A Primer on American Depository Receipts
The world is a big place, but for investors it doesn't have to be. In fact, investors seeking a diversified portfolio would do well to expand their horizons beyond the borders of U.S.
Even the most amateur of international investors needn't be intimidated of investing overseas. As international trade has surged, bringing formerly undeveloped economies to the forefront of the global stage, so have the offerings of foreign company stocks available to U.S. investors. That's right, you don't need to pack your bags or dust off your passport to be a global investor.
There are plenty of options for American investors wanting to buy shares in a foreign company. As of mid-2008, there are 2,250 depositary programs listed on various global exchanges. That figure represents 1,800 companies from 70 different countries. In addition, U.S. investment in foreign equities currently stands at approximately $2 trillion, according to data from JP Morgan. Listing foreign stocks on U.S. exchanges is a lucrative business that creates streams of fee-based revenue for big banks, so count on many more foreign listings in the future.
Let's take a look at how American Depositary Receipts (ADRs) can benefit your portfolio.
What Is an ADR?
In the investing lexicon, there are a plethora of acronyms and they all seem to run together after awhile, so let's define what exactly an ADR is. J.P. Morgan introduced Americans to the ADR in 1927, and they are a stock that trades on a U.S. exchange that represents a fixed number of shares in a foreign company. There are no selection criteria regarding a company's home country, so U.S. markets feature ADRs from developed nations such France and Germany as well as emerging markets such as India and South Korea.
One of the primary benefits for ADR investors is that once a company becomes listed on a U.S. exchange, they are subject to Securities and Exchange Commission rules and regulations and must report their earnings quarterly, just like an American company. Many foreign firms are required to report profit results just two times a year in their home domicile.
Types and Kinds of ADRs
Next, we need to look at the types of ADRs. There are three types, each called a level. Level I can be a risky area for investors to play in. These are often penny stocks, trading over the counter or on the Pink Sheets, and they are less regulated by the SEC.
Level I ADRs are the easiest way for foreign firms to get their shares listed on a U.S. exchange, which the company hopes, makes their stock more appealing to more investors. Potential buyers of Level I ADRs need to keep in mind that these stocks and their reporting methods are not subject to Generally Accepted Accounting Principals (GAAP) and are not required to issue quarterly or annual reports. However, they must publish an annual report in English on their company Web site. Many large, well-known foreign firms have level I ADRs (including Bayer, Fiat, and Imperial Tobacco) to decrease the cost of meeting regulatory requirements (see Regulatory issues Facing ADRs section) while still offering their shares to the American investors.
Level II ADRs are a notch above Level I issues and are more regulated. Level II companies must file with the SEC and are required to follow GAAP methods. They also must file a Form 20-F, the equivalent of a 10-K or annual report. Once a company becomes a Level II ADR, they are eligible for listing on more prestigious U.S. exchange such as NASDAQ or the New York Stock Exchange.
Level III ADRs are the cream of the crop. These are typically large, recognizable companies that are seeking exposure on American exchanges. Some ADRs that you may already know include: China Mobile, LDK Solar, Nokia, Petrobras and Sterlite Industries. These are the kinds of international stocks investors should be considering.
To become eligible for Level III, a company must file a Form F-1 with the SEC, which is essentially a prospectus. The company must also file an annual report, adhere to GAAP and make any material information available to investors in its home country available in the U.S. as well. This level is tied to a public offering of shares.
Regulatory Issues Facing ADRs
In 2002, Congress passed the Sarbanes-Oxley law, or SOX, in the wake of the Enron scandal to make corporate reporting standards more stringent. Unfortunately, an unintended consequence of this law is that it has made corporate filings more costly for companies and many experts believe this has tempered the amount of foreign companies wanting to list shares in the U.S.
Of course this is a negative not only for the banks that make money on listing these stocks, but it narrows the choices for investors. The law doesn't distinguish between U.S. and foreign companies for listing purposes and for the most part, the SEC doesn't either when it comes to enforcement action.
Regardless, the costs associated with SOX have dampened foreign firms' enthusiasm for listing their shares on U.S. exchanges, especially since Level II and III ADRs are required to be fully compliant with SOX.
The law's impact has been startling. In 2004 and 2005, listings of Level II and III ADRs fell to their lowest level since 1989, according to JP Morgan research. In addition, the number of foreign companies delisted from American exchanges began to rise soon after the law's passage. That trend has continued in recent years.
