American depositary receipt (ADR) was introduced in 1927 as a more convenient way for investors to buy and sell shares of foreign corporations. Put simply, ADRs represent a specific number (or fractions) of a share in a company that doesn’t already have a stock listed on the US stock exchanges and trade like a stock in the open market.
A Little Background about ADRs
Back in the days, it was very complicated to buy shares in different countries, which involved dealing with tax and currency issues. Subsequently, ADR was introduced to let U.S. banks buy shares from a foreign company and re-issue them on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) or the Nasdaq. During the introduction, the bank will also determine how many shares will correspond to each home country share. The reason why it isn’t a 1 to 1 relationship is due to the fact that banks want to price shares of ADR high enough to perceive substantial value and low enough for individual investors to take advantage. For example, exchange rates can make certain stock look like a penny stock, which will have a negative psychological effect on investors in the U.S.
A Reminder of Risks with ADRs
Other than the actual company that the ADR represent, investors should be aware of additional risks when buying into a foreign corporation. For example, there might be political risks in the home country that the foreign country is in. For example, if two countries start a war, you can bet that the prices of any ADR that is linked to those two countries will fall. While this is true for stocks in the U.S. as well, the additional risk in foreign countries is that you aren’t as sensitive with news abroad.
Also, currency plays a huge role in ADRs as shares are priced in U.S. dollars. For example, if the U.S. currency becomes stronger against the foreign countries’ currency, the earnings of the foreign company have to make up the difference before share prices will appreciate meaningfully. Of course, exchange rates can work in your favor as well. In an environment where the U.S. dollar is weak (and continues to become weaker), ADRs usually perform very well.
What does ADRs Mean for Us
ADRs provides investors a great way to diversify into foreign markets because it’s highly liquid, easy to manage and it trades just like any other stock. While there are brokerage firms like Etrade that will allow you to buy stocks in foreign countries, ADRs are available for everyone provided that the company you want to invest in has an ADR set up.
As an average investor who picks individual stocks, there is no reason why you shouldn’t look into ADRs. If you haven’t taken advantage yet, you are missing out since the additional diversification and ease of management is well worth it.