A Great Global Stock With a Free Kicker

Legendary investors are made by their ability to anticipate the trends that will shape markets well before those trends are widely seen or priced into the market. Superinvestor Warren Buffett closed out much of his derivatives exposure from subsidiary General Re by 2005, well before derivatives hit the wall from 2007 to 2009, which helped him avoid the meltdown.

Now a growing chorus, including voices of the Obama administration and prominent economists such as Fed Chairman Ben Bernanke, is calling for a change that will cause a massive shift in international trade. This means that agile investors have an opportunity to play this change before it's fully reflected in share prices.

Excellent exchange
The massive shift concerns China's exchange rate, which many analysts view as simply too low, destabilizing global trade. Since 1995, China has kept its rate effectively pegged to the dollar, at a low level that makes its exports ultracompetitive in world markets.

Now experts such as Nobel laureate Paul Krugman still believe the renminbi (also known as the yuan) is underpriced. Goldman Sachs is predicting a rise, and Wells Fargo expects that the renminbi could gain as much as 15% by the end of next year. Those would be massive tailwinds for well-positioned Chinese stocks.

Here's why the renminbi is likely to rise soon.

To maintain a fixed exchange rate, China has had to buys tens of billions of dollars every month, in order to resist the pressure toward currency appreciation caused by the piles of foreign capital inundating its too-cheap markets.

As if that weren't enough, China's exchange rate policy is confounding policymakers' efforts to get developed economies humming along again. As the Federal Reserve reduced interest rates to jump-start America, the dollar depreciated relative to other currencies. Since the renminbi was tied to the dollar, U.S. exports gained little to no advantage against China, while Europe suffered further. China effectively "piggybacked" American efforts.

As Krugman explains, "In the current environment, with high unemployment around the world and policy interest rates as low as they can go, this is a predatory, beggar-thy-neighbor policy."

Throughout this saga, China complains bitterly about high inflation, and laments its extensive holdings in dollars. As both Bernanke and a group of Citigroup analysts noted, currency appreciation would help tame China's inflation, helping it buy the natural resources it so desperately needs.

How now, Mao?
As I hinted above, one solution to this situation is for China to allow the renminbi to appreciate relative to the dollar. That's the line taken by the Obama administration, which recently informed China that currency policy will occupy a prominent place in the two countries' economic talks.

If China allowed its currency to appreciate, its manufacturing and other export-reliant industries would suffer in the short term. That increase in costs would in turn squeeze major importers from China, such as Best Buy (Nasdaq: BBY) and Home Depot (NYSE: HD), which source massive amounts of products from there.

However, the currency move would help American companies that are quickly expanding Chinese operations. Coach (NYSE: COH) has seen great success in China, with results running about a year ahead of estimates. It reported double-digit same-store sales there in its most recent quarter. McDonald's (NYSE: MCD), with its popular franchises in China, is looking to nearly double its store count by 2013, from about 1,100 outlets to 2,000.

But obviously, neither is a pure play on China, and neither will experience the full burst of the renminbi's appreciation. To find such an opportunity, it's a good idea to look at Chinese companies.

But rather than haphazardly buying Chinese stocks, hoping that American and Chinese politicians can come to an agreement, you'd be better off finding absolutely solid Chinese companies that are thriving now, and will continue to thrive if and when the renminbi appreciates. In that scenario, currency gains can become the tailwind to a great investment.

Stocks such as these would be likely winners from currency appreciation:

Source: Capital IQ, a division of Standard & Poor's.

By buying an efficient and reasonably priced company such as China Mobile, you have the opportunity to profit from an undervalued company and the renminbi's appreciation. Better still, your investment gains in dollar terms, even if the stock's relative valuation remains the same. Because currency appreciation, not investor demand, is driving the stock higher, a cheap company is still cheap, and you've captured a currency gain for free. Tack on the power of multiple expansion, and you could quickly see blockbuster returns.

An interesting proposition
There's plenty of noise in policy circles about China's cheap currency, but of course China is not the only place where you can use exchange rates to juice your returns. At Motley Fool Global Gains, advisors Tim Hanson and Nathan Parmelee have recommended rock-solid companies across the globe whose stocks are poised to gain from excellent fundamentals and a falling dollar. You can read all about them by clicking here to join Global Gains free for 30 days.

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This article was originally published April 16, 2010. It has been updated.

Jim Royal, Ph.D. , doesn't own shares of any company mentioned. Best Buy and Home Depot are Inside Value choices. Perfect World is a Rule Breakers recommendation. Best Buy and Coach are Stock Advisor picks. Motley Fool Options has recommended a bull call spread position on Best Buy. The Fool owns shares of Best Buy, China Mobile, and Perfect World. The Fool has a disclosure policy.