Stocks to benefit from a falling Aussie dollar

It's by no means the consensus view, but if one of the more bearish outlooks for the A$ is correct, it still has a long way to fall before it hits bottom. Due to a 'perfect storm' of increased reliance on foreign capital, fast falling interest rates and the weakness in the latest GDP numbers, one prominent fund manager claims the A$ is at far greater risk of tumbling to low of US40c than most people realise.

The direction of the A$ is largely determined by the underlying performance of the economy, commodity prices, plus interest rates and so far this year it's fallen as low as US68.28 cents in January, only to nudge US80c three months later before bouncing lower.

It's still possible over the short-term for the A$ to bounce higher, and the Reserve Bank of Australia (RBA) expects it to climb towards US77c by end-2016.

But it's only a matter of time, the maverick fund manager argues before foreign investors realise how overvalued the A$ really is. Adding to downward pressure on the A$ would be further RBA rate cuts to 1% and possibly lower, and a long-awaited decision by the Federal Reserve (The Fed) to gradually increase its own interest rates.

The currency has dropped more than 20% over the past 12 months, and the consensus view is that it does remain overvalued. However, while possible, a further 45% fall from current levels of around US73 to US40 does appear unlikely, with a fall to the mid US60c being a more realistic outcome.

Nevertheless, you should consider both eventualities, the wider repercussions for the stocks you currently own, and how you can profit from it.

While the correlation between the A$ and share price movements – and interest rates for that matter – has declined somewhat in recent years, there are some useful guiding principles that you as an investor should understand.

First principles of currency impact

Currency should never be the primary determinant of stock selection, but with a sizable chunk of listed company earnings sourced offshore, you can't incubate yourself against currency risk/opportunity.

That's why you need to know the currency impact, and the more direct the currency exposure, the greater the earnings hit (good or bad) is likely to be.

Everything else being equal, a 10% drop in the A$ could typically be expected to increase company earnings by a notional 3%.

A falling A$ is typically good for exporters, especially companies in agricultural and manufacturing sectors as it boosts their price competitiveness in overseas markets, while property trusts with unhedged overseas exposure should also benefit.

With A$ expected to weaken, despite short-term upside, having exposure to quality stocks with overseas income streams makes a lot of sense.

To determine the A$ impact on earnings, it's important to find out what percentage of profits were generated from the company's international operations and apply the change in currency to this proportion of profits.

As a rule of thumb, stocks leveraged to a lower A$ can expect some lift in earnings per share (EPS), and a corresponding improvement in demand should be of particular benefit to large diversified miners.

Some of the stocks that fare worst from a 1c drop in the A$ include Qantas (ASX: QAN), Reject Shop (ASX: TRS), Virgin Australia (ASX: VAH), Pacific Brands (ASX: PBG), while some of the biggest beneficiaries include Iluka Resources (ASX: ILU), Alumina (ASX: AWC), Incitec Pivot (ASX: IPL), and Caltex Australia (ASX: CTX).

It's also important to note that the franking percentage of dividends is often the inverse to foreign earnings. This means that a larger company that pays low franking credits is likely to benefit from a weaker A$ as paying Australian tax is required to generate franking credits.

Similarly, if you're attracted to local stocks, and the 'currency play' is an added bonus, then pay attention to the company's hedge book to determine the 'translation effect' of bringing offshore profits home.

Sectors that benefit from a weaker A$

Established healthcare businesses, many of which have substantial operations outside Australia, like CSL (ASX: CSL), and consumer discretionary stocks typically benefit from a weaker A$, due partly to segmented pricing which makes local retailers more competitive relative to overseas online stores.

For major companies with substantial overseas operations/sales like Cochlear (COH), Ansell (ANN), Amcor (AMC), Brambles (BXB), Westfield (WDC), QBE Insurance (ASX: QBE), Computershare (ASX: CPU), and Aristocrat Leisure (ASX: ALL), to name only a few, a lower A$ results in higher translated overseas earnings.

At the smaller end of the market, companies like dental products manufacturer SDI Ltd (ASX: SDI), software business Integrated Research (ASX: IRI), and electronic parts catalogue provider Infomedia (ASX: IFM) also benefit from a weaker A$.

Mining stocks

A weakening dollar can be a double-whammy for some miners, by both offsetting expected weakening in commodity prices – especially iron ore – while boosting foreign earnings (exports) once they're repatriated to Australia.

