The US dollar is trading at 20-year highs against a basket of major currencies. It has benefited from the twin tailwinds of big interest rate hikes from the US Federal Reserves and recession fears.

When rates are rising faster in the US than in other parts of the world, the higher returns on offer attract more money into the US currency. In addition, the dollar is considered a safe haven currency and gets a boost when investors become nervous on the wider outlook.

Concerns about the UK economy mean sterling is particularly weak against the dollar, close to record lows, with consultancy Capital Economics predicting it could flirt with parity to its US counterpart next year.

Currencies are notoriously volatile and unpredictable and therefore it would be unwise to base investment decisions entirely on views over the direction of currencies. That said, a case can be made for tweaking exposure towards dollars within a well-diversified portfolio to exploit the potential for continued dollar strength.

Later in the article Shares highlights UK stocks which could benefit from continued dollar strength. There is also a case for increasing exposure to the dollar through a higher exposure to US stocks.

After all, the strength of the world’s largest economy means it is one of the few regions offering the potential for earnings growth.

One caveat here is that the strong dollar has been impacting earnings of some of the largest US companies which generate a big proportion of their earnings outside the US.

Dollar strength wiped billions off second quarter earnings from bellwether names such as IBM (IBM:NASDAQ) and Philip Morris International (PM:NYSE) prompting them to cut guidance. Therefore, domestically focused companies are better placed to take advantage of the strength of the economy and the currency.

What a strong dollar means for buying US shares

One downside of the current strength in the dollar is that it makes it more expensive for UK investors to buy US shares as your pounds will buy less shares of dollar-denominated US stocks at current exchange rates.

TRANSLATIONAL EFFECTS

While foreign exchange movements are unpredictable, they do have real world effects on investors’ portfolios and companies’ profits.

Consider Alice who has a US portfolio worth $1,000 in sterling terms. A year ago, it would have been worth around £740. Excluding share price movements, the same portfolio today would translate into £862 pounds, roughly 16% higher. Alice also owns a FTSE 100 ETF (exchanged traded fund) which benefits from sterling weakness against the dollar.

The FTSE 100 is not representative of the UK economy, because the larger companies in the index are global enterprises which have relatively small exposure to the domestic market. Schroder Investment Management estimates that around 71% of the combined earnings of the index are generated overseas.

This means the performance of the FTSE 100 is very sensitive to the value of the pound. The index benefits when the currency is weak and vice versa. In the weak pound scenario, every $1 of overseas earnings is worth more when translated back into pounds. It is not all good news though.

Companies which need to buy raw materials from abroad end up paying more which can impact margins. So far, the discussion has focused on UK companies which report in sterling. There is a small translation effect even when companies report in US dollars. For example, plumbing and heating products distributor Ferguson (FERG) reports in dollars and declares dollar dividends.

However, UK shareholders can elect to receive their dividend in pounds which means the company translates the US payout at the appropriate exchange rate. A higher dollar buys more pounds and increases the value of the sterling dividend. In December 2021 Ferguson paid a dividend of 166.5 cents per share.

The exchange rate for shareholders who elected to receive their dividends in sterling was announced in November, when it stood at $1.3451 and this resulted in a payment of 123.78p. At current exchange rates the same dividend would be worth 144.05p or more than 15% more.

TRANSACTIONAL EFFECTS

The last foreign exchange effect to consider is related to a potential mismatch between a company’s revenues and costs.

A good example is polymers manufacturer Victrex (VCT) which exports the vast majority of products. While the company does not disclose the proportion of its total costs incurred in the UK, it does say it is exposed to currency risks.

In the annual report the company provides a sensitivity table outlining the effect of a change in the pound/dollar on its profits.

A 5% change in the pound/dollar exchange rate is estimated to affect profit by £5.1 million which is around 6% of earnings. This means a 15% increase in the dollar versus sterling could potentially increase profit by around 18% (or reduce profit if the pound is strong).

Before getting too carried away, it is important to consider the mitigating actions a company like Victrex may take to reduce its currency exposures.

Victrex actively hedges between 75% and 100% of its expected sales one year forward. This reduces the maximum negative impact in a strong pound scenario.

