The recent slowdown in emerging markets and the anticipation of a U.S. Federal Reserve tightening cycle have wreaked havoc on many Asian currencies. What was once an afterthought for equity investors has now become a front and center concern.
There are various line items in financial statements that may be denominated in non-local currencies. For example, in some major cities, landlords of marquee commercial properties may charge rent in U.S. dollars. Fuel costs, which often make up 25% to 30% of the airline industry’s base costs, are also typically priced in dollars. When gauging balance sheets, it behooves investors to double check whether liabilities and debt are denominated in local currencies. The asset/liability mismatch may be accentuated in countries where real exchange rates deviate significantly from official exchange rates. Even in cash flow statements, capital expenditures on technology—whether it be hardware or software—may be done via foreign currencies.
Foreign exchange concerns could also impact incentive structures for company management. For example, there are a number of publicly listed local subsidiaries of multinational consumer product companies, and it is common practice for senior managers to go through rotation or assignments in different subsidiaries. In theory, it would make sense to link the performance-based equity incentive to local share performance. In practice, however, it often proves difficult to persuade star performers to take equity that is denominated in a local currency because most prefer equity in the parent company as “hard currency.” This obviously introduces an extra level of misalignment in management incentives and shareholders at local subsidiaries. This is in addition to the relationship between parent companies, which tend to be controlling shareholders, and their minority shareholders.
What’s the take-away? In times of extreme currency volatility, such as we have seen recently, it is not enough to rely on simple rules of thumb, such as owning exporters and shunning domestic companies. It is critical to examine currency exposure throughout corporate financial statements (including balance sheets, cash flow statements and proxies). While we tend not to tie investment decisions directly to currency views, we do still strive to understand a business’ true economics, which may differ significantly from the one portrayed by a firm’s published financials in calmer times, when currencies tend to move in one direction.
(c) Matthews Asia