by John Persinos, InvestingDaily.com
Investing Daily Article of the Week
As an investor, you can’t afford to be parochial. You must look beyond America’s shores and gain international exposure. Which brings me to this letter that I received this week from a reader:
“I’d like to buy the stocks of foreign-based companies but I need to have a better understanding of ADRs. How do they work? I never put my money into investment vehicles that I don’t understand. A primer on ADRs would be greatly appreciated. Keep up the good work! I love your daily column.” – Matt S.
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Let’s take a “time out” from covering the daily gyrations of the markets to answer Matt’s question.
If you’re looking to add international flavor to your portfolio, investing in companies that trade in the U.S. as American Depositary Receipts (ADRs) is an easy way to do so.
To create an ADR, a U.S. bank (called a depositary bank) buys shares of a foreign company in its home country. It then deposits them with a local bank (or custodian), often a branch, and issues ADRs representing a certain number of shares.
You can buy and sell ADRs through your broker, just as you can with any U.S. stock. They trade on U.S. exchanges or the Over-the-Counter Bulletin Board or Pink Sheets. Their prices are determined by supply and demand, but they generally track the underlying ordinary share.
With ADRs, you can access companies that may not otherwise be available to U.S. investors. You also skip the extra cost, difficulty and risk of buying shares in unfamiliar countries, and the hassle of currency conversion. That’s because all ADR transactions, including dividend payments, are conducted in U.S. dollars.
For companies, the benefits are equally straightforward: they gain access to U.S. capital markets, as well as an opportunity to boost their profile outside their home country and attract a broader range of investors.
ADRs 101
The first ADR was launched on April 29, 1927, by JPMorgan Chase (NYSE: JPM) for U.K. retailer Selfridges. The Selfridges ADR was listed on the New York Curb Exchange, the American Stock Exchange’s predecessor. Today, there are more than 2,000 ADRs available to U.S. investors.
One ADR may represent one or more shares of the foreign stock; it can also represent a fraction of a share. The depositary bank sets this ratio with the goal of establishing a price that’s high enough to demonstrate real value but low enough to attract individual investors.
For example, one ADR of Netherlands-based consumer giant Unilever NV (AMS: UNA, NYSE: UN), which trades under the UN symbol, represents one ordinary share on the Amsterdam Stock Exchange under the UNA symbol. Meanwhile, one ADR of Japanese carmaker Toyota Motor Company (TYO: 7203, NYSE: TM), trading under the TM symbol, represents two common shares.
The U.S. depositary bank handles most interactions with U.S. investors, including rights offerings, stock splits and dividends.
However, ADR investors may receive communications, including financial statements, directly from the company. When dividends are paid, the custodian bank receives them and withholds any foreign taxes, exchanges them for U.S. dollars and sends them to the depositary bank, which then sends them to investors.
As an ADR holder, you always have the right to obtain the stock your receipt represents, but most investors find it easier to simply hold the ADR.
There are two types of ADRs: sponsored ADRs, which are initiated by the company itself, and unsponsored ADRs, which are created by a U.S. bank without the issuer’s active participation, usually in response to investor demand.
The sponsored category consists of three levels:
- A Level I sponsored ADR allows a company to extend the market for its securities to the U.S. with minimal Securities and Exchange Commission (SEC) reporting requirements. It also is under no obligation to conform to generally accepted accounting principles (GAAP). Level I ADRs can only be listed on the over-the-counter market.
- Level II and Level III sponsored ADRs are required to register and file annual reports with the SEC, and financial statements must be reconciled to GAAP. A Level III ADR program is also required if an issuer wants to raise capital through a public offering of ADRs in the U.S.
Only Level II and Level III sponsored ADRs can be listed on the NYSE or NASDAQ. They also must meet the requirements of their particular exchange.
Unsponsored ADRs only trade on the over-the-counter market. Moreover, up to four banks can issue unsponsored ADRs for the same company. Note as well that ADRs trading over the counter have five-letter symbols that end in “Y,” such as Nissan Motor Company (TYO: 7201, OTC: NSANY)
The bottom line: ADRs are just as vulnerable to the company’s operating, economic, political and currency risks as the underlying stock, so thorough research is as important as ever. That could be a particular problem for investors in unsponsored ADRs, who may not get the same level of financial information and support from the foreign company.
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