How Currency Exchange Rates Will Impact These Stocks

James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Currency exchange rates play an important role in the success or failure of businesses that conduct major operations in foreign markets.  Having a basic understanding of a few key principles can give investors a significant advantage in the market. Given highly predictable inflationary conditions, let's discuss how you can make money by investing in individual exporters.

Dollars & Sense

Recently, the world has been focused on the Euro vs. the U.S dollar, as the battle between austerity and Federal Reserve intervention plays out.  However, a recent twist came from Japan, which issued a bold declaration to inflate the Yen.  This deliberate attempt to weaken the Japanese currency will ultimately trump the Euro vs. dollar battle in the race to the bottom.

Think of currency like any other good.  When more of a good hits the market (supply increases) the price (value) naturally decreases given consistent demand.

Let's take the example of the U.S. dollar and the Japanese yen.  To purchase Japanese goods, an American would need to convert dollars to yen.  If more yen hits the market (supply increases) the price (value) decreases.  This means that over time, you would receive more yen for the same amount of dollars.

The goal of this deliberate inflation policy is to make Japanese goods less expensive in overseas markets, by giving foreign currencies increased purchasing power from the new exchange rates.  Ideally, this will raise the amount of Japanese goods sold overseas (exports) and stimulates the economy.

In the last six months, we have seen the dollar go from purchasing approximately 78 yen to 94.  This represents nearly 20% increased purchasing power for Americans buying Japanese goods.

Foolish Results?

The policy of a weaker Yen appears to be working, with January export numbers for Japan showing a 6.4% increase.

While this can have some beneficial effects, there are also well-documented negative impacts from this type of artificial stimulus.

First, it makes imports cost more.  As new product cycles begin, increasing prices for imported materials will hurt Japanese companies' margins. Japanese consumers will also find imported products more expensive, diminishing their own purchasing power.

Finally, since Japan runs a trade deficit ($17.4 billion U.S. dollars),  largely because of increasing energy imports, a weaker yen could hurt the overall economy in the long run.  The trade deficit would suggest that continued weakening would be an unwise long term policy, which might cut short Japan's short-term experiment in weakening the yen.

Fast and Furious

However, one of the main industries to see an immediate positive impact from these Japanese monetary policies will be the Japanese auto manufacturers.

Toyota (NYSE: TM) is the nation's leading exporter.  While it does business in many countries, Toyota's bottom line is greatly affected by fluctuations in relation to both the Euro and the U.S. Dollar.

Over the last six months, the purchasing power of the U.S dollar is up almost 20% vs the yen. Meanwhile, the Euro has seen a nearly 25% gain vs the yen. That means consumers in these markets pay less for a Japanese-made Toyota.  This lower price will increase demand, and consequently drive greater exports from Japan to these markets.

Looking at a 52-week chart of the Japanese ETF iShares MSCI Japan Index vs. Toyota (Figure 1), it appears that the two were trading in tandem until news broke of the new currency policy.

Figure 1:

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The divergence that has occurred after that announcement is due to the fact that Toyota is largely export-based, while the ETF includes non-export oriented companies which will not stand to benefit as much.

One note of caution: In a materials based industry such as Toyota's, this short-term stimulative effect is often negated in the long term by increasing raw material prices for future product cycles.  Remember that currency fluctuations not only effect the price of products sold in different countries, but also materials acquired from overseas as well.

Honda (NYSE: HMC) is another Japanese automaker that stands to benefit -- but not as much as you might think.  While Honda is still Japan's No. 2 exporter, production of Honda vehicles in overseas markets has increased over the years.  Thus, the weakening Yen may not have quite as significant an effect on Honda as it will for Toyota.  This suggests to me that while Toyota may be the short-term beneficiary, it will also pay the greater price over the long term, and that Honda may be the safer long-term play.

Number Five Is Alive

Japans No. 5 exporter is also its largest electronics company, thanks in large part to a component business that includes semiconductor manufacturing.  I'm sure many of you might be surprised that the honor goes to Panasonic (NASDAQOTH: PCRFY), not Sony (NYSE: SNE).  Panasonic also includes the popular brands Sanyo and Technics. Under its various divisions, this company manufactures numerous products such as phones, televisions, appliances, cameras, and even power tools.

While Sony does come in as the No. 6 exporter out of Japan, it does approximately 50% of its manufacturing abroad.  So like Honda, Sony could be a safer long-term investment when the negative effects of the yen's devaluation begin to manifest.

Looking at a recent three-month chart (Figure 2), it's obvious that expectations regarding the potential for export increases have caused both stocks to outperform vs. the Japanese ETF.

Figure 2:

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This illustrates the significant effects that currency adjustments can have on stocks that are heavily influenced by exchange rates.  Also, it is noteworthy that in all of these cases, individual stocks have outperformed the Japanese ETF significantly.  ETFs have both good and bad qualities worth keeping in mind.

Foolish Conclusion:

Knowing how currency markets work can make you some easy money.  They play a large role in the success or failure of companies that do business abroad.  By learning the simple rules that govern the floating exchange market, and paying attention to global monetary shifts, you can find very profitable investments.

James Catlin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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