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.

 

 

Mutual Fund Mania – Choose wisely during RRSP season!

Usually the first vehicle of choice for new investors is a mutual fund. In days of yore, which in the investment industry is more than five years ago, investors usually bought equity funds but in more recent times balanced funds have grown more popular and even bond funds have attracted money.

Oftentimes, the first mutual fund experience is a disappointing one. There’s a reason for this. People intuitively want to be associated with success, so their first mutual fund will have these characteristics:

  • A great track record of top quartile performance over at least three to five years.
  • Billions of dollars invested in it, so it is “safe.”
  • Offered by an investment firm with a long and “distinguished” history.

Many years ago, there was much less data readily available and few statistical tools at one’s disposal, but I was curious and decided to examine a group of funds over time to see what their performance looked like. What I discovered is represented in the chart. There were no exceptions; every fund in my sample followed this same pattern.

It doesn’t take a mathematician to interpret a picture. If you invest in the fund when it’s a dog (ranks very poorly compared to other funds), the odds are great that given time it will be a top performer soon enough.

The problem is that most investors will pick a top performer. However, the top performer will soon become a dog, and the investor will be unhappy.

A great track record might actually guarantee poor performance.

When it comes to your money, intuition sucks. You “intuitively” steer towards something that “feels good.”

There is enough publicly available data nowadays to help you find a few funds that suit your tastes and examine their performance patterns. What suits your tastes may include funds that are easy to buy in and out of, those you have read about in the press, whose portfolio manager sounds smart on TV, or you may prefer socially responsible funds. When one of the funds that does occasionally perform very well has been in a slump over the past year or two, buy it. After the performance has improved over the course of a couple of years and you’re happy with the results, consider selling (or redeeming) it when the fund is in the top of the rankings (or wins an award) and buy a different fund that is in a temporary slump.

Being a curious sort, I once had the urge to see if award-winning funds followed the same pattern. After all, if someone wants a top-performing fund, wouldn’t they head straight for the ones that have just won awards for their outstanding performance?

I looked at the award-winning funds in any given year, and then checked their performance just one year later. Rather than examine every category (there are just too many nowadays) I stuck to basic Canadian equity, U.S. equity, small cap, international equity. Included were “thematic” funds popular at the time, such as ‘precious metals’ and the ‘dividend and income’ funds. Here are a couple of examples of what I usually found:

Results:

  • 100% of the winners were either 1st or 2nd quartile funds. The next year, 88% of these had fallen to 3rd or 4th quartile.
  • All the former 3rd quartile funds (dogs) rose to 1st quartile (stars) in the following year.

Winning an award (being a top performer) is not an indication of how that fund will rank in terms of its future performance, even in the following year. In fact, the odds are awfully good that your 1st or 2nd quartile pick will be below the median or worse one year later. Interesting! If there’s a lesson, I suppose it’s simply that funds should be bought because they meet your objectives, not because they’ve been performing well recently.

It’s not important to understand why this roller coaster occurs for mutual funds, it just does. Markets change, so, for example, when a growth fund invested primarily in technology stocks suffers, it’s no doubt because the upward trend in technology stocks, or their popularity among the herd, has either stopped or deteriorated. Apple is a prime example in the news right now.

Portfolio managers are just people working for people. I’ve witnessed the following scenario occur time and again:

  • Fund performance begins to soar.
  • Fund attracts lots of new money.
  • Marketing folks want more and more time from portfolio manager for meetings.
  • Money pours into the fund in droves.
  • Portfolio manager’s head swells (the “I’m a genius” syndrome).
  • Performance begins to deteriorate.
  • Money leaves the fund in droves.
  • Portfolio manager has to sell the fund’s best stocks (there are still buyers for these).
  • Performance sucks, and it takes two to three years for things to get back to normal.

Size really doesn’t matter…unless the fund is humongous.

A thinking person should be able to figure out that it doesn’t take a big fund or a big fund company to provide good performing funds. Think about it. Do you shop at the big box stores because the level of service is better? Is the quality of the merchandise better? No. You shop there because the economy of scale for the store allows them to buy products at a lower cost. They can order in bigger volumes and squeeze their suppliers. They then pass these savings to their customers.