As a case in point, Fortescue Metals Group (ASX: FMG) incurs nearly all of its costs in WA, while its iron ore is shipped off into international markets, where it's sold in US$. As a result, the stock is not only a highly leveraged play on the iron ore price, but also a play on the A$/US$ exchange rate.

35% of ASX stocks generate earnings offshore

Admittedly, with hedging structures offsetting revenue and input costs, the correlation between the A$ and share price movements isn't as easy to gauge as it once was.

However, a falling A$ means local manufacturing operations that sell their goods overseas or trade at a price determined globally, are more competitive. But on the flipside, companies with overseas manufacturing that sell into the domestic market like ARB Corporation (ASX: ARP), Super Retail Group (ASX: SUL) and GUD Holdings (ASX: GUD) are more exposed to a falling A$.

Some key stocks to watch as the dollar drops

Aristocrat Leisure (ASX: ALL): With around 60% of Aristocrat's revenue coming from North America, any further softening in the A$ will contribute favourably to the full year bottom line. The second half will also benefit from the growth in the Class III premium gaming segment installed base over the first half with increased installs in the second half also likely to support growth. With higher-end price targets now north of $15, the current share price still remains relatively attractive, and the stock is likely to be re-rated on the strength of successive acquisitions.

Mantra Group (ASX MTR): Signs of a further weakening in the A$ are adding to the attractiveness of Australia as a holiday destination. The stock is well positioned to continue its growth-by-acquisition strategy, and the purchase of the Ala Moana Hotel in Honolulu suggests it's increasingly willing to expand beyond its home turf to find the right opportunities.

Harvey Norman (ASX: HVN): With operations in NZ, Slovenia, Croatia, Ireland and Northern Ireland, an expected decline in the A$ is also likely to boost the retailer's earnings.

Treasury Wines Estates (ASX: TWE): Generates about three-quarters of its revenue from overseas, so a weaker A$ clearly helps. The company's China business will, within five years exceed the UK as the third biggest profit contributor for company, behind Australia and the US. The company is also on-track to have no debt by 2018 and has pledged to continue driving down costs, further acquisitions from the group are likely, this is also likely to warrant future upgrades.

Sydney Airport Holdings (ASX: SYD): Since 2006, Sydney Airport has averaged return on equity (ROE) of 9.09%, and this is forecast to jump from 19.95% in 2015 to 26.08% in 2016, 45.94% in 2017 and 119.92% in 2017. Adding to the sustainability of future growth is a long-term trend in visitor numbers, especially from Asia, with Chinese visitors up around 20% for the FY16 year to date with a lower A$ making travel to Australia even more attractive.

Macquarie Group Ltd (ASX: MQG): It's understood that 56% of Macquarie Investment Management (MIM) assets under management (AUM) growth from 2011 to 2015 can be attributed to the lower A$ – with 81% of assets denominated in other currencies. Assuming the A$ does have considerably further to fall, it's possible that the investment bank could again repeat the recent 'pre-GFC' performance.

Ardent Leisure Group (ASX: AAD): Much of the company's outstanding half-year result can be attributed to the expansion in its US-based family entertainment Main Event division – with 48% year-over-year A$ revenue growth during the first half of its fiscal year – which means Main Event now accounts for almost a third of the company's overall revenue. Any further A$ from here only boosts the 'translation effect' of bringing offshore profits home.

Kathmandu Holdings Ltd (ASX: KMD): Renewed overseas ambitions are a major shift in strategy since plans last year to close its four bricks and mortar UK stores and abandon expansion plans in Europe, to focus on the Australian business. A blended model approach deployed by the company's major competitors internationally – like North Face, Patagonia and Columbia –could see Kathmandu's polar fleeces, waterproof pants and hiking boots sold in overseas department stores, sporting goods stores and franchised shops under new business models.

Premier Investment's (ASX: PMV): Capturing the market's imagination is the brilliantly executed domestic and international expansion of the company's flagship brand, colourful stationary chain Smiggle – which saw global sales up 46.5% after adding 22 stores, including 18 in the UK. Premier plans to repeat the early success of Smiggle in Australia in Britain and aims to have 70 stores open in the UK by July and 100 by Christmas, and 200 Smiggles stores open and sales of $200 million-plus annually by 2021.