Foreign Currency

Foreign Currency (also known as Foreign Exchange or FX) is, quite simply, the national money of another country. For an American investor, the Euro, Japanese Yen, and British Pound are all foreign currencies. For a European investor, the U.S. Dollar or the Swiss Franc would be foreign. These currencies are traded against each other in a global marketplace, and their relative values are constantly shifting. The price at which one currency can be exchanged for another is called the exchange rate. For example, if the EUR/USD exchange rate is 1.08, it means one Euro can be exchanged for 1.08 U.S. Dollars. While it might seem like a topic for globetrotters and international bankers, understanding the basics of foreign currency is crucial for any investor looking to buy stakes in businesses outside their home country. The fluctuating value of these currencies can have a surprisingly significant impact on your investment returns, turning a great business decision into a mediocre financial outcome, or vice versa.

Even if you never plan to trade currencies directly, they will inevitably impact your portfolio if you own international stocks. This is due to a pesky but important concept called currency risk. Imagine you're a U.S. investor and you buy shares in a fantastic German car company. The company is a roaring success, its profits (in Euros) are soaring, and it pays a hefty dividend. However, during the same period, the Euro weakens against the U.S. Dollar. When you convert your dividends or the proceeds from selling your stock back into dollars, you get fewer dollars than you expected. The company did great, but the currency's movement ate into your personal return. This is currency risk in a nutshell: the underlying business can perform brilliantly, but a weak foreign currency can erode your gains when translated back to your home currency.

The global marketplace for trading currencies is the Forex (Foreign Exchange) market. It's the largest financial market in the world, dwarfing stock markets. However, it's dominated by governments, central banks, and speculators making massive, often leveraged, short-term bets on currency movements. From a value investing perspective, trying to predict whether the Yen will rise against the Dollar next week is pure speculation, not investing. The number of variables—from political scandals to unexpected economic data—makes short-term forecasting a fool's errand. The legendary investor Warren Buffett has often warned that currency markets are a dangerous place for investors, as their movements are incredibly difficult to predict with any consistency. A value investor's job is to analyze businesses, not to gamble on macroeconomic tea leaves.

While we can't predict short-term moves, understanding the long-term drivers of a currency's value helps us assess the risks of investing in a particular country. The main factors are:

A country with a strong, growing economy tends to have a strong currency. Foreign investors are more willing to buy assets (like stocks and bonds) in a country with robust GDP growth and low unemployment, which increases demand for that country's currency.

This is a delicate dance led by a country's central bank, such as the Federal Reserve (Fed) in the U.S. or the European Central Bank (ECB).

• Interest Rates: Higher interest rates generally attract foreign capital, as investors seek better returns on their money. This “hot money” flow increases demand for the currency, causing it to strengthen.
• Inflation: High inflation is like a slow leak in a tire; it erodes the purchasing power of a currency. Over time, a currency with persistently high inflation will almost always weaken against one with low inflation.

Money loves stability and hates uncertainty. Countries with stable governments, predictable policies, and a strong rule of law are considered safe havens. Their currencies (like the Swiss Franc) often strengthen during times of global turmoil as investors flee riskier regions.

Instead of trying to predict currency movements, a value investor should focus on managing the risk they present. Here’s a simple playbook:

• Focus on the Business, Not the Currency: Your primary job is to find wonderful businesses at fair prices. A great company can often thrive despite currency fluctuations, for instance, by having globally diversified revenue streams or pricing power that offsets currency weakness.
• Demand a Deeper Margin of Safety: When performing a valuation on a foreign company, be extra cautious. If the current exchange rate seems unusually favorable to you, ask yourself, “Would this still be a great investment if the local currency fell by 20% against my home currency?” This thought experiment helps you build an extra layer of protection—a margin of safety—against currency headwinds.
• Embrace Geographic Diversification: Don't put all your international eggs in one basket. Owning great businesses in several different countries and currency zones is a natural hedge. Over the long run, the ups and downs of various currencies tend to smooth each other out. This is a core principle of diversification.
• Check a Company's Currency Exposure: Read the annual report. Where does the company make its sales? A Japanese company that sells 80% of its products in the U.S. has a very different currency risk profile than one that sells 80% of its products domestically in Japan. Understanding this helps you see where the real risks lie.