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What are the ways to profit from the diving dollar?

January 10, 2008 16:14 IST

Let me put it bluntly: The U.S. dollar is nose-diving against foreign currencies. So far, it's down 12 per cent against the euro, 7 per cent to the yen, 8 per cent to the pound, 15 per cent to the Canadian dollar, and 10 per cent to the Swiss frank. And that's just in the past year alone.

And the effects are far-reaching, tugging at the standard of living Americans have grown accustomed to - far beyond the expense of a European vacation.

What's happening? Here's a list:

Domestic prices are up across the board because imports now cost more with a devalued dollar. Less purchasing power here means international companies will offer American consumers fewer products.

The United States is losing its grip on the overall world economy. At present rates, China will have a larger economy than the U.S. in 2050. A tanking dollar also weakens the United States' strength in international relations, as it hopelessly tries to negotiate with strong-currency countries and economies.

With move the dollar makes to the downside, tens of thousands of dollars are bled from your retirement savings. That "Magic Number" that retirees are planning on is getting higher by the day, mainly because of the rising cost of imports - namely oil and other commodities. This is driving up the overall cost of living. As a result, the amount you planned to retire on could already be too low by future standards, forcing you to work longer or lower your standard of living.

Thankfully, there are simple solutions to these currency conundrums.

By holding assets denominated in foreign currencies, U.S. investors can protect their savings from the twin assaults of inflation and currency devaluation. In dollar terms, the value of assets held outside the United States will grow in a gratifying fashion - as will the profits you reap from these strategies.

That is the crux of this report - how you can protect your assets against a declining dollar, and how you can actually profit from the increasing value of many foreign currencies. Here's what you need to know…

The Two Forces Draining the Dollar

The U.S. greenback will remain generally weak for two key reasons:

First, the United States is still running a $700 billion balance-of-payments deficit with the rest of the world. Asian central banks have been financing this by buying U.S. Treasury bonds. As we now also know, German regional banks have also been financing it by buying subprime mortgage debt. It is particularly good for the balance-of-payments ledger when foreigners buy subprime mortgage debt, helium-filled dot-com stocks, or the Brooklyn Bridge, because the profit that domestic shysters make from selling worthless assets to foreigners counts as income.

Nevertheless, both these once-favourable trends are showing signs of ending. This means the United States has to export more, which means the dollar must drop still more against the euro, sterling, yen, renminbi and the currency of anyone else that might be persuaded to buy U.S. products if they are cheap enough.

Second, the dollar will remain weak and probably get weaker - at least in the short run - because U.S. Federal Reserve Chairman Ben S. Bernanke has twice recently cut short-term interest rates: a half-percentage point (from 5.25 per cent to 4.75 per cent) on Sept. 18, and a quarter point (from 4.75 per cent to 4.50 per cent) on Oct. 31. Since the Bank of England, the European Central Bank and the Bank of Japan are all closer to raising interest rates than reducing them, Fed rate cuts make the even less attractive by comparison. And many analysts see additional rate reductions to come.

Assuming you agree that this trend is likely to continue, what should you be buying?

Profit Play #1: Capitalise on currencies. One great possibility is the actual foreign currency itself, preferably in the form of deposits, or short-term assets denominated in the foreign currencies you have identified.

If your bank allows you to make foreign currency deposits, that may be the simplest solution. You should avoid sterling, as Britain is already facing many of the same problems as the United States (a hyper-inflated real-estate market and an over-abundance of financial services, to name just two). European euros and Japanese yen are probably the best bets in individual currencies, although there is also a case for Canadian dollars, which have eclipsed parity with U.S. currency thanks to Canada's powerful natural resources sector.

Profit Play #2: Buy bonds - foreign currency bonds, that is. If you want to purchase foreign currency bonds, consider a foreign-currency bond fund (remember, foreign interest rates seem to be going up, which is why the individual bonds should be approached with caution).

Several of the major mutual fund companies are establishing these because foreign bonds are obviously an attractive investment for U.S. investors in a weak-dollar world. However, there aren't very many such funds available yet in the U.S. market and there don't appear to be any exchange-traded funds (better-known as ETFs) specialising in foreign currency bonds. One possible international-bond mutual fund is the no-load T. Rowe Price International Bond Fund (NASDAQ:RPIBX), which invests in high-quality, non-dollar-denominated bonds.

Let us issue two warnings. First, don't buy bond funds investing in foreign junk bonds (because you have then put yourself in the same position as the asleep-at-the-switch German banks that invested in subprime mortgages - you don't know what you are getting). Second, don't buy an emerging-markets bond fund, because emerging-markets bond portfolios, unlike stock portfolios, tend to be dominated by the countries with the most debt, which are consequently are the countries most in danger of defaulting.

