When to Invest in American Depository Receipts

American Depository Receipts (ADRs) are derivative securities which allow US residents to invest in foreign companies without the risk and expense of purchasing the stock on a foreign stock exchange. Through ADRs the stock of non-US companies trade indirectly on the US stock exchanges or over the counter market.

An ADR is issued by an American depository bank at the same time the underlying shares of the foreign company are deposited with a non-US custodian bank, usually by broker who has purchased the shares on the foreign stock exchange where the shares of the target company trade. The custodian bank safeguards the shares for its American counterpart depository bank, which has all shareholder rights to the shares. The American depository bank then offers some, but not all, of these rights to the purchasers of the ADRs through a derivative contract. The ADR is denominated in US dollars, keyed by a ratio to the value of the underlying foreign shares, and may pay dividends to the US owner of the ADR.

A good time to invest in ADRs is when the country where the foreign company operates is politically stable, has good economic growth potential and a stable or appreciating currency. Although the ADR is denominated in US dollars, its value is adjusted based upon the value of the underlying stock. If a country’s currency is devalued, this will negatively affect the value of the underlying shares, thereby reducing the value of the ADRs, even if the company is still making a good profit. On the other hand, growth, high income, and currency appreciation will cause the ADR value to increase.

In the current world financial environment China, while slowing a bit, is still experiencing growth rates over 9%, and has a relatively undervalued currency. China is under pressure from the US to allow its currency to appreciate and has not lowered interest rates to the precarious levels which could devalue its currency, unlike the US and Europe.

Investing in well-chosen Chinese corporations through the use of ADRs could provide a profitable and more stable vehicle to put investment funds to work than investing in US or European companies. For example, an investment made three years ago in Tsing Tao Brewery ADR would be now be worth about three times the original investment.

As with any investment, care must be taken in choosing ADR investments. Beyond the financial condition of the underlying company, risks include political risk, exchange rate (currency) risk, and inflationary risk. For example you might personally enjoy Italian cars and fashion but holding Italian ADRs over the last few years would have been a poor investment decision and generally would have resulted in losses, due to concerns and fallout from high levels of Italian government debt.

US securities law allows for several different levels of ADRs to be issued to individual investors. These include unsponsored and sponsored level I, II, III. The higher the level, the more US financial and legal compliance is required by the underlying company. For example, with a level I ADR, the underlying company is not required to file annual financial reports with the Securities and Exchange Commission (SEC), while with a Level III the company must provide an offering prospectus and financial information prepared in accordance with generally accepted accounting principles (GAAP).

Unsponsored ADRs are instruments where the underlying foreign company does not have an agency agreement with the depository bank, while sponsored ADRs are instruments under which the foreign company designates one or more depository banks to act as its agent. Rule changes by the SEC in late 2008 have made it much easier for foreign companies to issue level I ADRs, both sponsored and unsponsored, and this has resulted in an ADR boom. These level I ADR derivatives trade on the over the counter markets. Currently over half of all existing ADRs are unsponsored.

Because level I ADRs do not require much US financial transparency of the foreign target company, these investments carry considerable risk. For investors who wish to have access to information about the financial condition of the underlying foreign company, it is best to stick to Level II and Level III ADRs.

A good time to invest in ADRs is anytime you can find a profitable company operating in a stable, growing, financially sound foreign country. As the global economy recovers from the Great Recession, China, Brazil, India and other emerging market economies may offer great investment opportunities for the intrepid ADR investor.