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.
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.
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.
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:
| Date | $1 US Dollar buys |
|---|---|
| June 2015 | 125 Japanese yen |
| November 2019 | 110 Japanese yen |
From June 2015 to November 2019, the US Dollar weakened against the Yen, meaning one US Dollar bought fewer yen in 2019 than it did in 2015. When this occurs, it’s more expensive to buy Japanese investments. Using these numbers, let’s assume an investment in a Japanese company cost 15,000 yen per share. Here’s the difference in price, with the only component changing being the exchange rate:
| Date | Cost of ¥15,000 in USD |
|---|---|
| June 2015 | $120 per share |
| November 2019 | $136 per share |
Even if the investment cost the same in yen (¥15,000), the amount paid in US Dollars is more in 2019 due to the US Dollar weakening. This is an example of currency exchange risk, which occurs when a currency conversion negatively affects an investment. Here’s the math behind the numbers above:
June 2015
- = $120 per share
November 2019
- = $136 per share
A weak US Dollar works against American investors when purchasing a foreign investment. However, it works in their favor if they’re selling a foreign investment and converting back to US Dollars. If the investor sells the ¥15,000 Japanese investment, they would net $136 per share in November 2019, as compared to $120 per share in June 2015.
As we’ve demonstrated, a weak currency results in different outcomes depending on the circumstance. Here’s a summarization of these points:
Weak domestic currency
- Unfavorable converting into foreign currency
- Favorable converting out of foreign currency
Similar to a weak currency, a strong currency can be beneficial or detrimental, depending on the circumstance. From November 2011 to November 2019, the US Dollar strengthened against the Japanese Yen:
| Date | $1 US Dollar buys |
|---|---|
| November 2011 | 75 Japanese yen |
| November 2019 | 110 Japanese yen |
When the US Dollar buys more Yen, it’s less expensive to make a foreign investment. When the conversion from Dollars to Yen occurs, more Yen is obtained, allowing the investor to buy more of their Japanese investment.
| Date | Cost of ¥15,000 in USD |
|---|---|
| November 2011 | $200 per share |
| November 2019 | $136 per share |
In November 2019, a ¥15,000 investment cost $136 per share, which is dramatically cheaper than the $200 per share cost for the same ¥15,000 in November 2011. A strong currency is definitely favorable for buying foreign investments. Here’s the math behind the numbers above:
November 2011
- = $200 per share
November 2019
- = $136 per share
Of course, a strong currency has its downside. If you were to sell a foreign investment with a strong domestic currency, you receive less due to the conversion. Selling a ¥15,000 investment netted $200 per share in November 2011, versus netting $136 per share 8 years later in November 2019. This is another example of currency exchange risk.
Again, we’ve demonstrated a currency’s strength results in different outcomes depending on the circumstance. Here’s a summarization of the consequences of a strong currency:
Strong domestic currency
- Favorable converting into foreign currency
- Unfavorable converting out of foreign currency
Here’s a video that breaks down foreign currency risk further:
Series 65 test questions may involve foreign investments and currency strength. While foreign investments add to diversification, they also add a layer of complexity when involving currency conversions. Depending on the strength of the currencies involved, the investor may increase or decrease their overall return.
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