American depository receipts, or ADRs, are a method for U.S. investors to invest in overseas stocks without having to invest through international mutual funds. ADRs are the key methodology for foreign firms to make their stock available to U.S. investors.
ADR shares thus are foreign firm shares trading on the U.S. stock exchanges. Thousands of firms worldwide provide ADRs for U.S. investors. ADR shares have a unique structure. Those that are listed in the U.S. are backed by foreign company shares held in trust by a U.S. bank. These banks may include Bank of New York of J.P. Morgan Chase. ADR shares may be fixed for one — or a number – of the foreign stock exchange shares.
For example, in our recent article on “3 French ADRs to Consider“, French oil firm Total SA trades at a one-to-one share arrangement. This means that the price that it trades for on the Euronext Paris (ESE) European Stock Exchange is the same as here, minus the currency effect. It also means that when the firm declares its annual dividend, you will receive this full dividend after converting to dollars. On the other hand, Société Générale trades at a 5:1 ratio. For each share of the firm in Paris represent five shares here as an ADR. In this case, you will have to calculate out the dividend based on the ratio of shares held as an ADR versus home shares. Thus each investor in ADRs must know the translation rate to calculate share price and dividends paid. The share ratio is a critical factor to understanding ADRs. A big advantage of investing in foreign companies using ADR shares allows U.S. investors to participate in currency movements. This adds to the diversification of your portfolio.
The trustee bank such as Bank of New York that possesses the foreign shares backing an ADR will collect dividends paid in foreign currency and then convert those dividends to dollars. Then the money is paid out to you as an ADR shareholder. As an investor, you don’t know exactly what amount you will be paid until the actual payment date, as it depends on the currency translation at that moment in time.
Additionally, most foreign countries require that taxes be withheld from an ADR’s holders dividend payment. But U.S. investors can claim a tax credit if held in a taxable account. The tax depends on the country. France for example charges fifteen percent, but it varies widely. A substantial number of ADRs trade do not trade on the New York Stock Exchange with heavy volume, such as Toyota. Many ADR stocks trade in what is known as “the over-the-counter market”. This includes Société Générale and many other well-known firms like Roche and Nestlé. Ensure that any share you buy from this portion of the market are considered “sponsored by the foreign firm”. So why should any U.S. investors consider ADRs given the complications of ownership. First, international stocks provide good diversification for any U.S. investors. Each area of the market can offer different returns over time, as the table below indicates;
Although the U.S. has done much better than foreign markets since the Great Recession, during the previous decade Europe was the best performer. Opening up your universe to foreign ADR stocks allows you to have a wider selection to choose from. For example, in banking, European banks trade at a substantial discount to U.S. banks and also offer higher dividend yields. Ten years ago this was not the case, as the valuations were about even. Instead of investing in just Pfizer, Merck, or Eli Lilly, with ADR investing you can invest in GlaxoSmithKline, Novartis, and AstraZeneca. Currency is also a big issue. If you own Société Générale ADR and the euro currency strengthens against the dollar, both the price rise and dividend increase will be raised because both the price and the dividend payment is converted to dollars. The opposite may occur as well. The dollar has been strong for nearly seven straight years now, so now may be a good time to take the other side and bet on a lower dollar.
Overall, ADRs provide more selection, more diversification, and higher dividends for U.S. investors.