BOSTON (TheStreet) -- Caterpillar (CAT) - Get Caterpillar Inc. Report and Coca-Cola (KO) - Get Coca-Cola Company Report, both of which are members of the Dow, derive more than half of their sales from outside the U.S. Because of that, investors ought to follow the dollar's 14% rally against the euro this year, which is being fueled by Europe's debt crisis.
While Caterpillar, the world's largest maker of construction equipment, and Coke, the No. 1 seller of soft drinks, are connected to the global economy, their shares correlate differently with currency shifts. Those distinctions were highlighted yesterday when the euro fell to a four-year low against the dollar on concern a $1 trillion aid package won't solve Europe's sovereign-debt woes.
Coke's share price tightly follows the path of the U.S. dollar against a basket of currencies including the euro, Japanese yen and British pound. This is an inverse relationship since Coke's share price increases on a weaker dollar.
That's because Coke is an exporter. A weak dollar means its products look cheaper to foreign buyers, and the company gets more dollars with a stronger euro, yen or pound. As a result, revenue rises, as do profits.
The rise of the dollar is a disadvantage for Coke. The effects can be seen in Coke's 6.3% decline in 2010 versus the
increase of about 2%.
Caterpillar hedges its foreign-currency exposure. The company's stock has gained 12% this year.
Because Coke's cash flow is determined by difficult-to-predict factors, such as consumer demand, the company can only guess how much it should hedge. Rather than over-hedge and, therefore, take on speculative risk, Coke hedges conservatively, which leaves it open to currency risk.
Caterpillar, in contrast, deals in machinery that costs several hundred thousand dollars. Its backhoes and excavators are subject to sales contracts that specify the price and date of the sale well in advance of the transaction. That enables Caterpillar to hedge each sale using a forward contract, reducing revenue volatility.
Hedging cash flow takes care of Caterpillar's transactional risk. However, it's still exposed to economic risk because of its international reach. Foreign customers will see Caterpillar products as a better deal when the dollar weakens, which leads to increased sales. While the company may hedge out the risk of exchange-rate changes, it will still benefit from a falling dollar.
That cuts both ways. As the dollar strengthens, sales in foreign countries tend to taper off as products get relatively more expensive. Because of that, investors should be worried about a strengthening dollar, but only slightly, since the majority of the impact was taken out of the equation through the use of derivative contracts.
The dollar has been increasing in value as sovereign credit problems around the world led investors to seek a safer currency in which to park cash reserves. Greece has highlighted the risks of investing in a country with crushing debt. Now the worry has increased to cover much of southern Europe as contagion has become one of the hottest words even though many probably don't understand its meaning.
Caterpillar avoids most of the risk that comes with foreign-currency transactions, but there's still a component to the share price that can be explained by these movements. As the dollar strengthens in the face of possible sovereign debt downgrades, expect Caterpillar to lag behind a bit. Thanks to diligent hedging, however, investors should be more insulated from the move than companies like Coke are.
Global diversification is crucial for companies to succeed in the new economy, but if the stocks in your portfolio do business in Europe, be sure to look into their exposure to currency fluctuations.
-- Reported by David MacDougall in Boston.
Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.