The United States Dollar has strengthened versus nearly every currency on the planet, with the exception of the Brazilian Real. The Real is up 8% versus the USD over the last two years and up 3% versus the USD so far this year, despite a recent selloff.
Returns for international investments have two components: 1) the “local” return on investment in the investment’s local currency and 2) the gain or loss associated with movements in the currency’s exchange rate during the period of investment. Specifically, the strengthening of the local currency relative to an investor’s home currency during the investment period will add to the local-currency returns while a weakening local currency relative to an investor’s home currency during the investment period will detract from the local-currency returns.
Exchange rate movements can turn an ordinary investment into an extraordinary one; they can also turn an otherwise good investment into a lousy one. Trust us. We know. We’ve experienced both. Exchange rates matter.
Exchange rates represent a hidden risk associated with international investing. The currencies of nearly every emerging market in the world have suffered a 40% decline versus the USD at least once in the last 30 years. International investors that ignore exchange rates do so at their peril.
At KP7, we target undervalued investments in countries whose currencies we expect to strengthen relative to the USD during the investment period. If we are right about both, the revaluation of the investment in its local currency and the movement in the exchange rate will each work to our benefit. Bingo.
In Splash, we described the four major drivers of a currency’s exchange rate: cross-border investment, cross-border commerce, speculation, and government intervention. We used the Brazilian Real as an example to illustrate the effects of each, concluding that the Real was favorably positioned with respect to each of the four big drivers of currencies.
Our analysis for the Real, it turns out, was spot on. The Real has strengthened against the USD which has strengthened against most other global currencies. We figured the movement could be bigger, but we didn’t expect the durability of the strength of the USD. The Brazilian Real, while not a home run in terms of currency movements, has been one of the strongest currencies in the world since we wrote that piece.
Our currency assessment is only part of our investment thesis. The other part – and to be honest the far more significant part – is a bottom up analysis of the individual company. Our company-specific analysis is always the centerpiece of our investment thesis.
We were fortunate to find three Brazilian companies that were and still are disrupting the Brazilian financial services market. These digital-first disruptors are low-cost, fast, and nimble. The incumbents are high-cost, slow, and bureaucratic. We believed at the time that the disruptors offered a compelling investment opportunity, even ignoring the currency considerations. We still do.
Our company-specific analysis of these companies, it turns out, was also spot on. Each has revalued closer to what we would call fair value, although none has completely closed the gap.
We were right on the Brazilian currency. We were right on the individual Brazilian companies. Bingo. Our Brazilian holdings as a result have been KP7’s best performers so far this year. Nu Holdings, a Brazilian online bank, is up 85% for the year and +84% versus our cost base (all returns here are in our home currency, the USD). XP Inc., an online Brazilian broker similar to Schwab in the U.S., is up 47% for the year and +75% versus our cost base. Stoneco, which provides hardware and software to Brazilian merchants that enables them to accept credit cards, is up 10% on the year and +24% versus our cost base.
The local returns in Brazilian Reals for each of these investments has been good and with the strengthening of the Brazilian Real relative to the USD, each has done even better in terms of the our home currency. Bingo.
This is an illustration of the importance of exchange rates, not a victory lap. The danger of victory laps is they condition the mind to gloss over disconfirming data. We don’t do victory laps for that very reason. While our Brazilian holdings have contributed nicely to our performance for the year, we are not yet declaring victory. We like what we see to date and we continue to hold our Brazilian investments.
Our Brazilian holdings illustrate the bingo effect of getting both the company-specific analysis and the exchange rate analysis correct.
Had our three Brazilian investments been disrupting the Egyptian financial services markets rather than the Brazilian markets, our results in terms of our home currency would be quite different. The Egyptian Pound has lost 49% versus the USD over the last 24 months and is down 20% versus the USD so far this year. If they had been disrupting the Turkish financial markets, our results would have been even worse. The Turkish Lira has lost 72% versus the USD in the last 24 months and is down 33% versus the USD so far this year. Argentina? Don’t even think about it. The Peso is down 78% versus the USD in the last couple of years.
Yes, exchange rates do matter for international investors. We take them seriously.
