Currency movements and share price correlations

A nice post on the Freetrade community forum prodded me into a dig around into the relationship between the value of Sterling/GBP and a companies' share price.

The reasons for currency movements were nicely summarised in the post above.

The majority of businesses listed on the LSE are traded in Sterling. Any valuation of a business in non-sterling terms, will need to be converted back into Sterling if the shares are being traded in GBP. Assets and liabilities - the stock, cash, leases etc. belonging to the business has to be revised into Sterling if we are going to understand the value of the company, which is in then reflected in the share price.

Using the Dollar to Sterling comparison, lets look at what happens when the exchange rate varies. Assume that a company makes $1000 and that this has to be converted into GBP.

If $1 = £1 then $1000 = £1000
If $2 = £1 then $1000 = £500
If $0.5 = £1 then $1000 = £2000

In the above scenarios, if the two currencies are equal, then $1000 taken in the US ends up as £1000 when converted to GBP. If Sterling increases in value relative to the Dollar, as in the 2nd scenario, so that £1 now buys $2, the same $1000 taken in the US only produces £500. The opposite happens in the 3rd scenario, where Sterling decreases in value relative to the Dollar and now £1 only buys $0.5 - in this case our $1000 converts into £2000.

Investing in companies listed in the UK does not shield those investments from currency movements. According to research by FTSE Russell in 2017 (they don't appear to have a 2019 version) the FTSE 100 generated 71% of revenues globally rather than domestically (within the UK).

However, there are plenty of businesses whose earnings are UK based. So in theory we should see that if Sterling gets stronger, the overseas earners will see the value of the overseas earnings reduce and their share price fall accordingly. And we might expect to see the opposite for those companies that earn their money in the UK - an increase in the value of Sterling relative to the currency in which earnings are made should see their share price increase, if for no other reason than that it is a reflection of the strength of the UK economy. Lets find a few companies with a high % of overseas earnings and some equivalents making their money in Blighty.

First we need to find some companies with high % of non-UK revenues:
Ferguson: 10% from the UK (2019 annual report)
Ashtead: 11% from the UK (2019 annual report)
Unilever: 7% from UK/ Netherlands (2018 annual report - UK not split out separately)
Diageo: 23% from Europe (2019 annual report - UK not split out separately)
Compass: 23% from Europe (2019 final results - UK not split out separately)

Note: I've put the source of the info in brackets - there may well be better sources out there.

And some businesses with high % of UK revenues:
Lloyds: 100% from the UK (2018 annual report states non-UK activity is too small to report)
Autotrader: 99% from the UK (2019 annual report)
Rightmove: 98% from the UK (2018 annual report)
Barrett: 100% from the the UK (2019 annual report)
Morrisons: 100% from the UK (2018 annual report)

As we can see, for some large global companies reporting specifically on UK revenues isn't considered material and is not even on the radar.

However lets run some stats and see what we find. I have a googlesheet pulling currency movements and share prices - specifically GBP vs. USD over the last 5 years, and the correlation between the two. Feel free to download a copy - the ticker, and dates can be changed as you like.

For those needing a stats refresher, the correlation score (correlation coefficient aka R) tells us a bit about how these two numbers (currency movements vs. share price movements) are moving in relation to each other. The output ranges between -1 and 1. If they move up and down together, this is called a positive correlation, and a score closer to 1 indicates a stronger connection. If their movements don't appear to be synchronised at all, the score will be closer to 0, indicating no pattern detected. If the numbers move in opposite directions, the score will be closer to -1 and is called a negative correlation.

In addition there is something known as R² (coefficient of determination), which is supposed to indicate how much of the correlation between share prices and currency movements is a result of currency moves rather than anything else that might move the share price. You'll see this as a score between 0 and 1, which can be interpreted as a percentage.

Correlations:
Companies with high % of non-UK revenues:

	Correlation coefficient (R)	Coefficient of determination (R²)
Ferguson	-0.657	0.432
Ashtead	-0.659	0.435
Unilever	-0.788	0.621
Diageo	-0.692	0.479
Compass	-0.851	0.724

Companies with high % of UK revenues:

	Correlation coefficient (R)	Coefficient of determination (R²)
Lloyds	0.823	0.677
Autotrader	-0.567	0.322
Rightmove	-0.655	0.429
Barrett	0.101	0.010
Morrisons	-0.646	0.418

It would seem that the likes of Lloyds, Compass and Unilever will dance to the tune of currency movements, whilst the likes of Barrett have rather a deaf ear.

Whilst this is interesting, before thinking about using any such stats in one's investment decisions, it may be worth paying a visit to the spurious correlations website first 😀.