteed amount (extremely disappointing) or much less after the fees were paid to the company offering the product. If you think this stuff is new, trust me, it’s not.

guaranteedA fancy formula-based strategy back in the ‘80s called “portfolio insurance” was popular for a brief period. An estimated $60 billion of institutional money was invested in this form of “dynamic hedging.” It isn’t important to know in detail how the math works. Basically, if a particular asset class (stocks, bonds, or short-term securities) goes up, then you could “afford” to take more risk because you are richer on paper anyway, so the program would then buy more of a good thing. If this better-performing asset class suddenly stopped performing, you simply sold it quickly to lock in your profits. The problem was that all these programs wanted to sell stocks on the same day, and when everyone decides they want to sell and there are no buyers, you get a stalemate.

The “insurance” might have worked if you actually could sell the securities just because you wanted to, but if you can’t sell, you suffer along with everyone else—the notional guarantee isn’t worth the paper it’s printed on. Remember these are markets, and even though you see a price in the newspaper or your computer screen for a stock, there’s no trade unless someone will step up to buy stock from you. The market crash that began on Black Monday— October 19, 1987—was, in my opinion, fuelled by portfolio insurance programs. The market was going down, so the programs began selling stocks all at once. There weren’t nearly enough buyers to trade with. By the end of October ’87, stock markets in Hong Kong had fallen 45.5%, and others had fallen as follows: Australia 41.8%, Spain 31%, the U.K. 26.4%, the U.S. 22.7%, and Canada 22.5%.

Minimizing the Probability of Stupidity

If you’re gambling, follow the same steps you would as if you were investing. If it’s a particular stock you are anxious to own, do some homework, or at least look at someone else’s research available through your broker or on the Internet. When I was a younger portfolio manager, there were limited means to learn about a company. I would have to call the company and ask for a hardcopy annual report to be sent to me. When it arrived after several days, I’d study it a bit so I didn’t sound too ignorant, then I’d call and try to get an executive (controller, VP finance, or investor relations manager) to talk to me. If asking questions didn’t satisfy my need to know, then I’d ask to come and meet with them in the flesh. Nowadays, you have all the information you need at your fingertips.

Money.ca is a PRIME example of just one such source of valuable information available to investors today!

Mal Spooner
Mal Spooner