Individual investors have more resources than ever to manage their portfolios. However, buying foreign stocks is still mostly left to institutional investors, such as mutual funds and hedge funds, or professional traders.
Currency conversion, different reporting standards and higher transaction costs are among the barriers to buying international equities.
So, how can you buy stocks of overseas companies with relative ease?
American Depositary Receipts (ADRs) may be a practical solution.
What is an ADR?
An ADR is a certificate that represents ownership in shares of foreign stock. The underlying security is held overseas by an American depositary bank. Denominated in dollars, ADRs trade on U.S. stock exchanges and also the OTC (over the counter) market.
Types of ADRs: 3 levels of ADRs have different degrees of transparency.
Level 1: Level 1 has minimal SEC reporting requirements and compliance with GAAP (Generally Accepted Accounting Principles) is not required.
Reasons companies issue Level 1 ADRS include:
Gauge trading interest but not raise capital.
Build brand identity in the U.S. without GAAP or regulatory compliance
Company doesn’t qualify for listing on formal exchanges
Start at Level 1 then move on to 2 or 3 once requirements are met.
Level 2: With higher reporting, Level 2 ADRs offer more visibility and trading volume. Partial compliance with GAAP is required, which helps better analyze stocks across borders.
Reasons why companies may issue Level 2 ADRs:
Move up from Level 1 after confirming interest in the OTC market.
More regulatory and GAAP requirements have been met.
Stepping stone to raising capital at Level 3
Level 3: ADRs at this level meet SEC reporting and fully comply with GAAP. The depositary bank floats the ADR on a major exchange. Level 3 ADRs give foreign companies easy access to U.S. capital markets.
Reasons for issuing Level 3 ADRs include:
Raise capital
Prestige
Heavier Trading Volume
Considerations for ADR Investors:
Currency Risks: While ADRs are quoted in dollars, ADR returns and dividend payments still reflect the foreign currency. Your dollar adjusted returns can be positively or negatively affected based on the greenback’s relative strength.
Price Movements: ADRs shares do not move in lock step with the home country stock. This owes to supply and demand impact on stock price. However, ADR and domestic stock prices do move closely.
Political Risks: The politics and policies of foreign countries may be difficult to follow. Elliott Broidy is a venture capitalist who invested heavily in the now thriving tech economy of Israel. However, this took time and research typically found at the institutional level.
Changes in leadership or social instability may affect the outlook for some foreign companies. Tighter regulations may require costly compliance. Military conflicts or social unrest are also risks to consider.
Balancing stock analysis with your comfort level in the region should be considered.
Fees: Depositary Banks (DB) may deduct fees from ADR dividend payments. Along with brokerage commissions, you should fully understand DB fees before buying ADRs.
Investors may consider ADRs with diverse revenue sources across the globe to limit domestic risks.
How to Buy ADRs:
You can buy ADRs through most online brokers. A seamless transaction with straight forward commissions offers peace of mind over duties or other transaction costs.
Trade Settlement: There are no hassles with currency conversion or duty costs when buying ADRs. U.S. investors also enjoy familiar settlement and trade clearance. Institutional and retail investors alike may buy ADRs to cut transaction expenses.
Example Strategies for ADR Investing
Dividend Yield:The American economy currently has low interest rates and a weak dollar. This poses challenges to many income investors.
Meanwhile, a weak currency has broad effects on purchasing power, wage growth and corporate profits. Each of these can put a damper on stock performance.
Buying ADRs with high dividend yields can offer:
Added income boost when converting payments to dollars.
Cushion against volatility.
Higher returns in dollar terms during periods of greenback weakness.
Adding some foreign exchange risk to portfolios may be appropriate.
Low Cost Diversification: You can take concentrated positions in promising stocks with ADRs. This includes:
Control over buy and sell decisions
More control over capital gains
Dollar Cost Average to build a cost effective ADR portfolio.
Potential cost savings over international mutual funds.
Invest in companies that benefit from separate market conditions.
The negative correlation of some foreign stocks to U.S. markets can lower portfolio risk.
Examples of ADRs:
Toyota Motor Company ADR (TM), NYSE - Market cap $172 Billion. Toyota primary listing is on the Nikkei in Japan.
Petroleo Brasileiro Petrobras ADR (PBR), NYSE - Market cap $141 Billion. Petroleo's home country is Brazil.
Astrazeneca ADR (AZN), NYSE - Market cap $83 Billion. The pharmaceutical company’s home country stock is on the London Stock Exchange (LSE).
Summary:
Promising investments are not limited to American companies. ADRs offer a convenient and cost efficient way to invest in the global economy, wherever stocks may be.
About the author: This was a guest by post Marc Walambe. Marc has over 13 years of experience in the asset management and financial services industry.
Original post: An Investor's Guide to ADRs