KnowHow® News

May 2013: In the Know

Understanding ADRs and Diversification

By John Jagerson, Learning Markets Analyst1

Investment in foreign companies can be a great hedge against fluctuations in the U.S. markets -- be those ups and downs attributable to the domestic economy or issues relating to the country in particular, such as new regulations. Generally speaking, foreign companies have a different currency, a different pool of customers, and a different set of risks. This increases the odds that they will be able to offer diversification benefits during a downturn in the U.S. due to currency or other macroeconomic factors.

One of the most common ways investors invest in foreign companies and hedge their portfolios is by putting money into international funds -- but there are other ways.

Investors also have the option of foreign stocks that are listed on U.S. exchanges. Many of these are known as ADRs.

What is an ADR?

American Depositary Receipts, or ADRs as they are more commonly called, provide a way for investors in the U.S. to have access to foreign companies such as British Petroleum (BP), Toyota (TM), and Nokia (NOK) without having to deal with all the issues of investing in foreign markets directly. It also provides a way for a foreign company to tap into larger financial markets and, in turn, raise more capital than it may have been able to otherwise had it been limited to the equity markets in its own country.

Toyota, for example, started listing its shares on the New York Stock Exchange (NYSE) in 1999. Prior to this, if a U.S. investor wanted to buy shares in Toyota, she would have had to open a trading account in Japan and purchase shares in yen. Aside from the obvious issues of communicating with someone on the other side of the world, there would have been currency and taxation issues to consider. Toyota, for its part, previously had to limit its equity raising efforts to the pool of investors attracted to the Tokyo Stock Exchange (TSE).

ADRs remove these issues, mostly.

It works like this.

A depositary bank in the U.S. buys shares in a foreign company then turns around and issues receipts for those shares, which could stand for a fraction of the shares in the foreign company or more than one share, and any dividend paid is payable in U.S. dollars. These depositary receipts, or ADRs, are then traded just as any other security. The only real difference is that there are some differences in cost, regulation, and risks.

ADR Pricing and Arbitrage

At the onset, the price of an ADR is equal to its foreign equivalent. In the case of Toyota, one ADR represents two shares in the company. So, if the stock was trading on the TSE at 4,925 yen, or roughly $52 dollars, when it started listing its ADR on the NYSE, the price of the ADR would be roughly $104.

Again, that is just at the onset.

After that, like any security, an ADR is only worth what someone is willing to pay for it -- in other words, the price of the ADR fluctuates based on the demand for the security within the market like any other stock. That said, there is a trickle-down effect, meaning that ADRs tend to follow a similar pattern to the shares in its home country.

Look at this chart showing Toyota's ADR against its Tokyo-listed equivalent from January 1, 2013 through April 4, 2013. It shows the differences in each security's respective pricing. The two securities follow a similar course, but not identical.

Toyota Motors (TM):

There were times when the ADR was priced much higher than the TSE listing, and others (mostly others) when the situation was reversed, but they tended to follow each other. This presents an opportunity for a savvy investor.

Should the difference in the price of an ADR vary significantly from its initial ratio, the opportunity of “arbitrage” arises, meaning that an investor can simultaneously buy and sell his ADR shares to profit on the pricing difference.

Costs Associated with ADRs

Of course, there are costs associated with investing in ADRs. Depositary companies do not issue them for free.

There is a variety of administrative costs to consider. These are usually taken out of whatever dividend may be paid, but it adds up. Further, some ADRs have agreements in place which allow brokers to charge service fees on top of whatever transaction fees the investor would normally accrue for buying or selling a security.

Investors also need to consider how ADRs are taxed. Taxes can be withheld from the company's local government. In turn, these taxes may be used to offset U.S. taxes.

ADR Regulation

The ADRs listed on U.S. exchanges are going to provide shareholders with a similar level of information any other U.S. security does, in English and subject to most of the same reporting criteria as their domestic cousins. However, not all ADRs have to comply with the same standards as companies listed natively in the U.S. exchanges, so there are regulatory risks to consider as well.

ADRs fall into three categories, and each category has different regulatory requirements.

- Level I ADRs: A Level I ADR is traded in the Over The Counter (OTC) market. At this level, a foreign company can gauge the interest in its offering but for investors these carry the greatest risk because they have the loosest reporting requirements from the Securities and Exchange Commission (SEC).

- Level II ADRs: A Level II ADR has a few more requirements from the SEC and tends to have higher visibility than a Level I ADR. This class of security may even be listed on an exchange.

- Level III ADRs: The Level III ADR is the most prestigious and the most stable of the three classes. In this class, the depositary bank actually issues a float of the company's ADRs, allowing the company to generate significant capital.

ADR Risks

Investors buying ADRs also have several risks to consider.

In addition to the risks presented in any investment -- changes in value, changes in demand -- there are several risks unique to ADRs that must be considered. For instance, while they will react to normal market fluctuations like regular stocks, ADRs are still vulnerable to currency risks. If the value of the company's home currency falls too much relative to the U.S. Dollar (think about the Japanese Yen over the last several months), the effect will trickle down to the ADR eventually. The same can be said for changes in the home country's government.

These risks will vary from one ADR to the other. We might assume that investing in Toyota's ADR is going to be much more secure than a steel producer in Russia because economic stability is different. In addition to the potential differences in reporting requirements, the yen is much more stable than the Russian ruble, and the Japanese government has historically been more stable than that of Russia.

Moreover, even if the issues relating to regulation in the company's home country is not necessarily an issue, the price of the ADR could vary wildly if other investors perceive a change in legislation or the foreign regulatory environment to be an issue -- like any other security, perception is nine-tenths of the price.

ADR Investment

As long as investors understand the risks involved with ADR investment, securities like this may provide diversification benefits for a well-planned portfolio against macroeconomic conditions stateside -- but it takes a little extra legwork to really understand what factors may affect the stock.

Being knowledgeable about an ADR and the risks associated with that company's country of origin can do much to help weed out less than favorable investments as well as provide opportunities to exploit inconsistencies in the market. That may include buying into an ADR whose home country's economy is poised to rise due to stimulus or pursuing arbitrage opportunities when the price of the company's stock and ADR become disparate. However, none of that can happen unless the investor pays attention to the ADR itself, both its reporting and its pricing, and the larger markets.

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