Small Cap Risks: Exchange Rate Risks

From an investor's point of view, small cap companies are often exposed to a number of risks that are far more commonly experienced compared to larger companies. These risks are reasons why small cap companies do not always reach high valuations or even industry average valuation multiples. Indeed, a large number of companies trading on low multiples during the height of bull markets are often exposed to one of the main risks, which include customer dependency, exchange rate impacts and liquidity problems, amongst others. Investors should therefore be able to assess for some of the most common risks to avoid getting caught in a 'value trap' - a situation when a company looks 'cheap', but with good reason. This three part series will look at a few of the main small cap risks. Company reviews will promptly resume thereafter. This is the final part of the series.

What are Exchange Rate Risks?

Exchange rate risks unsurprisingly relate to the exchange rate between two countries - for example, the Great British Pound (GBP:USD) United States Dollar exchange rate tends to fluctuate between 1.4 and 1.8. That means that 1 GBP can buy you, depending upon the exchange rate at the time, between 1.4 and 1.8 USD. It is the fluctuations in exchange rates that can cause companies serious problems. Once again, if these risks are present, then a large discount on valuation metrics is justifiable.

Just as a starting caveat, exchange rate risks are only fully present for companies who operate overseas and who do not have hedging arrangements in place - since hedging arrangements can take many forms and can be quite complex, this tutorial will not cover how they work. However, a hedging arrangement essentially allows a company to mitigate exchange rate fluctuations, therefore shielding them from potentially serious negative impacts. Exchange rate risks can actually be both direct and indirect.

Which Companies are directly affected by Exchange Rates?

Companies affected by exchange rates can be shown in the simple table below, and they will be affected to varying extents. The table is applicable to all exchange rates, so you can switch US for any other country with a different currency to the GBP.

The table above illustrates that exchange rates directly impact all LSE listed companies, apart from those who are based in the UK and who sell in the UK only. That is because they are not involved in foreign currencies and they report their earnings in GBP. However, all other companies are, albeit to differing extents. For simplicity, where it says 'Based in', that will assume that all fixed costs are incurred in that country (e.g. office rental). Variable costs (i.e. cost of sales) will be dependent upon the country in which the product is sales. I have numbered each box and will refer to them below.

1. No Impact

2. The exchange rate risk arises from the US sales component and now relates to the GBP:USD exchange rate. Since the company is based in the UK, let's say it reports its results in GBP - it must therefore translate all of its USD sales and profits into USD. Remember that the problems arise when there are large fluctuations in the exchange rate - small fluctuations are not so much of a problem. Notice in the table below that the company's GBP-denominated US sales would fall by 33% if the US dollar was to weaken from 2 dollars to the pound, to 3 dollars to the pound. Therefore, the GBP sales are lower and the company will report lower sales in its report.

Companies therefore often give a Constant Currency line in their results where they state what growth would have been had exchange rate fluctuations not taken place. This gives a clearer view of the rates of organic growth being achieved.

3. This is a more serious form of 2. Rather than just a portion of the company's sales and profits being harmed by a weaker dollar (same as a stronger pound), the entirety of the company's sales are. Furthermore, since the fixed costs are being incurred in the UK, they remain high and do not fall in line with the dollar weakening. The table below examines how being based in the UK in such a situation is disadvantageous from a profit perspective

The above may look daunting but it is actually relatively simple. In year 1, there is a GBP:USD exchange rate of 1:2 - one pound buys you two dollars. Remember that this is a company based in the UK who sells in the US only. The operating profit is $3m and that is equivalent to £1.5m. Let's say that the fixed costs in the UK total £1m - no translation is required as it is already in GBP. In year 2, the exchange rate moves to 1:3. The operating profit is still $3m, but the GBP translation is now only £1m. Recall that the UK fixed costs are in GBP, so they do not change. GBP translated profits of £1m minus UK fixed costs of £1m equals zero. Therefore, the profit, when selling in the US and based in the UK is £0.

However, when you are based in the US, have the fixed costs in the US, this is a different story. UK investors work in GBP so will translate USD figures back into GBP. The GBP translation of profits is still £1m in year 2. However, fixed costs are in dollars. Originally, the dollar fixed costs were $2m when the exchange rate was 1:2. But the fixed costs do not change - when we now translate the US fixed costs of $2m into pounds at the 1:3 exchange rate, it only translates to £667k. GBP translated profits of £1m minus GBP translated fixed costs of £667k equals £333k.

Therefore, the GBP profit when based in the US and selling in the US is £333k, which is better than £0 when based in the UK and selling in the US. Having fixed costs and sales in the same country acts as a natural hedge.

4, 5, 6, 7 and 8 are all either the reverse of the above situations or are less severe forms

Exchange Rates can have Indirect Impacts

As visible in the trading statement of Pure Wafer (LSE:PUR) below, exchange rate impacts of competitors can also have a negative impact on a company, even though it is indirect. Taking the reverse of situations described earlier, if a competitor experiences favourable exchange rate movements, then that may enable them to cut prices and become more competitive. That is what looks to have happened to Japanese rivals of Pure Wafer.
How to Examine the Exchange Rate Risks

1. Verify that the company is actually prone to exchange rate risks using the table at the start of the article
2. Check for hedging arrangements to see if there are safeguards against exchange rate fluctuations - these can greatly reduce the risks
3. Check the economic state of the country - For example, if a company is reliant on the Turkish Lira, check the performance of the Turkish economy and for any exchange rate forecasts. Exchange rates are often proxies for the health of an economy so if an economy enters a decline, the exchange rate relative to other currencies may weaken. Currencies tend to strengthen when a country's central bank is set to up interest rates (is one example)
4. Decide upon whether the country is 'high risk' - Events like wars can significantly impact exchange rates, as has been the case in Ukraine with the Hryvnia, which has weakened dramatically
5. Determine the proportion of the company's revenues and profits that are exposed to the currency
6. Check the exchange rate chart - Is the exchange rate volatile or is there stability (preferable). Are there any recent dramatic movements, and if so, find out why. What is the medium-term trend?
7. Check for a sensitivity analysis - Companies exposed to exchange rate movements sometimes give these in their annual report and accounts. It tells investors how much a certain exchange rate fluctuation would impact upon both profits and revenues and allows you to cut out and difficult calculations