Offshore investing - Allan Gray
Offshore investing

Central Banks and Big Macs: Finding value in currencies

One of the easiest ways to lose money is to buy something for more than it is really worth. When picking stocks, we seek to avoid permanent capital loss by buying shares of businesses that are priced well below our assessment of their intrinsic value. The currency equivalent of this involves shifting exposure away from currencies with the greatest risk of purchasing power loss, and toward those that appear to be undervalued.

As a simple illustration, a Big Mac costs about US$5.30 in New York and ¥450 in Tokyo. All else being equal, the cost of a hamburger should be about the same whether you are in Manhattan or Marunouchi, so we should expect the exchange rate to be about 85 yen per dollar. The actual rate is 142 yen per dollar, meaning that a Japanese visitor to the US will pay ¥750 for their burger – more than 60% above what it would cost them at home. Meanwhile the American in Japan will get a burger bargain at just US$3.15, or a 40% discount to the US price. This suggests that the dollar’s purchasing power is much higher than it should be, and vice-versa for the yen.

As simplistic as the Big Mac method may seem, we come to a similar conclusion after far more extensive analysis. No matter which economic model we use – whether based on purchasing power or other methods – the yen looks exceptionally undervalued relative to the dollar. Our research suggests that its fair value is near 100 yen per dollar. With the exchange rate currently at 142, that is an unusually wide gap between value and price.

There are reasons why this discrepancy has made sense. The US Federal Reserve has been eager to tame inflation and has been more aggressive than most major central banks in hiking interest rates. Japan has long had the opposite problem – not enough inflation –and the Bank of Japan has therefore been slow to abandon its longstanding near-zero interest rates, even in the face of accelerating core inflation over the past year.

The difference in yields between the two countries has proven irresistible for many investors, fuelling capital flows into the dollar at the expense of the yen. Indeed, in the post-pandemic period – when the US rate hikes began in earnest – the exchange rate has moved closely with changes in the yield differential between 10-year US Treasuries and Japanese Government Bonds (JGBs).

At a time when the Almighty Dollar appears priced for perfection, we believe it carries substantial risk of a purchasing power loss. We’ve aimed to mitigate that risk by shifting part of the Orbis funds’ currency exposure away from the dollar and towards more attractively valued currencies.

There, the yen sticks out. While the euro and British pound have strengthened by about 15% versus the dollar in 2023, the undervaluation in the yen remains as extreme as any we have seen for some time.

As a reminder, we have a separate process for making currency and stock selection decisions. Our equity analysts focus on identifying the most attractive ideas in their areas, and our currency team provides an independent perspective on each portfolio’s overall currency exposure. This allows both teams to focus on what they do best – we don’t want our stockpickers to be part-time currency traders – while also giving us the ability to fine tune exposure to specific currency risks and opportunities.

In the Orbis Global Equity Fund (the Fund), Japanese stock selections currently account for 14% of the portfolio compared to about 7% of its benchmark. On an accounting basis, we therefore “inherit” a substantial overweight position in the yen simply by virtue of the Japanese shares that we own. But given the yen’s attractiveness, we have increased the exposure further (via forward contracts), bringing the yen’s exposure to 17% – almost three times its weight in the benchmark. Compare this to the US, where our stock selections account for 47% of the portfolio versus two-thirds of the benchmark, and where we’ve dialled back our currency exposure further still.

At a time when the dollar has been strong, positioning ourselves away from it has been painful. As with our contrarian stock selections, however, we are willing to look past short-term underperformance and let intrinsic value guide our decisions. If anything, it’s often that pain that creates the opportunity. Historically this approach has served our clients well as currency management decisions have modestly contributed to the Fund’s relative returns over its more than 30-year history. There were plenty of times along the way when currency positioning didn’t matter all that much. But there are moments when it can really matter – and we think this is one of those times.

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