Stockwatch: Why sterling's fall matters

As sterling stays weak, what will be the extent of the damage to importers? One thing is certain, companies need to provide more detail on exchange rate issues, so investors can consider where stock falls are overdone and growth premiums over-cooked.

Sterling is finally finding slight support after double-digit percentage falls triggered by the EU referendum - but for how long will it hold?

With a £32.6 billion current account deficit, the imbalanced UK economy will take years to adjust to Brexit, assuming trade agreements are struck and exporters have the vigour to exploit lower sterling.

Sentiment may already be subject to noise, but one currency dealer sums up the mood: "We do normally like a good contrarian trade, but the pound is showing absolutely no inclination to bounce and it certainly feels as if there is much more downside; there is no point in trying to catch this falling knife."

Outside the heat of the markets, the International Monetary Fund still reckons sterling is 3-9% overvalued on a range of measures.

Pricing in risk

Such a financial landslide appears to be compromising clothing retailers which typically operate within a model of Asian sourcing and US dollar invoicing. Their mindset is understandably focussed on marketing, hence sterling's plunge taking them by surprise - in terms of what (few) safeguards they appear to have in place.

The stock is on a forward PE multiple around eight timesLatest prelims from mid-cap Sports Direct show the sportswear retailer hedges itself with forward currency/product sales.

Even so, post-referendum volatility is "likely to impact US dollar purchases and therefore profitability for which the company is currently not hedged for the year to April 2017 and beyond".

That's remarkable, considering sterling/dollar weakness has been a longstanding trend; also there is no clarity as to what extent of invoicing this applies to, but it's probably the vast majority. With the stock on a forward price/earnings (PE) multiple around eight times, however, it's priced in plenty of such risk.

Foreign Exchange smokescreen

Compare this with AIM-listed online fashion retailer Boohoo.com, whose 2015 results offered no such "clarification" beyond a geographic sales breakdown implying 66.6% to the UK, 11.6% to rest-of-Europe and 21.8% rest-of-world. "Growth in sterling terms has been impacted by currency headwinds across our international business, especially in Europe and Australia," it said at the time.

There's strong momentum to absorb currency swingsIt's interesting that headwinds extended beyond sterling, as if countries are in "beggar thy neighbour" devaluations to combat the global scourge of deflation. But if effective financial controls are in place at Boohoo, why can't management say more? They characterise Boohoo as "impacted" by this in its year to end-February 2016 and as post-referendum effects will be worse, investors need to know.

On the positive side, its latest revenue update cited 41% year-on-year revenue growth in the three months to end May, "slightly ahead of expectations" i.e. there's strong momentum to absorb currency swings.

There is still a cost within intrinsic value, against the market, where at 55p Boohoo trades on 38 times the consensus earnings forecast for the current financial year and 31 times for the year to end-February 2018. Subtracting £58.3 million year-end cash, the multiple is more like 34 reducing to 28.

Polarised post-Brexit market

Another factor is enduring high ratings in the market, where pockets of growth exist in a generally weak environment. The market is already polarised in response to the Brexit vote: witness housebuilders and financials on single-figure PEs despite high yields, while overseas earners and specialist growth plays are quite the opposite.

Bear in mind possible over-pricing as some holders sell to lock in gainsA consumer recession might not compromise Boohoo badly, perhaps reducing an aspect of UK sales while benefitting from competition against high street stores. When I drew attention to the stock at 33p last November I queried: "is this the next ASOS?"

The AIM-listed online retailer had a PE averaging 113 times in 2013, moderating to 55 times on a forward basis today - which likewise has no dividend and scant asset backing.

By way of comparison, Boohoo's price/earnings growth (PEG) ratio ranges from 1.1 to 1.4 (see table below) - ideally you are looking for less than 1, but sub-1.5 isn't unacceptable - whereas for ASOS it's about five, then two times, way too high in principle.

Attractive story continues to strengthen

I suggested accumulating Boohoo on its PE multiple - then - of just over 20 times (subtracting its £60.4 million cash at the time) and nothing has changed in an attractive marketing story; it continues to strengthen.

Meanwhile, the chart has run into a consolidation that doesn't precisely fit a "head-and-shoulders" pattern, but is of sorts. Some holders are locking in gains amid general complacency towards the foreign exchange effect; which is not to assert the stock as an outright 'sell' - but to bear in mind possible over-pricing.

Will its story be overall strong enough to refresh the bulls? This business should continue to transform fashion retailing; it will, however, need to contend with weaker sterling for some time, likely years; and its earnings growth rate won't always be in the region of 30% (as expected currently).

Boohoo has improved its communications since having to warn on profits in early 2015, but management need to show that (unlike Sports Direct) it has not had a blind spot for managing currency exposure.

It's a salutary example how companies need to address this internally and via updates, otherwise stocks on blue-sky ratings will suffer.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.