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Overseas Companies, Home Market

What Lies Beneath ADRs

Diversifying your portfolio with international stocks isn’t just a smart idea. It’s also easy — especially if you invest in American Depositary Receipts.

An ADR is a certificate issued by a U.S. bank that’s comparable to, but not the precise equivalent of, a stock certificate issued by a U.S. company. Each certificate conveys ownership of shares in a public company, giving you the right to vote on corporate matters, receive dividends if the company pays them and sell the shares in the secondary market. (In reality, of course, electronic records have all but replaced physical certificates.)
What’s different about an ADR is that a company based outside the United States issues the shares, which a U.S. bank, in collaboration with the issuing company, accumulates to underlie the ADR. The shares remain in the country of origin, held by the U.S. bank’s local custodian.
The bank prices the ADR in U.S. dollars and offers it for sale in the U.S. market. In other words, the U.S. bank serves as an intermediary between the issuing company that wants access to U.S. capital markets or a larger shareholder base and U.S. investors who want convenient access to international equities.
(By the way, you may hear the terms American Depositary Share and American Depositary Receipt used interchangeably, which isn’t precisely right. The difference basically is that an ADS is the underlying security of the financial instrument known as an ADR that’s issued and traded.)

Setting the Price of an ADR

An ADR may represent one share, multiple shares or a fractional share of the underlying stock. That’s determined by the bank as part of the initial pricing process. When the ADR is offered for sale, the sponsoring bank wants the price in dollars to fall within a range that’s acceptable to U.S. investors — generally more than $5 a share and less than $50-$100, though there are no official boundaries. (Many investors won’t buy penny stocks. Owing to inflation, today these are stocks trading at less than $5 a share. And some individual investors won’t buy stocks at the higher end of the range because they believe the price is too high, even if the P/E is reasonable.)
To achieve the desired price, the bank determines the number of shares per ADR based on the stock’s share price in the currency in which it’s denominated. The bank also considers the relative strength or weakness of that currency against the dollar.
For example, if the correspondence is 1:1, the ADR represents one share, while if that relation is 1:10, the ADR represents 10 shares. You can check individual ratios and obtain other basic information by visiting websites dedicated to ADRs. Value Line provides this information in the report footnotes for ADRs it covers.
Once the ADR begins to trade, the market price is determined by supply and demand, just as the price of any stock is.

On the Level

Three types of ADRs are available to individual investors: Level 1, Level 2 and Level 3. Level 1 shares are traded over the counter, either because the issuer doesn’t meet the listing standards of one of the exchanges or because it doesn’t wish to comply with Securities and Exchange Commission disclosure requirements. A company may also test investor interest with a Level 1 ADR, though many investors avoid OTC transactions because of the equity’s potentially limited liquidity or lack of information about the security.
Level 2 ADRs are listed on an exchange, provide documentation the SEC requires and trade the same way as other listed securities. These ADRs include some of the best-known multinational corporations. Level 3 ADRs are also listed and provide SEC filings but go one step further by raising capital in the U.S. market with an initial public offering.

Weighing the Merits

As the owner of an ADR, you have the right to exchange it for the underlying stock — though most investors don’t. In fact, one of the reasons to buy an ADR is that it’s generally cheaper than investing abroad on your own, despite the fees the bank assesses to offset its costs and realize a profit. It’s also less of a hassle, since the bank handles the potentially complicated currency, legal and tax issues that accompany cross-border investing.
Although you can delegate those responsibilities, you can’t avoid the potential risks of investing overseas. These include the normal ups and downs of investment markets, the impact of management decisions and political unrest, which can create an unanticipated loss even at a strong company, especially in emerging markets.
In addition, an international investment’s value is affected by the dollar’s changing value in relation to the currency in which the underlying stock is denominated. For example, since dividends have to be exchanged into dollars before they can be paid to you, currency fluctuations can directly affect what the
dividends are worth.
On the other side of the coin, the broader your exposure to world markets, the better positioned you are to benefit from strong returns in various places and at various times. Although trouble in any major market can have a ripple effect on the global economy, the situation within a country still dominates how its securities markets perform.

Expanding Opportunity

Though you may think of international investing as a fairly recent phenomenon linked to increasing globalization, ADRs have actually been around since 1927, when JP Morgan made shares of Selfridges, the British department store, available to U.S. investors. Today 2,000 companies in both developed and emerging markets are traded as ADRs. In addition, a number of participating banks have created ADR indexes, which can serve as the basis of exchange-traded funds and other indexed investments.
So if you’re interested in investing in companies outside the United States, there’s no lack of opportunity.

Virginia B. Morris is the Editorial Director for Lightbulb Press.

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