How Currency Markets Are Upending the Dow Today

Although we don't believe in timing the market or panicking over market movements, we do like to keep an eye on big changes -- just in case they're material to our investing thesis.

A strong dollar is good, right?

On the surface that seems like an easy question to answer because a stronger dollar leads to more purchasing power, which is good for U.S. consumers. But the question gets far more complicated for U.S. companies that operate overseas and report earnings here at home.

Today, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) is down 0.26% in late trading partly because Procter & Gamble (NYSE: PG  ) warned investors that profits would be lower than expected in 2014 because of currency headwinds.

This is important for the Dow because so many of the large conglomerates in the index are heavily invested abroad and could see profits fall if currencies continue to decline around the world. For example, 3M (NYSE: MMM  )  collects more than 70% of its sales from foreign consumers and still makes a large percentage of products here in the U.S., which leaves currencies more problematic, something I'll cover below.

Even growing sales of Tide internationally might not bring more profit to Procter & Gamble.

What P&G said today
Even though P&G expects core currency-neutral earnings to rise between 12% and 14%, it said today that it expects about a 9% headwind from currency changes. All-in, generally accepted accounting principles earnings are only expected to be up 2% to 5%, a far cry from the double-digit growth when currency changes are taken out.  

The challenge for companies like Procter & Gamble and 3M is that a strong dollar makes international sales look smaller and can have a compounding effect on earnings. For these companies, a weaker dollar would help earnings growth, which seems counterintuitive on the surface.

Why do currencies impact earnings?
To understand how currencies impact earnings, let's look at a hypothetical example in which the currencies start at a value of $1 to 1 Jewel (my fake currency name). Let's say that in quarter No. 1 a U.S. company has 100 Jewels of sales in a foreign currency and makes a 10-Jewel operating profit on those sales. In the U.S., the income statement would show $100 in sales and a $10 operating profit.

In quarter No. 2, the foreign country's currency falls 10%, meaning the same 100 jewels in foreign currency sales fall to $90 and the 10-Jewel operating profit falls to $9. But this assumes that costs are also in Jewels, which may not be the case.

If the product was imported from the United States for $50 it would cost $55.56 in quarter No. 2, further lowering the nine-Jewel operating profit to 4.44 Jewels. Now translated back to dollars the operating profit is $4.

In this example, the 10% drop of a currency led to a 60% decline in operating profit, which is something like what might happen with companies such as Procter & Gamble and 3M, which make a lot of products here and sell them overseas.

Currencies can impact your investments
Don't overlook the impact currencies can have on your investments. They're key for companies that do business overseas and they'll be a headwind for Dow Jones Industrial Average components in 2014.

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