ADRs & foreign investments

American Depositary Receipts (ADRs)

If you didn’t already know, there are businesses outside of the United States (shocking, right?). Let’s say
you wanted to invest in one of those businesses; specifically, a Japanese business. You’ll need to do a fair
amount of work to invest in their stock.

First, you’ll get in contact with a broker-dealer who has access to the Japanese markets. Some US broker-
dealers offer access to international investments, but not all of them. Also, you may have to pay extra fees
for this service.

Next, you’ll need to learn the basics of the Japanese markets. In Japan, the Tokyo Stock Exchange is
similar to the New York Stock Exchange (NYSE). It’s where stocks of larger companies trade in Japan.
While their markets are familiar to ours, there are a few differences you may need to be aware of. For
example, the Tokyo Exchange closes for lunch every business day between 11:30am and 12:30pm. If you
really needed to buy or sell a stock quickly, this may be a problem.

FYI - American markets do not close for lunch.

After you find the right broker-dealer and know the basics of the Tokyo Stock Exchange, you’ll convert
your US Dollars to Yen to pay for the shares. This may present a problem, especially if there’s a bad
exchange rate (weak dollar or strong yen - see below for more on currency exchange risk) or if there are
significant fees through your broker-dealer for the conversion.

Sounds complicated, right? American Depositary Receipts (ADRs) were established in order to avoid
these problems. ADRs are created by domestic financial firms with foreign branches. Companies like JP
Morgan (which created the first ADR in 1927) purchase large amounts of foreign stocks that have high
US demand. These foreign stocks are then placed into an account, which is usually structured as a trust
(we’ll talk more about trusts in a future chapter).

From there, the financial firm “slices” up the account into a bunch of “receipts” for the stock. The receipts
are then registered with the proper regulator (SEC or state administrator) and then sold to US investors in
US markets.

Sidenote
Registration with the SEC
When an investment is sold publicly, it typically needs to be registered with either the Securities and
Exchange Commission (SEC) or the state administrator prior to sale. Depending on the structure of the
offering, it may be registered with the SEC, the state administrator, or both.

What is involved with registration? Essentially, filing a bunch of paperwork with the regulators. It’s the
issuer’s responsibility to divulge any “material” information about that security. Through this process,
the public is provided with enough resources to make an informed investment decision should they
choose to buy the security.
We’ll discuss more about who must register their securities, exemptions from registration, and more
about the general process later in this material.
Definitions
Material - Any information that would influence an investment decision; important information about an
investment - In some cases, the foreign issuer will work with the bank creating and issuing the ADR,
essentially encouraging the creation of the ADR. Having an expanded audience of investors is almost
always a good thing for issuers. If they need to raise additional capital later, the issuer can consider
selling additional securities in their country and in the United States. With more investors aware of their
existence, they have more access to money.Luckily for investors purchasing an ADR, there’s no need to
know how a foreign exchange works, deal with a foreign securities broker-dealer, or convert money into a
foreign currency. Honda Motor Corporation is an example of an ADR. Honda is based out of Japan and
its stock primarily trades on the Tokyo Stock Exchange. However, Honda’s ADR (ticker symbol: HMC)
trades on the NYSE and in US Dollars. Purchasing their shares is as easy as buying any other American
stock.
Definitions
Ticker symbol
A set of characters that represent an investment. Every publicly traded stock has a unique ticker symbol,
making it easy to track without typing out the full business name. Examples of ticker symbols:
• F = Ford Motor Company
• BAC = Bank of America Corporation
• MCD = McDonald’s Corporation
Although ADRs look and feel like any other American stock, they do come with some unique
characteristics. First, most ADRs do not provide voting rights. Because the shares are technically owned
by the financial firm that created the ADR, the investor isn’t actually viewed as an owner of the foreign
stock. It’s much easier for the financial firm to vote on the shares themselves, especially when the vote
takes place in a foreign language.

ADR investors do not receive pre-emptive rights, but are compensated for their value. The financial firm
responsible for initially creating the ADR receives rights if they are issued. Those rights are then
liquidated in the foreign market for their going market price and the proceeds are allocated to ADR
holders as dividends.

Like common stockholders, ADR holders maintain the right to receive dividends, but there’s an added
risk to be aware of. When a dividend is declared by the issuer, it is paid in the foreign currency. From
there, the financial firm that created the ADR will convert the dividend payment to US Dollars.

Although the investor receives the dividend in US Dollars, the conversion rate between the foreign
currency and the US Dollar may not be favorable. This is why ADRs are still subject to currency
exchange risk even though payment is made in US Dollars. Additionally, the foreign government may
withhold part of the dividend payment for tax purposes. If this occurs, the IRS provides a tax credit to
investors for any foreign government tax withholding.

