Lately, I know of too many people jumping into international funds who have no business investing overseas. Everyone's getting in the game. Small-town financial advisors are telling their middle-class American clients to considerably beef up their international exposure. Publications that should know better are touting investments in China, India, and other emerging markets without regard to due diligence and otherwise all-important measures of corporate valuation.

They're doing this because, in hindsight, the weakening dollar has boosted the returns on international investments. Take special note of the word "weakening." I said weakening, not weak. The return on an international investment is only boosted when the dollar falls. Not just because the dollar is weak. And the gain doesn't mean anything if it's just on paper. You haven't really gained anything until you "realize" it by liquidating the investment and locking it in.

It works like this: Dollars are converted to a foreign currency, which are in turn invested in foreign securities. Assuming there's no change in the value of the investment, when it is liquidated, the same amount of foreign currency is received as originally allocated, excluding transaction costs. Finally, when the money is exchanged back into dollars, if there has been no change in the exchange rates, the same dollars come out of the transaction as were put in. In other words, it's a wash.

This might seem like a pointless bit of information, but the impact of currency exchange on an investment can be quite confusing. Many investors don't realize that it's not the weak dollar alone that adds value to a foreign investment -- it's the change in the exchange rate. Specifically, the devaluation of the dollar is what adds to the value of a foreign investment. When the investment is liquidated and the assets are exchanged back into dollars, the stronger value of the foreign currency will purchase more dollars, so more dollars come out than were put in.

Humpty dollar
Try as they might, all the king's horses and all the king's men couldn't pick the dollar back up again. To my way of thinking, contrary to popular opinion, the dollar's weakness is actually a testament to its power and leadership. Right now, the weak dollar has received unofficial approval from the U.S. government, because it's done nothing to support it. Meanwhile, foreign governments worldwide are pleading for support of the dollar -- and are buying them -- in an effort to force the currency back up.

But to no avail. The dollar hasn't budged. Though, one might say, it's so weak there's no saving it.


From a trader's perspective, shorting the dollar has been a reasonably safe bet, and will continue to be so long as the government continues its laissez-faire approach to supporting a strong dollar. But don't count on that to continue forever.

Dollar's destiny
About the same time the Fed decides it's time to raise rates, expect a re-commitment to the dollar's strength from the U.S. government, because the two go hand-in-hand. A weak dollar puts upward pressure on the prices of goods imported into the U.S., and therefore is a potential source of inflation. At the point where the economy is deemed sufficiently on sound footing, and the threat of inflation becomes detectable, the Fed will likely look to raise rates and support the dollar in the currency markets.

But at the first sign of real support for the dollar, currency speculators will want to close out short positions and get long, creating a "short squeeze." If that happens, the dollar could rise surprisingly fast and, as it strengthens, the realizable return on foreign investments could fall equally fast. To put it another way: Starting from the break-even point, if the dollar rises in value against the currency of a foreign investment, when the investment is liquidated and the currency is exchanged, it will be at a loss. For the average long-term investor, betting on currency fluctuations alone is a bad idea. But it is a good idea to understand the impact exchange rates have on the companies you invest in.

The exchange effect
The effect of exchange rates works differently for companies than for individual investors. The investor buys the foreign currency, and then sells it back again. It's a round trip. Companies, on the other hand, are affected by the level of a currency. For example, if DaimlerChrysler (NYSE:DCX) manufactures a car in Germany and sells it in the U.S., it is paying euros for the assembly costs, and selling it for dollars. If the dollar is relatively weak, then the company will get relatively fewer euros with the dollars it got from the sale of the car. It's a one-way transaction. Every time DaimlerChrysler sells a car in the U.S. that it makes in Germany, it takes a hit if the dollar is weak.

However, this effect can be far less significant for companies that have manufacturing plants in the same country in which they sell the goods. For example, Toyota (NYSE:TM) put up some great numbers in 2003 despite the relatively strong yen, because many of the cars it sold in the U.S. were made in the U.S. The company buys dollars with yen to pay manufacturing costs, and then converts the dollars received for auto sales back into yen.

Another example is Caterpillar (NYSE:CAT), which has manufacturing plants outside of the U.S. It might have had an additional gain if it manufactured machinery stateside, and then sold the machinery overseas (ignoring shipping costs). However, since Caterpillar makes machinery in the same country in which it is sold, the impact of currency exchange is irrelevant.

Big names, big numbers
Many U.S. companies have substantially benefited from the weak dollar, including IBM (NYSE:IBM), Coca-Cola (NYSE:KO), and Eastman Kodak (NYSE:EK).

IBM's fourth-quarter revenues increased by 9%, or $2.2 billion, from a year earlier. Some $2 billion of that came from favorable currency transactions. On a constant-currency basis, revenues rose by just 1%. Currency translation contributed 5%, or more than $5 billion, to Coca-Cola's operating income. And thanks to the weak dollar, Kodak's revenues rose 10% to $3.8 billion. Without a weakened dollar, revenues would have risen a mere 4%.

On the other hand, foreign companies doing extensive business in the U.S. have been negatively affected by the weak dollar, including Honda (NYSE:HMC) and DaimlerChrysler. Honda reported that its unchanged revenues of $18.5 billion would have increased by more than 6 % to $20 billion. DaimlerChrysler's 2003 revenues decreased 7% to $171.9 billion. Had it not been for the strong euro, revenues would have been up 3%. The unfavorable exchange rate cost the company $18.5 billion.

Leave it to the daredevils
It's important to understand the impact of currency exchange on your investments. The large drop in the dollar, over a relatively short period of time, illustrates that exchange rates can have a very significant impact on a company's bottom line and on your account balance. Furthermore, at these levels, the risk of betting against the dollar far outweighs the potential reward. Long-term investors shouldn't be selling the dollar short anyway. Leave that to the daredevils.

If you put money into an international investment now, and are expecting the weak dollar to boost your return, then you're betting against the dollar. Hey, if you like to buy high and sell low, then go for it.

Fool contributor Mark Mahorney wrestles bears in Denver and promises to respond to all emails. He owns no companies mentioned in this article. The Fool has a disclosure policy.