Without the hedge a strong pound would reduce the value of overseas revenues and impact profitability.

It can be tricky to work out transactional benefits as firms often don’t break down their cost base by geography and lots of companies will have their costs spread across multiple territories. If the US is the dominant market then production facilities and sales teams will often be based in the US too.

Defence contractor Ultra Electronics (ULE), currently in the process of being taken over by one time UK-listed rival and now private equity owned Cobham, is an exception with more than 60% of its revenue derived from North America but more than 50% of its assets located elsewhere.

Spirits maker Diageo (DGE) derives nearly 30% of its sales from the US but has only 10% of its staff in the country.

THE BIG DOLLAR EARNERS

Several UK stocks have significant US revenue as the table shows.

As discussed a number of these business announce their results in dollars so there is no direct translational impact from a stronger dollar.

However, it is worth remembering that these businesses’ share prices are in sterling. So when the dollar earnings are converted to compare for valuation purposes, they will carry more weight.

For example, at an exchange rate of $1.30 Ferguson’s consensus forecast 2022 earnings of $9.36 would be worth 720p, implying a PE or price to earnings ratio of 13.6 times. But at the current rate those earnings are worth 810p and the PE is a more attractive 12.2 times.

The commodities conundrum

Most commodities are bought and sold in dollars and therefore resources firms declare their earnings and dividends in dollars too. Typically a strong dollar is bad news for commodities demand because it makes metals and energy more expensive for buyers outside the US. However, the major supply issues in 2022 associated with the war in Ukraine have seen these markets have remained relatively strong despite the rising US currency.

Ferguson and the likes of tool hire business Ashtead (AHT), building materials firm CRH (CRH) are plugged into the US construction and infrastructure markets, all three report in dollars.

Promotional products firm 4imprint (FOUR), which also reports in dollars, has been a surprise winner this year despite the gloomy economic backdrop.

Though it is a leader in its field, the space it operates in is so fragmented that it is still able to grow even if the overall market is shrinking.

Another dollar reporter is healthcare software firm Craneware (CRW:AIM) which does pretty much all of its business in the states with hospital operators.

Defence firms like Ultra mentioned above and BAE Systems (BA.) are heavily plugged into US defence spending with the US Department of Defense having one of the largest global military budgets.

Compass (CPG) £18.25

Proportion of revenue from US (2021): 62.2%

Reporting in sterling, catering giant Compass (CPG) should benefit from a translational effect given 62.2% of its revenue was derived from the US in 2021.

The shares aren’t cheap at 22.4 times consensus forecast 2023 earnings but we think this is justified by the company’s attributes.

It is a rare example of a business delivering growth and upgrades in 2022 as demand has returned in the wake of the pandemic.

Though not immune to inflationary pressures, Compass’ scale gives its considerable bargaining power with suppliers and the scope for growth is considerable when you consider it has just 10% share of the global food services market.

The current environment will ramp up the pressure on smaller regional providers and incentivise companies and organisations focused on in-house catering to outsource to Compass.

This is also a decent total returns story. At the half-year stage it committed to pay out 50% of underlying earnings in dividends and to return any excess capital through buybacks and special dividends.

Pearson (PSON) 889.4p

Proportion of revenue from US (2021): 63.7%

More than 60% of academic publishing play Pearson’s (PSON) sales came from the US in 2021 and it reports its results in sterling. The company has endured a bumpy ride as it has transitioned away from big expensive academic textbooks to a business focused on digital learning.

However, its latest results for the six months to 30 June suggested it had made significant progress on this front. Revenue in the first half of 2022 increased 12% to £1.79 billion from £1.6 billion a year before. Pre-tax profit jumped to £179 million from just £4 million and the company announced it had identified a further £100 million worth of costs it could take out of the business.

The shares trade on 16.6 times 2023 consensus forecast earnings.

Shore Capital says: ‘First-half results detailed a pleasing performance, strengthening our conviction that a long and sometimes painful digital transition has left it well-placed to benefit from positive trends in global learning spend.

‘There was also particularly pleasing and unexpected news on efficiency benefits, which should help it to unlock this potential and has positive implications for margins. We forecast attractive earnings growth and strong cash generation.’

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