Profit Play #3: Grab the Global Titans. In this case, the so-called "Global Titans" we are referring to are U.S.-based companies with lots of business overseas.

Our Global Titans will benefit from the weak dollar in three ways:

First, if they do business as local companies overseas, their assets and income in foreign countries will be worth more in dollars.

Second, if they export from the U.S., their income will go up relative to their costs - a wonderful position to be in.

And third, the falling dollar actually makes the price of their exported products go down in foreign-currency terms, which makes these U.S. wares more competitive in foreign markets and against rivaling products. That could boost sales outright.

There are lots of these companies. Three terrific choices would be The Coca Cola Co. (NYSE:KO), which does business all over the world, The Boeing Co. (NYSE:BA), which is the United States' largest exporter and restaurant-operator Yum! Brands Inc. (NYSE: YUM), which boasts such great brands as KFC, Pizza Hut and Taco Bell. Both Coke and Yum! are going great guns globally, and both boast excellent brand recognition in such key markets as China.

Boeing will benefit from a huge upswing in air travel as global markets develop: It recently forecasted a need for $340 billion worth of commercial aircraft in China alone over the next 20 years. All three stocks are currently trading at Price/Earnings (P/E) ratios greater than 20, but the earnings should be strong.

Profit Play #4: Capitalise on Canada. Initially, this profit play was titled "focus on foreign shares," and our recommendation was to purchase stock in strongly positioned foreign-based firms, making sure to avoid the shares of foreign firms that exported heavily to the U.S. market (since such companies suffer from a weak dollar even as firms such as Boeing benefit from it). To do this, you must examine the possibilities region by region. Once we did so, we realized that Canada afforded some of the very best opportunities around.

Canada's true strength does not lie in manufacturing, or even really in agriculture - too bloody cold during the winter! In today's world - with interest rates low and commodity prices high - Canada is in a very strong position and for two reasons. In its Athabasca tar sands, Canada has oil reserves that are somewhat larger than the Middle East. And it's the world's largest producer of uranium, with 25 per cent of the world market (Australia is second, with about 23 per cent).

Taking uranium first, Canada still has 9 per cent of the world's known uranium reserves, so it will be a major producer for decades to come. Unfortunately, Canada's two largest uranium producers - Cameco Corp. (NYSE:CCJ) and the French-owned Areva (OTC: ARVCF.PK) are trading at historic nosebleed P/E ratios of 42 and 50, respectively. And Areva is only traded in New York, and on the dreaded "pink sheets," meaning it may be illiquid. Nevertheless, you may want a modest flutter here - earnings growth in both companies appears stellar.

In oil, the Athabasca tar sands are estimated to have reserves of 1.7 trillion barrels, about four times the current proven reserves of Saudi Arabia. More important, Canada is a lot closer and friendlier than the Middle East, or even Venezuela, which has the other big tar sands reserves at Orinoco. Oil production from Athabasca is currently profitable at about $30 per barrel, which in times of low oil prices is not competitive with Middle East production costs of about $2 per barrel. However oil prices have been soaring for several years, and at current oil prices approaching $100 a barrel, Athabasca is hugely profitable.

After all, it's easy to see that $100 minus $30 is a nice, fat gross margin you can make money on. And there should be an extra kicker to come in Athabasca earnings, as it's only been relatively recently that oil prices made the leap from the $60 level.

Canada's oil resources aren't as expensive for investors as uranium. The best pure Athabasca play is Suncor Energy Inc. (NYSE:SU), which is a positive bargain at 20 times earnings. Most of the oil majors are currently in Athabasca; Royal Dutch Shell PLC (NYSE:RDS-B), in particular, has a big participation. Even so, Athabasca is only a modest part of its overall operations and earnings - but at nine times earnings, the shares may be worth a look.

Profit Play #5: Evaluate Eastern Europe. In Europe, the rising euro is likely to make Western Europe increasingly uncompetitive, by boosting its costs. In addition, several Western European countries - most notably, Britain, Spain and Ireland - have recently had housing bubbles even larger than the United States in relative terms, and as a result may suffer accordingly. A much better bet is the emerging growth area of Eastern Europe and Turkey, the latter benefiting from the improved political links and growing trade with the EU.

Since Eastern Europe has much lower labor costs than the EU, as well as solid educational systems, the synergies are obvious. There are very few American Depository Receipts (ADRs) from the region, so the best bet for emerging Europe investors is the Spider Standard & Poor's Emerging Europe ETF (AMEX:GUR), which invests in the share indexes of the Czech Republic, Hungary, Poland, Russia and Turkey. However, this ETF was founded only in March 2007, and currently has a market capitalization of only $29 million.

