Newsletter September 23, 2007

InvestorsFriend Inc. Newsletter September 23, 2007

Currency Exchange Costs

When Canadians buy U.S. products or U.S. stocks they may not be aware that that they are paying a fairly hefty and hidden commission to convert the currency.

With the Canadian and U.S. dollar trading at about equal values, this hidden commission may become more visible.

I have investigated the fees and found that it costs investors and consumers from 0.9% to 2.5% to exchange money. The lower fee was through TD Waterhouse where the entire transaction would be electronic. I found that a “round trip” of investing in a U.S. stock in a Canadian currency account and then later selling that and going back to Canadian currency would cost 1.8%. That is hefty and absolutely dwarfs the more visible stock trading commission.

The situation at bank branches seems much worse. I was quoted a “round trip” cost of 3.4% to convert $10,000 at an HSBC branch. (Presumably about 1.7% for each direction) Thomas Cook, which specializes in exchange transactions quoted me a round trip cost of a shocking 4.5%! And look as you will, I doubt you will find this fee posted visibly in any bank branch.

CIBC visa charges a hefty 2.5% in addition to the official exchange rate and American express charges the same 2.5%. (A coincidence?).

I’m normally in favor of free markets and figure for the most part competition will eliminate excessive profits.

But foreign exchange for consumers seems to be a business with little or no real competition and (not coincidently) with little visibility of the fee. Who asks the foreign exchange commission when they choose a credit card? Ask your bank how much of the exchange difference is a bank fee and I suspect you will have difficulty to get anyone to even understand your question, let alone answer it. When a consumer changes currency he or she basically can’t see the bank’s commission, the commission is rolled into the exchange rate. So when they changed $10,000 Canadian and received $9,000 U.S. or charged $10,000 U.S. on a credit card, most consumers would be blissfully unaware that the bank made an easy $100 to $250 or more on that one-way conversion.

To me, this looks like an extremely (or obscenely?) lucrative business for the banks and credit card companies. The banks take a little bit of risk on exchange rate movements since they have to keep an “inventory” of currency on hand in the branch. But I suspect that risk is rather small. Also consider that gasoline retailers take similar commodity price risks and handle a dangerous physical product and their total markup is only about 4% (and falls to 2% after we pay with a credit card.). When banks and credit cards change currency electronically, they would need little or no inventory and face no variable costs and probably no credit risks. To make about 1% on that kind of transaction is a sweet business indeed. And for the credit cards, 2.5% can only be called obscene. The credit card companies already make their full normal fees on the transaction from the merchant and from any interest costs. The extra 2.5% for foreign exchange seems to be just an extra fee.

My advice is to shop around when making currency transactions or choosing a credit card. Always get both the price at which they are willing to sell the currency to you and the price at which they are willing to immediately buy it back. The difference is the “round-trip” cost of conversion. The one-way cost is approximately half of the round-trip cost.

Also Canadians who do much traveling or U.S. business should open U.S. dollar accounts and look into obtaining U.S. dollar credit cards.

Investors should generally open U.S. dollar accounts for their U.S. investments. This is not possible in RRSP accounts. But you may be able to use money in a U.S. dollar money market fund inside an RRSP and the broker may not charge conversion fees when buying and selling U.S. stocks using the funds in the U.S. dollar money market fund. TD Waterhouse allows this, although it has to be done by phone rather than online.

You May be Richer Than You Think

American investors who invested in Canada are enjoying tremendous gains from the higher Canadian dollar.

In contrast Canadians who invested in U.S. stocks have been hurt by the rise in the Canadian dollar. It’s undeniable that they would have been better off to have (against almost all advice) stuck to 100% Canadian investments only. In my view, it was indeed absolutely prudent to invest some funds in the U.S. even though hindsight says it was a bad move.

But I would argue that Canadians investors have also benefited greatly from the rise in the Canadian dollar.

All of your Canadian net worth that used to be worth as little as 62 cents on the dollar in the United States in now worth fully 100 cents on the dollar. This is no small point.

It has been over 30 years since a Canadian could trade in their money for U.S. dollars at parity or higher.

