The popularity of passive investing is largely limited to the United States, because in the rest of the world stock returns have not had the stellar run that the U.S. has. There’s a good reason for this: currencies. While stocks can look good on a local currency basis in, for instance, the UK, a major hit to the currency from a significant event (Brexit in this case) can mean both higher inflation and lower local purchasing power, which erases much of those returns.
America’s currency is by and large the most stable in the world, which means that Americans don’t give much thought to this aspect of investing. It also means that a lot of American financial analysts, when combing through companies’ revenue and earnings reports, will try to ignore currency effects. For a global company that earns a significant part of its revenue abroad, like Coca-Cola (KO) or Facebook (FB), this is a significant phenomenon.
In some cases, that foreign exposure can creep up to be a significant risk factor, but that’s rare, which means that a lot of investors will try to focus as much as possible on results without taking into considerations fluctuations in currencies. The term used for this is “constant currency basis”, and it’s a conventional way of calculating results without taking into account exchange rate changes.
Let’s take an example. Say, in year one, a company is based in America and does business in Japan, earning yen. In the first year, the exchange rate is 100:1, so for every 100 yen received, the company receives $1 in revenue. Then, in year two, the company gets the same amount of revenue (100 yen), but the exchange rate is now 80 yen to $1, so the company banks $1.25 in dollars.
If we reported the company’s sales without currency effects, it looks like a 25% year-over-year gain in Japanese sales, which would be a massive fundamental tailwind for the company. But that’s a lie; in local currencies, revenue was flat on a year-over-year basis. So what we would need to do, instead, is look at year 2 with year 1’s exchange rate, and saw that revenue was $1.00 in year 2 on a constant currency basis—thus flat compared to year 1.
A flat revenue growth trend is very different from a 25% jump, which is why constant currency is an important tool when analyzing a company’s fundamental performance.
There is a problem, however. Let’s say a company such as Proctor and Gamble (PG) sells a lot of products in emerging markets. These countries tend to have currencies that decline in value over time (the reasons behind this are complicated, so let’s just assume this as a given for now). If a country is constantly selling in a currency that loses value over time but records its results in USD or a stronger currency, this will be a fundamental headwind to growing sales and profits. In many emerging markets this headwind is counteracted by high GDP growth (emerging markets tend to grow faster than developed ones). However, sometimes that doesn’t happen (e.g. Venezuela), and sometimes the growth rate matures rapidly as the country reaches the middle income level (e.g. China).
In this case, currency effects need to be analyzed carefully and incorporated into a valuation model of the company’s future, even when results are looked at more broadly on a constant currency basis. This is where it’s helpful to get both with and without currency effects from management—and if a firm is heavily exposed to these kinds of markets but doesn’t willingly release these numbers, that could be a big red flag.