Time to dump U.S. stocks?
The Canadian dollar has been on a roll. At the beginning of March The loonie hit new 14-year highs, as it flirted with US88.5c before dropping back. At that rate, it only takes $1.13 to buy one U.S. greenback. Can par be far off?
As the loonie continued to soar, I received an interesting e-mail from a reader who asked a pertinent question. Here’s what he had to say:
“My question has to do with the devaluation of the U.S. dollar and the corresponding increase in the value of the loonie. I keep seeing recommendations for U.S. companies and wonder just where the logic comes from. These may good and viable investments but are the gains in these U.S. dollar stocks going to be nullified by the rise in the loonie? Would it be prudent to sell U.S. securities with the idea of repurchasing later?” – Joe S.
Our reader raises a very good point. Clearly the exchange rate is a factor that must be considered by investors when they are looking at the options available to them. Between January 2003 and now, the loonie has appreciated in value by about 40 per cent against the U.S. dollar. That means if any U.S. dollar securities in Canadian portfolios did not grow in value by at ast that much over the same period, the investor lost money.
It appears likely that the Canadian dollar will continue to gain in value. But even if it should get to par, that would only represent an increase of about 13.5 per cent from current levels. In other words, in percentage terms the risk is somewhat less, albeit not insignificant.
Canadians who wish to have some U.S. equity exposure have to adopt a clearly-defined strategy to manage this risk. Here are a couple of options.
Invest in U.S. equity funds that employ currency hedges. Among actively-managed funds, the two RBC O’Shaughnessy U.S. entries, Value and Growth, use this approach. Both have been high achievers as a result because their market gains have not been eroded by currency losses. The RBC O’Shaughnessy U.S. Growth Fund, which specializes in small to mid-cap stocks, has been a standout in recent years. The companion U.S. Value Fund has a large-cap focus. It has not done as well, but the three-year average of 16.4 per cent is certainly nothing to complain about. Remember, these returns are in Canadian dollars. Both these funds are long-standing recommendations of our Internet Wealth Builder and Mutual Funds Update newsletters.
You can also find several index funds which take currency out of the equation. These were originally designed to be fully RRSP-eligible at a time when foreign content was capped at 30 per cent. As a result, they invest primarily in Canadian dollar denominated index futures. One example is the TD U.S. RSP Index Fund. It turned in an average annual return of 15.9 per cent over the three years to Jan. 31. By comparison, the regular TD U.S. Index Fund only managed a gain of 4.8 per cent a year. That’s a big difference!
Choose U.S. stocks with above-average growth potential. When you pick U.S. stocks look for above-average growth potential. If the capital gain beats the currency loss by a wide enough margin, it’s worth the risk.
For example, last August we recommended Burlington Northern Santa Fe (NYSE: BNI) in my Internet Wealth Builder newsletter. At the time it was trading at US$54.30. Based on a recent price, it is up 46 per cent since then, more than enough to leave a Canadian investor with a nice gain even after taking currency into account. In September, we recommended Hughes Supply (NYSE: HUG). It is being taken over by Home Depot at a premium of almost 50 per cent over the price we paid.
So don’t give up on U.S. equities. The American market is much larger and more diversified than ours. But only hold securities you feel are good bets to outperform any future currency gains the loonie makes and be sure you have a strategy for dealing with the exchange rate issue. Plus, remember one important point: the loonie hasn’t always risen in value against the greenback. There have been prolonged periods of weakness. In the right circumstances, we could see them again.
This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. The IWB was chosen by The Globe and Mail as one of the top five investment newsletters in Canada. For more information about becoming an Internet Wealth Builder member, go to http://www.buildingwealth.ca/partner.cfm?partner=50Plus