A given amount of income or wealth in Canadian dollars has risen over 50% in U.S. dollar terms since the lows reached around the start of 2003. Most Canadians will at some point vacation in the U.S., almost all will buy products imported from the U.S., and many will retire to the U.S. at least for winters.

The cost of U.S. vacations for Canadians is down dramatically. The cost of many imports from the U.S. are down dramatically (or soon will be as competition and cross-broader shopping) forces import prices down in Canada.

The cost of a U.S. vacation home in Canadian dollars is down over 15% in 2007 due to exchange rates and that is on top of price declines that are happening in the U.S.

Any Canadian that is considering moving to the U.S. will enjoy a large increase in the value of any financial assets that are being transferred into U.S. funds.

The bottom line is that when a Canadian’s income and net worth rises 50% in U.S. dollars that is a very big deal and so Canadians may indeed be richer than they think.

Can’t Beat This Stock Market Down With a Stick?

There are a number of Sticks and Hammers that are putting downward pressure on the stock market:

  • Mortgage defaults are rising and are expected to keep rising in the U.S. for the following main reasons: Large mortgages were issued to people to buy houses at inflated prices, with none money down, and (most incredibly) based on “stated” (but not verified) income. These mortgages are also know as “liar loans”. Even larger mortgages were issued to people at incredibly low “teaser” rates and the lenders crossed their fingers and hoped that the borrowers would be able to afford the much higher payments after these mortgages “re-set” to much higher rates after several years (which they are now doing). These mortgages were then packaged up and sold to corporations and investors as safe investments. As the borrowers start to default en-mass there is an ugly domino affect that spreads the losses around.
  • The bull market’s very age weights on it, markets tend to go up in the long term but do so in fits and starts. After five years of strong markets we are over-due for a year of negative returns.
  • Long term interest rates have trended up compared to the start of 2007. It is long-term interests much more than short-term rates that should matter most in stock market values.
  • New house inventories are up and house prices are declining in the U.S. This could cause many people to slow their spending and some people to default on mortgages. (Why pay a mortgage on a house you can’t afford when the value of the house is less than you owe?)
  • Driven by the above factors the U.S. economy is generally thought to be heading for a recession.
  • In Canada the impact of a high dollar will hurt many companies and virtually crush others. This should start to really show up in the Q3 earnings reports.

For these reasons the market has taken noticeable dips on several occasions this year. But amazingly it has bounced back each time and today, buoyed by the recent short-term interest rate cut, it sits at almost record highs. Markets in the U.S. may also be expecting further interest rate cuts. Also the U.S. government seems likely to continue to act as a cheerleader and try to convince Americans that they should continue to bid stock and house prices up. And in Canada it is entirely possible that interest rates will be cut to curb the rise in the dollar. That would give a boost to stocks in Canada. Another reason for the buoyant market is the fact that earnings so far have remained quite strong and the P/E ratio of the market does not appear to be very high and in fact is generally near a low point of the past 10 years.

I am bullish on markets for the long-term. However, in the short-term I am somewhere between cautious and down-right fearful of a temporary market decline in the range of perhaps 15%.

Overall, I am keeping most of my funds in the stock market but I am trying to raise my cash position for possible bargains ahead. I am also keeping my money in higher-quality stocks – Companies that I am reasonably comfortable in owning even if their share price declines. I favor companies that are almost certain to eventually bounce back from any market decline.

Subscribers to our Stock Research have access to our current Stock Picks as well as to the composition of my own portfolio.

Impact of the Higher Dollar on Your Investments

The positive or (more likely) negative impact of the much higher Canadian dollar on various companies varies by individual company and depends on any hedging strategies. But the general rules are as follows:

Revenues mostly from outside of Canada with expenses mostly in Canada equals the house of severe pain (exporters)

Expenses outside of Canada and revenues inside Canada equals heaven (importers)

Operations outside Canada (revenues and expense) equals more moderate pain

Recently I looked at the probable impact on each of the companies that are featured for our paid Subscribers.


Shawn Allen, President
InvestorsFriend Inc.

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