From time to time, you’ll hear the term “ADR” if you are an investor. But what is an ADR and are ADR shares good investments? Let’s define “ADR” first and then determine if they are a good fit for your portfolio.
What is an ADR?
“ADR” stands for American Depository Receipt. These are simply shares in foreign companies that trade on an American exchange like the NYSE, AMEX or NASDAQ. They trade just like stocks and ETFs.
Why would a foreign company want to trade shares on an American exchange?
Because that’s where the action is. ADRs give foreign corporations access to more capital because the ADR gives investors easier access to buy shares of these foreign companies. Think about what you’d have to do without ADRs if you wanted to buy stock in a foreign company. First you would have to exchange dollars for foreign currency. They you would have to open a brokerage account overseas. Finally you would have to stay up all night to watch your share prices because of the time difference. Drag.
ADRs solve all those problems for investors.
How does it work?
American banks buy a fixed number of shares and repackage them into other shares they list on American exchanges. Simple.
What are the advantages for investors?
ADR’s provide another level of scrutiny. Foreign companies are notorious for using “creative accounting” techniques. Unless you are very skilled at reading financial statements (in a foreign language) it might be tough for you to determine if the company is Kosher or not. The ADR process takes some of this problem off your shoulders.
That’s because the bank that packages the ADR will require the foreign company to provide in depth financial statements and the bank will scrutinize those documents.
What to be careful of when considering ADR shares
First, keep in mind that the ADR could represent multiple shares of the company on the foreign stock exchange and this is really important. Why?
Let’s say you don’t like to trade penny stocks. The bank knows that most investors don’t. As a result, they could bundle a bunch of shares that trade for a very low price into an ADR that is equal to at least $10. For example, let’s assume that XYZ stock on the Venezuelan exchange trades for 1 Bolívar. That is only worth $.25. It’s a penny stock and you probably would never go near it.
The bank could create an ADR that might represent 100 shares of XYZ and sell each ADR for $25 each. The problem with this is that you are buying a penny stock and you don’t know it. You can solve this problem simply by looking into what the underlying stock is trading for on the foreign exchange and then converting the local currency back into dollars. I recommend that you take this step if you buy ADRs.
Another problem is that there are different levels of SEC scrutiny when it comes to listing ADRs on American stock exchanges. You want to restrict your purchases to level 3 ADRs. These are shares that are floated through an IPO. These shares must pass muster with the SEC (still no guarantee of safety or profitability) in terms of registration, capitalization and number of shares traded. Lower level ADRs have even less scrutiny so I’d suggest that you avoid them.
Are ADR’s for you?
Maybe. If you like to buy and sell individual stocks, you should absolutely look into buying ADRs. However, for most people, stock trading isn’t a good use of their time. It doesn’t matter if you buy ADRs or U.S. stocks, when you buy individual shares you must develop a detailed strategy, dive into the financial records of the companies and watch them closely. I feel that a much better investment strategy is to buy mutual funds and/or ETFs and allow the managers of these funds to do the stock picking for you. You can buy funds so inexpensively these days that this is a far better route for most investors.
Do you buy stocks of foreign companies? Have you done so through ADRs? What was your experience?