Wednesday, October 12, 2011

Markets Affect The Business

There is an implicit assumption in value investing that market values or changes in market values do not affect business values. This is not entirely true. This occurs not only from a macroeconomic perspective (e.g. some economists believe wealth effects in the market lead to changes in business conditions), but also from a microeconomic perspective. For example, a bank whose price is falling may lose the confidence of lenders with whom it transacts on a frequent basis. This can and has led to deterioration in a bank's value as a result of its price movements.

Banks are not the only example. Market volatility can indeed affect business value. Nowhere is this more clear than in the currency market.

The recent volatility in global stock markets has been accompanied by rather dramatic movements in currency values. Some companies are barely affected by currency movements, while others are severely affected. (For example, both exporters and importers are likely to be affected.)

Sometimes currency prices can have such dramatic effects on business values that such businesses are as predictable as those in commodity industries. For example, consider ADF Group, which has been previously discussed on this site as a potential value investment.

Recent currency swings between the Canadian and US dollars have likely dramatically affected operating profits. Consider this note from the company's latest financials:

"[A] 10% strengthening of the Canadian dollar over the U.S. currency would result in 
a $3.3 million decrease in income before income taxes...for a complete fiscal year."

This is no small amount, since the company's current market cap is just $40 million. A prolonged currency move (that lasts several years) could thus change this company's business value by more than its market cap!

Value investors look to find companies at cheap prices in relation to their business values. However, it's important for such investors to recognize when market prices can actually affect business values. It's not all bad in this regard, however; cheap prices combined with buybacks can actually increase business values, as discussed here.

Disclosure: No position

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