Larger financial institutions enjoy similar economies of scale. Of course, the transactions and administration costs of the bank or insurance company are lower, and these benefits might come your way in the form of lower fees and expenses, but we’re not talking about buying lawnmowers. Rates of return on funds managed nimbly and intelligently can make those fees and expenses pale by comparison.

Bigger is safer possibly when you’re banking, but legitimate capital management companies are structured so that they never really touch your money. The custodial (where the money is physically held) and administrative (recordkeeping) functions are usually provided to these firms by big banks or huge financial institutions anyway—for safety and regulatory reasons and it makes the potential for fraud near impossible.

The reason why large financial services companies got into the fund management business was simply economics. They were providing banking, custodial, and administrative services to mutual fund and other asset management companies anyway, so why not also earn management fees by offering their own mutual funds and private wealth management services?

Take it from someone who knows from experience. Managing a massive quantity of money in one fund is much more difficult for a portfolio manager. You can only buy big companies. A portfolio manager will try to buy the best big companies, but since everyone else with big portfolios is doing the same thing, it’s not like you can outsmart them. It’s sort of like playing poker with jacks, queens, and kings being the only cards in the deck. If the three other players see three kings on the table, everyone knows you still have one in your hand.

Applying some discipline is important when directing your savings and will spare you much grief. For several years since the financial crisis, investors have swarmed into bond (see chart – it shows the net Sales of bond mutual funds) and balanced funds because of their strong relative performance and are considered to be less risky. Even today buying into income-oriented funds ‘feels good’ – everyone else is doing it, past performance is good and the fright we all experienced during the financial crisis still stings a bit.

Equity funds have been avoided for years – constantly redeemed – despite the fact the stock market returns have been outstanding since the crisis more or less ended (or at least stabilized). Now that the past returns are looking better, investors will be shifting money out of the bond funds (and perhaps balanced funds as well) and chasing the top performing equity funds.

This is an inferior strategy. If you examine the best ‘rated’ funds you will find they hold more dividend paying and income securities and will likely drop in the rankings very soon after you buy them.

With RRSP season comes a plethora of marketing campaigns and firms will be pushing us to buy their best performing funds (we are so quick to buy what ‘feels good’). Since you won’t see many advertisements for those not doing so well today, but are likely to do very well tomorrow, it would be wise to do a bit of homework before buying in. Good luck!

Mal Spooner

 

 

 

Invest like you shop and your savings won’t drop!

Huge lineups of shoppers looking for deals on Black Friday and the massive retail sales that occur the weeks after Christmas are testimony to the ability of people to shop wisely.  I know many families that defer buying expensive gifts (for their kids but especially for themselves) until after the Christmas holiday in order to save hundreds of dollars.  So why are people so bad at investing their money?

A recent study by Blackrock, the largest money management firm in the world, confirmed what all of us know already:  The average investor sucks at investing.  Despite the fact that the skills and emotional fortitude necessary for successful shopping are pretty much applicable to the task of investing one’s money, it seems the average person just won’t use these abilities when making important investment decisions.

According the the American Research Group Inc., the average shopper plans to spend $854 on gifts this year. Let’s assume it will be the same next year and the next.  Virtually everyone realizes that since they’ll be spending the money anyway, shopping smartly and getting all gifts at perhaps a 20% lower price leaves them better off.  Wealthier in our example by more than $500 after three shopping seasons in fact!

But when it comes to buying investments, investors prefer to pay a premium.  What proof do I have?  Many years of observation, but the results speak for themselves.

The average investor managed to earn less than virtually all asset classes at his disposal earned over ten years according to the Blackrock study.  To be perfectly honest, I’m surprised the average investor did so well.

I’m not sure about how the study was conducted.  If everyone that participated had a home and kept all their money in a checking account….the result wouldn’t be very surprising would it?  Let’s assume that the sample was comprised of real “investors.”  Some with homes and minimal savings, but others actively investing serious money in both bonds and stocks. Where would they be going wrong?

It’s hard to imagine retail investors trading aggressively in the bond market, but assuredly a significant amount of their long term savings could include fixed income securities.  It’s equally difficult to conceive that the lion’s share of their savings might be in gold or oil.  Likely, the average investor does include stocks in his retirement savings and participates actively in decisions.  He/she would either use an adviser to implement asset allocation decisions or occasionally channel money into or out of funds.

