Sterling has crashed before. And it could crash again. In this situation we need to have some insurance in place.
The pound has fallen hard against the dollar and hit a 4 ½ month low against a basket of currencies. Nervousness is back again. Your sterling assets are rapidly losing value on the international stage.
But you can insure against a falling pound. And there’s a way to do it which means you won’t lose if we avoid the crash. We’ll look at that in a minute; first let’s see how this story could pan out…
What could happen in a crisis?
There are many theories that try to explain currency movements. Some theories are based on interest rates and inflation expectations, while others focus on the idea that similar goods should be of equal value regardless of currency.
But frankly, all these theories fall to pieces during a panic. If speculators believe the pound will continue to fall, they sell it. Falls feed on themselves. Soros made a famous attack on the pound back in 1992 when devaluation forced it out of the ERM. Today there are more Soros’s about. Hedge funds control vast amounts of wealth and if they gang up on a country, a vicious currency collapse is possible.
If the Bank of England loses control, its normal policy levers may not work. In fact, they can even go into reverse. During the ERM debacle raising rates were supposed to resuscitate the pound. They didn’t. The markets ran amok.
If a crisis hits, we don’t have a clue how the Bank will react. In the past they have introduced exchange controls, hiked rates and even phoned the IMF for a loan. They also have the option of doing nothing at all, though I can almost guarantee that they won’t play this card.
As we don’t know which way the Bank will go, it’s pointless to try to second guess them. The safest bet is to hedge against sterling devaluation, not to bet on the Banks’ policy response.
How to hedge sterling devaluation
To reduce your risk to the pound, all you need do is to sell it and buy foreign shares. But which currencies to buy? Which shares to buy? On top of this, you’ll likely end up increasing your transaction costs.
The good news is that you don’t need to work out which currencies are likely to do better than others. You don’t need to go hunting for foreign companies to invest in. In fact you don’t even need to worry about changing your pounds into dollars, euros, or whatever to buy the stock.
All you need to do is be a little selective among the FTSE stocks to find which will be the winners as sterling devalues.
Separating the winners from the losers in a sterling crisis
In the event of currency turmoil, not all stocks will react in the same way. For some the new environment will be a disaster, for others it’ll translate into profits.
The companies to avoid are those whose costs are in foreign currency, but have sales in sterling. Many retailers fall into this category. They’ll import wares in expensive foreign currency, and then sell them for devalued sterling – not a happy place to be.
The winners from a sterling collapse will be companies whose costs are in sterling, but have foreign sales. When they sell their products in the international markets, they receive strong currency, yet their input costs don’t move.
Pharmaceuticals – the great bet
So, what’s our top recommendation in the winner’s category? It’s pharmaceutical giant GlaxoSmithKline (ticker: GSK).
GSK has practically no sterling revenue. The table below is taken from their recent accounts, you’ll see that sterling sales are a trifling 3% of the total.
Better still, GSK’s earnings are pretty much a diversified basket of world currencies. This is exactly what we’re looking for.
GSK Earnings by geographic segment. Year ending 2009
|
World market by geographic region |
Value £bn |
% of total |
|
USA |
187 |
40 |
|
Europe |
131 |
28 |
|
France |
25 |
5 |
|
Germany |
24 |
5 |
|
Italy |
16 |
3 |
|
UK |
12 |
3 |
|
Rest of World |
150 |
32 |
|
Emerging markets |
66 |
14 |
|
Asia Pacific |
20 |
4 |
|
Japan |
50 |
11 |
|
Canada |
11 |
2 |
|
Total |
468 |
100 |
A significant proportion of GSK’s employees are based in the UK, so relatively speaking, these staff become cheaper as the pound falls. The pharmaceutical industry is heavily geared towards research and development, so a reduction in staff costs is very welcome.
When all of these foreign sales are translated into sterling, the figures just get better and better all the while sterling falls.
There’s another reason to suspect that GSK’s share price will keep its value even though sterling tanks. As sterling falls, GSK looks cheaper in the eyes of foreign predators. If GSK becomes too cheap, a foreign buyer will eye it up for takeover. Even though GSK is a massive company, capitalised at £63bn, it is not too large to be snapped up at the right price.
Just look at the graph for GSK over the last 5 days as the pound has been falling.
Five day chart for GSK
Of course, putting GSK in your portfolio isn’t going to remove all your currency risk. The strategy here is to try to reduce holdings in businesses that rely on imports, but earn sterling income. At the same time, to try to increase weightings towards companies with foreign earnings and sterling input costs.
What if sterling doesn’t collapse?
If sterling keeps bumbling along, that’s fine. The story doesn’t really change for GSK. It’s still a top quality blue chip player offering a handsome dividend yield (over 5%) with the opportunity for growth.
Don’t wait too long to rebalance your portfolio. If the pound collapses it’ll happen quickly and it’ll be too late to buy insurance.
Good investing,
Bengt Saelensminde
For The Right Side
P.S. The Fleet Street Letter team has recently put together a comprehensive report on how to fight the sterling weakness. Make sure to read through this to understand what’s in store for UK investors:
THE "GREAT FINANCIAL DECEPTION" OF 2010
Your capital is at risk when you invest in shares; never risk more than you can afford to lose. Please seek independent financial advice if necessary. Fleet Street Publications Ltd. 0207 633 3600.
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