Value Investing With Currency Risk | iStockAnalyst.com

To get the most out of the possibilities offered by value investing, investors should be prepared to buy outside of their home countries. For example, the natural disaster in Japan last year likely caused the prices of some securities to fall undeservedly from the viewpoint of the long-term investor. (Today, some areas of Europe may be in the same position due to less natural disasters.) But a major concern of international investors is currency risk. Long-term value investors situated in developed countries, however, shouldn't worry about it.

In the short-term, the demand for one currency over another can fluctuate as a result of numerous factors, including interest rate differentials, inflation expectations, and economic growth expectations. Currency speculators also seek to predict these and other factors, resulting in rather unpredictable demand shifts for various currencies over short periods of time.

But over the long-term, the strength in a nation's currency is generally governed by the productivity of its citizens. But the productivity in developed, capitalist nations is relatively stable and correlated. This is because advances by businesses in one country can be purchased and/or copied freely in other countries. (E.g. The PC is widely used as a productivity tool in all developed countries. Imagine how productivity would vary across developed countries if only one country had it!)

Consider how this has played out historically by considering a comparison between the US and the Canadian dollars. These two countries are open to trade and are capitalist societies. In 1948 (which is as far back as this table goes), one US dollar got you 1.003 Canadian dollars. Today, one US dollar gets you .99 Canadian dollars, for a difference of 1% over 50 years. Yes, over shorter time periods there have been wild swings in the exchanges rates. But over the course of your investing lifetime, the impact of these swings should be muted.

As an example, consider an investor whose investing career is 40 years long. Even a sharp currency adjustment of 50% over this period translates to only about 1% per year. To hedge a currency position for just one year, you would often pay transaction costs that are higher than this! Clearly, the selection of the right securities over time is worth far more than the currency movements, for those with a long-term perspective. Of course, implicit in this argument is an assumption that the two countries will remain capitalist.

Unfortunately, this line of thought breaks down when developing country currencies are involved. The productivity of developing countries is lower than that of developed countries. For this reason, one may expect the currencies of developing countries to appreciate over time as they play catch-up (by adopting some of the processes developed countries already practice). On the other hand, the catch-up process is not without risk, as developing countries are more prone to events that can result in economic catastrophe and/or inflation (which results in a depreciation of currency).

Depending on the long-term investor's goals and outlook, he may prefer a hedging strategy when there is such uncertainty. But when dealing with developed economies where one expects capitalistic and free-trade policies to continue, the costs of hedging appear to outweigh any adverse results that may occur from currency effects.

The Brandes Institute takes a closer statistical look at the subject here.

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