Consider one proxy for stocks, the S&P 500 Index over roughly the same time frame as the study.  It’s certainly been a rollercoaster, but a simple buy and hold strategy would have contributed nicely to the average investor’s nestegg.  In my opinion the only way the average investor could have done so poorly is by losing money making poor investment calls along the way.

Generally, folks wait until the stock market has climbed quite a long way upward before committing their own money – see the “Buy” indicators on the graph?  This decision is made based on the past performance charts and tables that are promoted ad nauseum by the investment industry when the rates of return earned by their funds have been excellent.

Even though past performance means nothing, for some reason impressive historical returns awaken the greed in all of us, just like an extremely large lottery jackpot suddenly inspires many more people to go out and buy lottery tickets.

Unfortunately, great historical performance is very often followed by lousy market environments – evidenced clearly by the graph of the S&P 500 Index over the ten year period.  As anxious as people are are to pile into a market that has been rewarding (after-the-fact), they are just as eager to get out of a losing situation that leaves them feeling they’ve been suckered.  The average investor sells at the worst possible time.  A few of these buy high/sell low episondes is sufficient to reduce the overall return he/she has earned in other assets like bonds or the family home.

Put another way, the shopper in you is always on the lookout for discounts while the investor is more than happy to pay a premium to the list price.  Greediness completely overides any bargain-hunting intuition.

Back to our shopping example.  Imagine that you can shop wisely and get gifts at prices 20% below list.  But also imagine that you and your family can use those gifts for a time and then sell them at a 20% premium to list.  Crazy?  You can actually do this with your investment portfolio.  Apply those shopping skills to your savings and you’ll be surprised how much better off you can be.

 

 

 

Malvin Spooner.

 

 

 

 

 

Is the Horse Dead Yet?

This will be the last blog about “free lunches” and the supposed good deals they represent! The last item I will tackle are the BOGO concepts – some are Buy One Get One 50% off – some are the Buy One Get One free version.

There is not time to go into all of the differences and mechanics in one blog, so I am going to pick retail store merchandise. Margins on goods purchased by stores for re-sale range from 500% (and sometimes more) to 200% (and sometimes a bit less if a store chooses to carry what they term as a loss-leader). An average retailer mark-up is in the 300% + range. They use this because they know some items will be returned as defective and some will be returned but can be re-sold. Retailers also have to cover staffing, buildings, etc. – which are expensive!

In the ideal world, the many buyers working on behalf of the retailers will guess “correctly” about future styles and demand – and well-trained ones get pretty good at it – but no-one bats 1000. The next issues shipment JIT – Just In Time – the manner in which automakers try to function. When customer demand underperforms the buyers’ purchase assessment, inventory remains on hand or in a wharehouse. If JIT shipping is not an option, then very large amounts of wharehouse space is required – particularly for large appliances and furniture.

Wharehouses are a pure COST item – they never generate revenue and neither does product inventory sitting on a shelf.

So as in many things, timing is everything. When timing is off – whether demand or shipping, costs are incurred and many times, it is cheaper to sell of items – allegedly at “below cost” to clear mis-calculated consumer demand items or unplanned shipments – hence BOGO came along – but remember the average 300% markup – so even BOGO 50% gives the retailer a 225% markup net over 2 items – so they are still OK. BOGO 100% still gives a profit, although it is down to 150% net over 2 items.

The point is, sale costs – even 50% off – are built in to their initial costing of items – no-one can get fashion, demand and delivery 100% bang on the numbers – so “fudge factors” are included along the way. Sales that are 60% off are still not $$ losers for the retails – although much better pricing for consumers! Take an item costing $10.00 – the 300% markup places it on the shelves at $30.00, BOGO 50 results in 2 items sold for $45.00 against 2-item cost of $20 – they still have a markup of 225%. BOGO 100 results in 2 items sold for $30.00 versus a cost of $20 – markup is now $150%. An 60% discount takes the $30 item down to $12.00!

Keep all of this in mind when looking at the next big BOGO sales!