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ADR's
There are numerous
ways American investors can participate in the international markets. The
simplest is purchasing a U.S. company with a large international presence.
Exchange traded funds and mutual funds are also excellent ways to invest
overseas. Generally, funds are classified as global funds (includes U.S.
companies), international funds (excludes U.S. companies), regional funds,
country funds, and index funds.
However, for the more
experienced investors looking for specific company diversification, or to
participate in some of the faster growing overseas companies, depositary
receipts are available.
Depositary receipts are
the result of repackaging a foreign company’s locally traded shares into an
internationally traded security. There are three types of deposited
receipts:
·
American Depositary
Receipts (ADR) are traded in
the United States.
·
European Depositary
Receipts (EDR) are traded in
Europe.
·
Global Depositary
Receipts (GDR) are traded in
the US, Europe and other foreign markets.
ADR’s are created when
an investment bank coordinates purchasing local shares of a foreign company,
stores them overseas with a custodian bank and issues ADR’s in the United
States. The depositary bank issues the ADR certificates that are backed by
the foreign shares that are held by the foreign custodian bank. ADR’s are
traded on the U.S. exchanges and on the over the counter market. ADR
purchases and sales are conducted with U.S. dollars. Dividends paid on the
foreign shares are also passed through to the ADR holders in U.S. dollars.
Some countries require withholding tax on the dividends distributed. The ADR
holder will get the net amount of the dividend, and at year-end will receive
a 1099-Div form, showing the amount of foreign tax withheld.
There is also a
conversion ratio between ADR’s and the foreign shares. Each ADR represents a
specified number of foreign shares.
Pros and Cons of ADR’s
Pros:
·
ADR’s are traded in U.S.
dollars and trade on the U.S. stock exchanges.
·
Conversion ratios are
established to price ADR’s comparable with U.S. stocks.
·
Securities are safeguarded
by the foreign custodian in a cost efficient manner.
·
ADR’s provide exposure to
the U.S. capital markets, as well as a U.S. currency that can be used for
acquisitions. ADR’s are also used as compensation to motivate U.S.
employees.
·
ADR’s can mitigate the risk
of a falling U.S. dollar.
Cons:
·
The price of foreign shares
that are traded in their local currency, adjusted for exchange rates and
conversion ratios, can vary materially from the U.S. dollar ADR share
price. In China, for example, “outsiders” are paying a higher price then
the “locals” for the same claim on a company’s cash flow and assets. I shy
away from ADR’s that have this type of distortion.
·
ADR’s that are traded in the
OTC markets must comply with their home market’s accounting rules, not
U.S. accounting standards, and are exempt from the Sarbanes-Oxley
legislation.
·
Financial reporting by the
foreign company may be untimely and hard to come by.
·
Dividends paid on the
foreign shares are passed through to the ADR holders in U.S. dollars, but
foreign taxes may be withheld.
Types of ADR’s
There are two types of
ADR’s: company sponsored and unsponsored ADR programs. The distinguishing
feature is who pays the depositary expenses, the sponsoring company or the
ADR holder.
There are also three
levels of ADR shares:
- Level I
– These ADR’s can only be established using existing foreign outstanding
shares and are only allowed to trade on the over the counter market or on
pink sheets. No new capital is allowed to be raised as a Level I ADR.
This is an inexpensive way for a foreign company to get the liquidity and
exposure of the U.S. capital markets. The foreign company must file form
F-6 with the SEC, which describes the terms of the ADR’s and limited
information on the issuer. The annual SEC form 20-F is not required.
- Level II –
With Level II ADR’s the issuing company is getting broad exposure to all
the US major exchanges: NYSE, AMEX and NASDAQ. These ADR’s are established
with existing foreign shares outstanding. Like level I shares, the issuing
company cannot raise new capital. With level II shares, the issuer must
meet the requirements of the exchange that it is listed on. It also must
have partially reconciled its financial statements to U.S. GAAP. The
foreign company is required to file forms F-6 and the annual 20-F with the
SEC.
·
Level III
– These ADR’s are used to raise additional capital. SEC form F-1 and F-6 is
required. The issuer must also meet the listing requirement of the exchange
that it’s listed on. Additionally, SEC form 20-F is filed annually.
Financial statements must reconcile to GAAP. Level II and III ADR’s are
required to meet the Sarbanes-Oxley Act’s corporate governance requirements.
Regarding how to select
an ADR, your selection criteria are the same as with U.S. stocks, but with
an added foreign currency risk exposure.
Young
adults, however, need to be careful here. The urge to jump in is great,
especially with a falling dollar, and tremendous growth overseas.
Nevertheless, be mindful of the three rules for international investing:
research, research, and research!
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