Businesses operate all over the world, not just in the United States. Suppose you want to invest in a Japanese company. If you tried to buy the stock directly in Japan, you’d have to handle several extra steps.
First, you’d contact a broker-dealer that can access Japanese markets. Some U.S. broker-dealers offer international trading, but not all do. You may also pay additional fees for international access.
Next, you’d 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 many larger Japanese companies’ stocks trade. Even though the markets are broadly similar, there are operational differences you need to know. For example, the Tokyo Stock Exchange closes for lunch every business day between 11:30 a.m. and 12:30 p.m. If you needed to buy or sell quickly during that window, you wouldn’t be able to trade.
FYI - American markets do not close for lunch.
After you find the right broker-dealer and understand the basics of the Tokyo Stock Exchange, you’d convert U.S. dollars to yen to pay for the shares. That conversion can create issues if:
This is where American Depositary Receipts (ADRs) come in. ADRs were created to make it easier for U.S. investors to invest in foreign companies without trading directly in foreign markets.
ADRs are created by domestic financial firms with foreign branches. Firms like JP Morgan (which created the first ADR in 1927) purchase large amounts of foreign stock that has high demand in the U.S. Those foreign shares 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 divides the account into many “receipts” representing the stock. These receipts are then registered with the SEC and sold to U.S. investors in U.S. markets.
In some cases, the foreign issuer works with the bank that creates and issues the ADR, effectively encouraging the ADR’s creation. A larger investor audience is generally beneficial for issuers. If the issuer needs to raise additional capital later, it can consider selling additional securities both in its home country and in the United States. More investor awareness can mean more access to capital.
When the issuer works with the bank to create the ADR, it’s called a sponsored ADR. Only sponsored ADRs can be exchange traded and they include translated financial documents.
Unsponsored ADRs are created without the issuer’s assistance or knowledge. They may only trade in the OTC markets, and their financial disclosures are not translated. Here’s an example of an untranslated financial disclosure form from Ageas, a Belgian insurance company with an unsponsored ADR trading in the U.S.
Luckily for investors purchasing an ADR (sponsored or unsponsored), there’s no need to understand how a foreign exchange works, use a foreign securities broker-dealer, or convert money into a foreign currency.
Honda Motor Corporation is an example of a sponsored ADR. Honda is based in Japan and its stock primarily trades on the Tokyo Stock Exchange. However, Honda’s ADR (ticker symbol: HMC) trades on the NYSE and in U.S. dollars. Buying it is similar to buying any other U.S.-traded stock.
Although ADRs look and feel like other U.S.-traded stocks, they have some unique characteristics.
First, most ADRs do not provide voting rights. Because the underlying shares are technically owned by the financial firm that created the ADR, the ADR investor typically isn’t treated as the direct owner of the foreign stock. In practice, it’s simpler for the financial firm to vote the shares, especially when voting materials are in a foreign language.
ADR investors also do not receive pre-emptive rights, but they are compensated for their value. The financial firm that created the ADR receives the rights (if issued). Those rights are then liquidated in the foreign market at their current market price, and the proceeds are allocated to ADR holders as dividends.
Like common stockholders, ADR holders have the right to receive dividends, but there’s an added risk to understand. When the issuer declares a dividend, it pays the dividend in the foreign currency. The financial firm that created the ADR then converts that payment into U.S. dollars.
Even though the investor receives the dividend in U.S. dollars, the exchange rate between the foreign currency and the U.S. dollar may be unfavorable at the time of conversion. This is why ADRs are still subject to currency (exchange rate) risk.
In addition, the foreign government may withhold part of the dividend for tax purposes. If this occurs, the IRS provides a tax credit to investors for any foreign government tax withholding.
To summarize, ADRs make it easier to invest in foreign companies through U.S. markets using U.S. dollars. They still come with specific characteristics and risks, including limits on shareholder rights and exposure to currency exchange rates.
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