American Depositary Receipts | Trading | Common stock

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

First, you’ll need to contact a broker-dealer (BD) with access to the Japanese markets. Some American BDs 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 notable differences. For example, the Tokyo Exchange closes for lunch every business day between 11:30am and 12:30pm. If you needed to trade quickly, this might be a problem. FYI - American markets do not close for lunch.

After you find the right BD and know the basics of the Tokyo Stock Exchange, you’ll need to convert your US Dollars to Yen to pay for the shares. You may face a bad exchange rate (weak Dollar or strong Yen) or significant conversion fees.

Sounds complicated, right? American Depositary Receipts (ADRs) were established to avoid these problems. ADRs are created by domestic financial firms with foreign branches (e.g., an American bank with an office in Japan). Companies like JP Morgan (which made the first ADR in 1927) purchase large amounts of foreign stocks with high US demand. The stocks are placed into a trust account (we’ll talk more about trusts later), then the account is sliced into “receipts” for the stock. The receipts are then registered with the SEC and sold to American investors in US markets.

Sidenote

Registration with the SEC

We’ll discuss this later in the primary markets chapter, but you’ll need to know a few basics for now. When an investment is offered to the public, it typically requires registration with the Securities and Exchange Commission (SEC) before sale. The Securities Act of 1933 is a law that requires most issuers to register their securities with the SEC.

What is involved with registration? Essentially filing detailed paperwork with the SEC. The issuer is responsible for publicly divulging any “material” information about that security. These disclosures are provided in the prospectus, which investors may access and read. Through this process, the public can make an informed investment decision before investing.

Definitions

Material information: Any information that would influence an investment decision; important information about an investment

Investors who purchase ADRs don’t need foreign market knowledge, BDs with access to international markets, or money conversions. 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:

TSLA = Tesla Inc.
BAC = Bank of America Corporation
MCD = McDonald’s Corporation

Although ADRs look and feel like any other American stock, they have some unique characteristics. First, most ADRs do not maintain voting rights. Because the shares are technically owned by the financial firm that created the ADR, investors aren’t actually viewed as foreign stock owners. It’s much easier for the financial firm to vote on the shares themselves, especially when it 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. When the issuer declares a dividend, it is paid in foreign currency. The trust holding the stock then converts the dividend payment to US Dollars (so it can be paid to ADR holders). The conversion rate between the foreign currency and the US Dollar may not be favorable. Therefore, 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

Exchanging from one currency to another can be risky. If you’ve heard the term “strong currency” or “weak currency” (e.g., 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 stock primarily trades in Japan and pays cash dividends in Japanese Yen. When a dividend is paid, Yen is converted to US Dollars.

It would hurt your return if the US Dollar strengthened (or, if the Yen weakened - the same thing) just before the dividend payment. It takes more Yen to purchase the same Dollar with a stronger 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

Key points

American depositary receipts (ADRs)

US-registered receipts for foreign investments
Created by domestic financial firms with foreign branches
Trade in US dollars in US markets
Subject to currency exchange risk
No voting or pre-emptive rights
Foreign government tax withholding creates a US tax credit