Sidenote
Currency Exchange Risk
When exchanging from one currency to another, risk can be involved. If you’ve heard the term “strong
currency” or “weak currency,” (for example, the US Dollar is strong in Vietnam), then you’ve
encountered this concept.
Let’s explore this idea with an example. Assume you invest in Honda’s ADR. Honda is a Japanese
company, and does a majority of its business in the Japanese Yen. When Honda makes a dividend
payment, it makes the payment in Yen.

Behind the scenes, the yen is converted to US Dollars. If the US Dollar strengthened (or, if the Yen
weakened - same thing) just prior to the dividend payment, it would hurt your return. With a stronger
Dollar, it takes more Yen to purchase the same Dollar. Because of currency exchange risk, the dividend
payment results in fewer US Dollars.

Bottom line: when investing in foreign securities, currency exchange risk (also known as foreign currency
risk) applies. In general, the risk applies in these circumstances:

• The currency being exchanged out of weakens - The currency being exchanged into strengthens
To summarize, ADRs create an easy way for investors to purchase shares in foreign companies in US
Dollars and in US markets. They come with their own unique characteristics and risks, but provide a
simple solution for investors seeking investments from around the globe.

Foreign investments

Beyond investing in ADRs, making investments in foreign securities used to be a very cumbersome
process. It’s a much easier task in today’s digital and instantaneous world. Many brokerage firms allow
their customers to invest directly into foreign stocks and bonds, and nearly every firm provides an
opportunity to invest in foreign securities through securities like mutual funds and ETFs. Regardless of
the way it’s done, investing in foreign securities comes with unique benefits and risks.

A big benefit of foreign investing is diversification, which is an important aspect of investing. If you
owned only one stock in your entire investment portfolio, you could lose everything if the company went
bankrupt. To avoid this risk, investors tend to invest in numerous securities across different industries and
regions. That way, there’s a balance to a portfolio.

In 2018, the energy sector (natural gas, oil, etc.) was the worst performing sector, down more than 20%
by the end of the year. If all of your money was invested in energy stocks, you would’ve lost a
considerable amount of money. However, the health sector (pharmaceuticals, medical technology, etc.)
was up over 4% over the year (2018 was not a great year in the stock market; in fact, the S&P 500 was
down over 6%). By having some money invested in the health sector, losses from energy would be
balanced out by the gains from health. This is diversification.

Foreign securities provide an opportunity for investors to diversify their investments. There have been
many times in the past when domestic investments weren’t performing as well as foreign investments. If
the US economy is going through a recession, losses could be balanced out by having exposure to some
foreign investments.

Depending on the foreign investment, additional risks could exist. Foreign investments from countries
with large and strong economies (like Japan or Germany) would generally be considered the safest forms
of foreign investing. Investments from smaller, possibly third-world countries come with much more risk.
Investments in companies or organizations from smaller, but growing foreign economies/countries are
referred to as emerging markets.
Countries like Mexico, Thailand, and South Africa are considered emerging markets. While these
countries haven’t historically been big players in the global economy, their economies are growing and
gaining momentum. Investments in companies or organizations in emerging markets come with a
substantial amount of risk. Many of these countries have governmental issues (corruption, “red tape,”,
etc.), economic problems, and weak infrastructure for business.

For example, Venezuela has a history of nationalizing businesses, meaning the government overtakes a
private company and claims it as a public good. If you owned stock in a foreign company and it was
nationalized, you could lose an immense amount of money and/or opportunity. You were the owner, but
now the foreign government is. This could be a risk when investing in emerging markets.

While these investments present a fair amount of downside risk, they also come with immense potential
for profit. If investors can stomach the volatility that comes with emerging market investments, there’s a
history of significant profits made off these investments. Plus, smaller economies have more room for
growth, offering more opportunity to make profits.

Another risk of foreign investing involves currency. In order to invest directly in foreign companies
and/or organizations, currency must be converted. For example, investing directly in a Japanese company
would require a conversion from the U.S. Dollar to the Japanese Yen. At the time of the conversion, the
value of each currency can either work for or against the investor. You’ve probably heard of weak and
strong currencies. Neither are considered universally “good” or “bad,” but each comes with
consequences.

A weak currency can be beneficial or detrimental, depending on the circumstance. For example, a weak
domestic currency would work against an investor if they’re investing in a foreign company. When a
currency is weak, it means that it doesn’t buy as much of another foreign currency. Here’s a real-world
example: