When going over Planet 13 Holdings ($PLTH) financials, I noticed they reported some $220k CAD in foreign exchange (forex) losses during the quarter.
Long time readers will have heard me go off about this sort of thing before with respect to cannabis companies. To a trader, having to report an unexpected loss on forex is absolutely nuts. It’s analogous to lighting a fire and throwing money on it.
$PLTH’s forex loss isn’t much nor material. But I know of another Canadian company that unexpectedly added more than $3MM to a budgeted $25MM capital spend – simply by leaving forex exposure unchecked.
This company had ordered equipment from the US in early 2018 (denoted in USD). In the 8 months it took for the equipment to ultimately arrive and be installed, when invoices are raised and payments released….. USD had advanced against the Canadian Dollar (CAD) $0.11. Specialized staff brought in to help can also be US resident, and their hourly rates would be denoted in USD. These losses on currency exchange are installed at a capital level no less. Think about the impact to future returns that a 12% increase in capital cost has against forecasted revenue. A 10% variance on a capital spend can inhibit returns for years.
If your investment portfolio contains an equity denoted in a different currency than which you are tax resident: Congratulations!
You are the proud owner of foreign exchange risk. Naturally, that equity position in your portfolio also presents price risk. Changes in either price or forex will go straight into your investment returns. These exposures can move in tandem or in opposite directions.
Risk management is an active process that identifies and quantifies financial risk inherent with exposure. Hedging these exposures removes the risk that changes in exchange rates will impact a company’s earnings. A hedge is often done in minutes, (literally), and is usually a virtually costless exercise.
CAD advanced against USD by 60 basis points (bp) from July 1st to September 30th of 2020. For a company that’s pulling in revenue of say, $10MM/mo and reports in CAD, that means they left $180k in revenue behind. In the case of a store with a 50% margin, $180k represents 4 hours of store sales in a month. That’s 4 hours in a month that the store is open and selling – and making absolutely nothing. I would hope that business people think about that, I think about it in precisely those terms.
A simple hedge could have kept that money. That hedge would have been to sell expected the three months of expected USD revenue forward in exchange for CAD. This can be done with futures, forwards, or swaps.
The currency could move the other way (of course), and in this case, the company would have had $180k more than if they’d done nothing. I’ve seen companies – at the CEO level – utterly balk at hedging. They avoid ‘trading’ and such like the plague. It’s a personal appetite, and some of them view ‘losses’ on a hedge to be a negative, rather than simply eliminating exposure.
Here – the values are immaterial, but they illustrate the point. Think about when/if sales really take off, and we’re staring at companies doing a billion or more a year in revenue.
The purpose of a hedging program is to trade risk for certainty. And in the case of business, that means one might want to ensure that incoming revenue is known and that there’s no moving parts. Dead simple. Hedging in these instances could be done monthly, weekly, or even daily depending upon the magnitude of revenue. In commodity trading – where notional currency exposures on a single physical trade can be in the millions – forex is hedged on a per trade basis. I’ve included an example below.
In the case of $PLTH, their native balance sheet currency is in USD, as is revenue, so I wondered how could they report a loss on currency. I pulled out the calculator, and came up with a value that was within $3k of their number. This is the kind of thing that gets me excited. While it’s just a single value (and immaterial), if I can wander around a set of financials and back into what’s reported…….it indicates the financials are tight. If a shop is clumsy or unsophisticated, losses/gains in currency is a great indicator.
Besides, good disclosure tells me exactly what I want to know. From $PLTH’s most recent MD&A:
Which means $PLTH has thought about it, and at this point, doesn’t care. Another reason why I like them so far…they are aware of it. In stages of build like the US industry is experiencing, prioritization of activities needs to happen, and managing forex exposure is probably far down the list of things that matter to them at the moment.
Should sales ramp hard, that might change. As it is, these guys have a single store that’s shows it’s running at $100MM/yr in sales(!). And they will likely migrate south when exchange rules and laws are changed concerning cannabis (they disclose that very reality in their MD&A).
This is relevant because over the next couple of years – and if you are a Canadian – you will have USD exposure land in your book – as outfits drift to the US exchanges, and the native currency of their balance sheet and/or the ticker changes to USD. There is no way in the world that companies with substantive earnings in USD will stay in Canada. Not a chance. If one does, it’ll be an outlier.
As it is, if you hold $TRUL or $CURA or $GTII – with this recent price run, you’ve just increased your USD exposure by a boatload – simply by standing there. If your cannabis holdings are deep on MSOs, you could be holding forex exposure on pretty much the entire amount of your book. Given USD revenues under a CAD share price, forex exposure is (somewhat1) effectively handled for you by the market. The moment that a ticker changes its’ currency, your book will crystallize existing forex exposure and open new exposure at the rate of the day it occurs. For folks with significant positions, I would want to know what those numbers are. If you’re on the right side, you might have picked up forex gains along with price accretion.
And that’s the point of this post. Whether you manage that exposure is up to you.
I hope that helps add to your knowledge about exposure in general, and forex in the specific. The interested reader might want to expand their knowledge on derivatives and their use in hedging. Understanding delta is a great place to start.
I’ve seen many retail investors use terms around financial concepts without having a genuine understanding of them. I’ve had many folks come up to me at Lift Expos using phrases and buzzwords they’ve picked up, often incorrectly. Binders happily install these terms in retail investors. It’s cool on the ear, and presumeably, it means they’ll sound just like the professionals do. It’s seductive to many, and it’s painful for me to hear terms used by people who don’t fully understand them. The people who push option trading on retail have a very special place in hell reserved in my heart. I really don’t like those sorts. Far more than I dislike the binders. To me, those who push and peddle option trading to Average-Joe Retail are the equivalent of a guy selling switchblades to middle-schoolers behind the playground at lunch.
Advanced Hedging Example
For readers looking for something more advanced, here’s a relatively simple hedge from natural gas trading. In this case, our trader thinks that physical natural gas prices in Alberta are going to go up, and wants to profit:
A physical purchase of forward monthly fixed price AECO (CAD) gas is made. This trade raises three exposures: price risk, basis risk, and currency risk. Basis refers to the differential between NYMEX (USD) and AECO – prices can vary wildly depending on regional demand and supply factors. The trader only wants AECO price exposure though, so to hedge the latter two exposures, they would sell enough NYMEX futures to notionally match the physical volume of the trade (to eliminate basis risk), while simultaneously purchasing forward USD in an amount that equals the notional dollar amount of the futures (to eliminate currency exposure). All that remains is naked fixed price physical AECO exposure, denominated in CAD. No more moving parts.
Should AECO fixed prices advance and trade wishes to eliminate exposure, they could buy a swap for fixed price and pay index (acquire financial length), that matches the tenor of the delivery, crystallizing profit. Price risk gone: all that remains is to schedule physical delivery of the gas.
If the market for cannabis gets big enough and creates a critical mass of forward risk to earnings, we will see cannabis futures and forwards coming into existence. It’s a ways off at the moment (hemp would likely come first), but sectors driven by multi-billion dollar revenues always look for ways to mitigate price risk. Producers of corn, wheat, barley, and a dozen other softs have been doing this for decades.
Confession: I’m a commodity guy at heart, simply because they are much cleaner to trade and hedge than equity, and much more correlated to fundamentals. Equity is riddled with dirty hedges.
GoBlue and I had a good discussion about ‘transactional’ forex exposure versus ‘translational’ exposure. The former applies to revenues and expenses, the latter being related to assets and liabilities. For a Canadian with exposure to a US company, if the ticker is denoted in CAD – the share price itself is the mechanism that translational exposure is presented. In other words, holding a company (like $LHS for example) the share price captures and eliminates translational forex risk.
1 – That ‘somewhat’ refers to advanced material regarding share price itself being a self-hedging mechanism. It’s outside the purposes of this post.
The preceding is the opinion of the author, and is in no way intended to be a recommendation to buy or sell any security or derivative.