Some opponents of SOX argue that law diminishes the effectiveness of the U.S. as premier financial center and opens the door for other financial capitols to steal business away from American companies. As of the 2007, foreign listings were at their lowest level in 16 years while delistings were correspondingly higher.
Of course there needs to be some benefit to buying ADRs and there are several advantages to be sure. First, an investor cannot hope to properly diversify his portfolio if his holdings are all based in the same country. Owning ADRs can help if American markets are lagging foreign peers. For example, if you own a Brazilian ADR that trades on the NYSE, that stock may perform well even if U.S. markets are not because its performance is based more on Brazil's economy than North America's.
Second, buyers of ADRs don't have to worry about paying foreign taxes. If you were to buy an Australian stock trading in Sydney, you would be subject to Australian taxes on any capital gains. With that same company's ADR, you only have to worry about paying U.S. taxes.
Third, ADR investors can benefit from foreign currency valuations. Meaning, if your Australian ADR increases its dividend and the Aussie dollar is strong against the U.S. dollar, your dividend is worth more because the payout is converted into U.S. dollars. Speaking of dividends, foreign companies -- although they may only pay dividends once or twice a year -- have a storied tradition not being as stingy as their American counterparts when it comes to shareholder payouts. Compare a U.S. stock and European stock from the same sector and you're almost certain to find the European company has a richer dividend.
Finally, the cost of buying a stock on a foreign exchange can be prohibitive. Your broker is almost certain to ding you with several more fees beyond just the cost of the trade for the privilege of buying direct in London or Paris. With ADRs, we are able to reduce the cost of our foreign investments dramatically.
There are risks with ADRs, just as there would be with any other investment vehicle. International economic trends have made the world a smaller place, as we noted, and this means trading partners are more dependent on one another than ever before. A developed nation can be dependent on an emerging market for essential needs such as commodities and this can be perilous for investors if the emerging market is unstable politically.
Imagine this hypothetical scenario: You own the ADR of a European industrial conglomerate that has made a substantial investment in a previously war-torn emerging market. If political tensions in that emerging geography flare up, it could be a disaster for your investment.
Next, there is the aforementioned currency risk. When buying ADRs, we want to buy them from a country with a strong currency, especially against the U.S. dollar. A strong currency is a sign of a country's overall economic health. Plus, if the company raises its dividend, the payout when converted to U.S. dollars is that much higher for the American investor. Own shares of a Latin American ADR and another currency crisis there occurs, your investment could be wiped out. In other words, look for strong currencies.
And along the same lines of currency risk, there is of course the specter of credit and inflation risks. It's a good rule of thumb to shy away from equities in countries that are known to have rampant inflation concerns. Credit concerns are pretty straight forward. Every country that issues government backed bonds, or sovereign debt, has a credit rating. If you're stuck holding shares of an ADR whose home domicile's credit rating has just been downgraded, expect to lose some money.
Fortunately, these concerns can be mitigated with diligent research prior to committing any of your hard-earned capital. Checking the SEC Web site for the aforementioned filings such as the 20-F is a good idea. All you'll have to do to search the site is enter a ticker or company name. In addition, depository banks that sponsor ADRs are a great resource for ADR investors. Check out the Web sites of Bank of New York Mellon, JP Morgan, Citibank and Deutsche Bank, as they are dominant players in ADR sponsorship.
Another odd risk that ADR buyers need to be aware of is termination of a company's ADR program. While this is not a common scenario, a terminated ADR simply means the company or the depository bank listing the shares in the U.S. has decided to end the program. Investors receive written notification that the ADR will be delisted and have the option of selling their shares or taking the underlying security. If you take the underlying shares, when you want to sell them, you'll likely have to do it in the company's home exchange, which will increase your transaction cost substantially.
Taxes and Conclusion
Tax considerations for your ADR holdings are pretty straightforward. Capital gains earned these investments are treated the same as they are with domestic investments. Dividends are also taxed the same way for domestic and foreign investments.
Many countries do withhold a portion of dividends paid to foreign investors -- for example, Canada withholds 15% of payments. This amount can be recovered by filing for a foreign tax credit when you file taxes.
At over 80-years old, it's fair to say that ADRs are here to say on U.S. exchanges and that's good thing for American investors. As globalization continues to increase, so will ADR offerings. This investment class can do a lot of good for your portfolio and even give a much needed jump-start. The world is a changing and your investments should change along with it in order to maximize returns.
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