Profit Play #6: Buy Brazil. At first glance, Latin America offers only modest potential to benefit from a declining dollar, because that region's economies are so closely tied in with the United States and its currencies generally follow the dollar - albeit with a few crises all of its own. However, since non-U.S. growth is a powerful driver of global-natural-resource prices, it is desirable to take advantage of Latin America's huge base of natural resources (although the populist tendencies of the local politicians can make this risky).

Currently, the most-economically-sound countries in that region are Brazil and Colombia, both of which have recently shown signs of better government and genuine economic growth. Therefore, it well worth considering either, or both, of two Brazilian ventures: Either mining company Companhia Vale do Rio Doce, sometimes referred to as CVRD (NYSE:RIO), or the oil company Petroleo Brasilero S.A (NYSE:PBR), more commonly referred to as Petrobras. Both companies are trading at reasonable earnings multiples (15 for CVRD and 13 for Petrobras), and each stands to benefit both from local economic and population growth, as well as from the insatiable-and-growing world demand for commodities and energy.

Profit Play #7: Invest in India. Finally, our worldwide dodging-the-dollar profit journey brings us to Asia, most certainly the world's most dominant growth region - not only for the last five years, but also for the next 25. Unfortunately, both of the two fastest-growing Asian markets, China and India, are richly valued at present. Both countries are also dependent on exports to the United States, so would suffer margin erosion in the event of a very weak dollar. Indeed, China equities are somewhat pricey at the moment, but India is somewhat cheaper, with a P/E ratio of around 20, very reasonable given the Indian economy's persistent 8 per cent growth rate.

Picking individual stocks is difficult, and there are not many with ADRs that U.S. individual investors can trade. Fortunately, there is an ETF that invests in the Indian portion of the Morgan Stanley Capital International share index - the iPath MSCI India Index fund (NYSE:INP), which is satisfactorily large at $366 million.

Profit Play #8: Take a position in Japan. In Asia, I am the most bullish on the four most developed economies: Japan, South Korea, Taiwan and Singapore. All of these countries have living standards close to that the of the United States, while Korea, Taiwan and Singapore still boast exciting rates of economic and productivity growth. However, if your intention is to hedge your holdings against a declining dollar, Taiwan and Singapore may not be the best bets, because they are both relatively small domestic markets with high export dependence on the U.S. economy.

Japan, on the other hand, is the world's second-largest economy, and has only recently gotten back on the growth track after a decade of recession caused by its late-1980s speculative bubble. A weak-dollar strategy should focus on the smaller Japanese companies, since they would benefit from domestic Japanese growth, meaning their profits are not tied to exports. Hence my recommendation would be the streetTracks SmallCap Japan ETF (AMEX:JSC), an index fund devoted to smaller Japanese companies.

Profit Play #9: Call on Korea. South Korea is a rapidly growing economy whose stocks are currently selling at a very attractive multiple of around 12 times earnings. And there are a number of waves to catch in that market, as the country is a major global player - if not an outright leader - in such areas as telecommunications and heavy manufacturing. And it's an interesting political play, because the current government under Roh Moo-hyun is fairly anti-business, but the pro-business Grand National Party candidate is leading in the polls for the December presidential election. Should the GNP win, it's likely that the Korean market would move to a multiple that better reflected the country's attractive growth prospects.

There's one other point that's worth noting - and it's a significant one. In late October, U.S. investing guru Warren Buffett, chairman of the immensely successful investment vehicle Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), paid his first visit to South Korea, where the billionaire has invested in 20 of that countries companies, including a 4 per cent stake in the country's leading steelmaker, (NYSE: PKX). If Buffett sees Korea as a worthwhile market, then I know my analysis is correct.

In South Korea, I would make two recommendations. One would be the country's largest bank, Kookmin Bank (NYSE:KB), which is poised to benefit from the acceleration in growth that political change may bring. The other recommendation would be SK Telecom Co. Ltd., (NYSE:SKM), Korea's largest cell phone company, which has international operations in China, Vietnam and the United States, with the latter only a small part of its operations.

The Bottom Line: In a weak-dollar world, a mix of strategies is the best antidote. It can provide additional profits, as well as downside protection. You shouldn't turn your portfolio upside down to bet on a weak dollar, but you should make certain that some of your money is invested to benefit from it.

Martin Hutchinson is Contributing Editor of www.moneymorning.com

Martin Hutchinson