Recently the US dollar has surged. Its gain versus a basket of major currencies since the beginning of July as measured by the US Dollar Index ‘DXY’ is almost nine per cent as of this writing. Most of this appreciation has come at the expense of the New Zealand Kiwi, the Australian dollar and the euro. Many people like to point out that the recent weakness in the euro should be a boon to European exporters and large dominant European companies. This may explain some shorter-term fluctuation in profits but empirically it is not a major long-term driver. One has to remember that companies that dominate the European stock markets tend to have business units in several major currency blocs, and in many cases, the companies are actually hedged against large currency swings. In either case, the recent weakness is only short in duration, i.e. the euro has only been falling versus the dollar for about five months and the deprecation of a whopping ten per cent makes up almost all the accounted five year weakness of 14 per cent. So when does currency strength/weakness matter and how can you think about equity investing with currencies in mind?

It seems to me that the prevailing conventional wisdom is to invest in stocks where the countries have strong currencies. The goal of course is that you will gain from rising stock prices AND then multiply this gain with that of a strengthening currency. Sounds really great in theory but in reality it actually turns out to be the opposite if you consider some factors.

In 2012 Elroy Dimson, Paul Marsh and Mike Staunton published a study in the Credit Suisse Global Investment Returns Yearbook 2012. The summary from their analysis ‘Currency Matter’ is that there is “no support for the ‘stick-to-strong-currency’ strategies.” In fact, they suggest that it is best to buy the weakness. Their analysis shows that equities performed the best after currency weakness, not strength. In fact, the outperformance after currency weakness “is robust to standard forms of risk adjustment” as well. In other words, even when taking into account the risk of certain currencies the equity markets provided superior returns.

To summarise the study if you bought stocks in the strongest currencies over five years from 1900-2011, you’d have a US dollar-gain of about nine per cent annualised. If you bought stocks in the weakest currencies of five year periods from 1900-2011, you’d have a US dollar-gain of about sixteen per cent annualised. If you only use the year’s post Bretton Woods agreement (which took effect in February of 1973), then the differences are even greater. The stocks in the five years best-performing currency markets from 1972-2011 delivered an 11.1 per cent US dollar-annualised gain. But the stocks in the weakest five year performing currency markets from 1972-2011 delivered a whopping 30.1 per cent annualised gain in dollar terms.

This reversion is likely similar to what happens with value stocks. Weak currency countries are often distressed and perceived to be high risk. Thus equities in these markets have probably been discounted and sold to the point of offering potentially excellent long-term value. On the other hand, within countries with strong currencies the news is likely to have been proportionately positive — thus there is little negative discount associated with its equity market and prices are likely to offer less value. For the value investor this makes sense intuitively. Buy low and sell high. The timing, of course, is the tricky part but a five-year period does appear to offer good odds.

I wouldn’t rush out and buy Argentinian stocks and immediately sell all Chinese ones, but it offers food for thought.

The Credit Suisse study tells us that stocks exposed to weak currencies are likely to subsequently deliver outstanding results to US dollar-based investors in subsequent years. This is only one study and history doesn’t always repeat itself but I would suggest it’s something to consider when diversifying internationally.

Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd. The views expressed are his own. Anchor Investment Management Ltd is licensed to conduct investment business by the Bermuda Monetary Authority. He can be reached via e-mail at nkowalski@anchor.bm

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.