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Market Update

An Easier Way to Buy Foreign Stocks

Want to own international companies? ADRs may be just the ticket.

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Investors looking through the list of companies on U.S. stock exchanges will likely notice three letters next to some of the names. Two-hundred twenty-eight businesses on the New York Stock Exchange, 108 on the NASDAQ and numerous more on the over-the-counter market have the letters "ADR" next to their listings.

Many investors know ADR stands for American depository receipt, and that issuing ADRs is a way foreign companies can get their shares listed on U.S. exchanges. But investors may not know much more about ADRs beyond that. Yet ADRs are an important part of the U.S. market and provide smaller investors access to companies that they may not otherwise get.

ADRs became popular in the 1990s when there was almost no way for U.S. stock-pickers to purchase foreign company equity. Brokerages weren't as sophisticated then and didn't have access to as many international markets, says Michael Breen, a director in Morningstar's global research team. Companies that were already public in their home market would take some of their shares, give them to a custodian organization (such as a bank), and the custodian would then issue those shares on a U.S. exchange. Those shares could then be bought by U.S. investors, in U.S. dollars.

Despite it being easier today for U.S. investors to purchase stocks on foreign exchanges, many foreign companies continue to issue ADRs. Why? Because many companies find several benefits to listing in the U.S., says Bob Stammers, the CFA Institute's director of investor engagement. First, having a U.S. listing can enhance the visibility of a company and its stock. If the operation has business interests in the U.S., having stock trading on one of its exchanges can help build the company's brand, says Stammers. 

"There's extra visibility and media attention," he says.

Listing in America can also diversify a company's shareholder base. Despite having two listings, investors are buying from the same set of shares and stock prices and valuations should be the same in both markets. Therefore, when a company lists abroad, it now has a pool of international investors and local buyers who own its stock. Usually, having a wider variety of equity holders reduces volatility, says Stammers.

The other main benefit is that it can help improve the company's valuation. Trading in a larger and more liquid market can help increase buyer demand, which might then push up the value of those shares, again, on both exchanges, he says.

Of course, a foreign company can list directly on a U.S. stock exchange, and many do, but those that choose this route don't already have a listing on their home stock exchange. The ADR is meant for businesses that have already gone public, says Stammers.

3 Levels of ADRs
There are three main types of ADRs that companies can list on a U.S. exchange. A level one listing is the most basic, and it allows companies to sell shares on the OTC market. It's the least expensive option for companies to pursue, and it also requires the least disclosure, says Eduardo Figueiredo, an investment analyst with Aberdeen Asset Management, who contributes ideas to Aberdeen Emerging Markets (GEGAX), which earns a Silver medalist rating from Morningstar. These companies do not have to comply with Sarbanes-Oxley rules and can't issue new shares in the U.S. after their initial ADR offering, he says.

While many smaller companies choose this route, many larger ones do as well.  Nestle (NSRGY), for instance, has an OTC ADR listing. Breen adds that while many level one companies only issue one annual report in English, many others over-report and provide the kind of full reports that American investors are used to.

Level two and level three listings, which can get a company on the NASDAQ or NYSE, are similar in that they must company with Sarbanes-Oxley, and they're required to deliver the same documents that U.S.-based public companies must provide. The main difference is that level three companies can issue new shares on a U.S. stock exchange after their initial ADR offering, while level two operations can only sell existing shares. Naturally, listing costs differ depending on the level.

Figueiredo says a lot of foreign technology firms use ADRs to list in America. U.S. investors tend to have a much larger appetite for tech companies than investors in other countries do. 

"You might have a limited investor base dedicated to that sector, but once it's able to reach the U.S. market via an ADR program, that brings it to a much broader pool of people," he says.

Technology, though, isn't the largest sector weighting among ADRs. According to the S&P ADR Index, an index made up of non-U.S. companies on the S&P Global 1200, of which many are level two and level three listings, 27.2% of the index is in financials, 15.9% is in energy, and 11.7% is in healthcare. Only 7% of companies on the ADR index are information technology-related.

If you're so inclined, you can easily find out a company's ADR level. Anything listed on an OTC exchange is a level one ADR, but if you want to decipher between a level two and level three listing, look at a company's F-1 statement. If it's a level three company, which gives it the ability to raise additional capital in the U.S., it must provide additional information that a level two company doesn't have to give, says Stammers. For instance, it should have information on how it plans to use the proceeds of an equity raise, risk factors, offering prices, name of legal counsel and disclosure of commissions, among other items.

Easy Access for Individual Investors
One of the big changes in the ADR market over the years is for whom for the market is designed. Institutional investors used to buy ADRs because it was easier to purchase them than owning foreign stocks directly. Now, though, institutions are much larger, have far better access to global markets, and understand the nuances of local economies. Many institutions also want to take advantage of currency movements that direct listings provide--and if they don't, they're able to more easily hedge the currency today.

Some institutions today may still use ADRs in markets that have weak investor protection laws: Buying a stock listed on a U.S. exchange gives an institutional investor the ability to take a company to court, if it needs to. Some countries also have liquidity issues and high transaction costs, which make it difficult to invest in that market.

"It's a mixed bag as to why an institution might buy an ADR,” says Stammers.

For individual investors, though, ADRs offer a much simpler way to get foreign stock exposure. These stocks can be purchased like any other U.S.-listed stock, though one ADR is not usually equal to one share. It's often a 10 to 1 ratio where one ADR purchased is equals 10 shares of a stock, but it can vary. In any case, the ADR is purchased in U.S. dollars, and dividends are paid in U.S. dollars, too. Purchasing an ADR rather than buying directly on a foreign exchange also takes away the many tax headaches that come with buying a foreign stock, says Breen. Some countries have withholding taxes and it can be a challenge to get that money back. Buy an ADR and you don't have to worry about foreign withholding tax.

“You can easily buy an interest in a company without the hassles,” he says.

However, be sure to read through the company's 20-F filing, which outlines the rights given by the company to a foreign shareholder. In many cases, U.S. investors will have the same rights to an ADR company as they would with a U.S. business, but that's not true in every case, says Figueiredo. For instance, some companies don't allow ADR shareholders to vote--they may say that the depositary bank gets to vote on the investor’s behalf--or it might say that one can vote, but it may not be processed or accepted.

Investors should also look to see if they're able to buy more shares of the company if the business issues more equity. This information is available--investors can also ask to read the contract between the depository institution and the listing company--but people must seek it out. 

"There are several things in terms of minority rights that investors need to be aware of," he says. "Read the warning section in the 20-F."

Even though investors are buying ADRs in U.S. dollars, they should still be mindful of currency risks in the company’s home country. Since the ADR listings tend to track the performance of the domestic listing, if a nation's currency gets devalued, or depreciates against the U.S. dollar, that ADR listing could lose value or not gain as much as the home country's stock. You're taking less risk by buying in greenbacks, but currency fluctuations can still impact your return.

Lastly, investors who limit themselves just to ADRs for their foreign exposure could be missing out on some good companies that don't list in the U.S. But Breen notes that investors can still build a reasonably diversified portfolio of ADRs. Morningstar covers more than three dozen ADRs, and several--including AstraZeneca (AZN), British American Tobacco (BTI),  Sky (SKYAY), and GlaxoSmithKline (GSK) --are trading in 4-star range, suggesting they're undervalued. In addition, AdvisorShares Dorsey Wright ADR ETF (AADR) invests primarily in a basket of ADR companies.

Even though buying foreign stock is easier these days than it was in the past, the ADR is not going away anytime soon. The benefits of an ADR--simple to buy, U.S. dollar denominated, enhanced disclosure--make it easier for retail investors to get access to foreign stocks. The only thing investors need to remember is that they're buying a foreign company, and not a U.S. one.

"The process is the same," says Breen. "You won't be able to tell the difference."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.