Saturday, May 13, 2006

Investing in ADR (American Depository Receipt) Stocks

Invest in Foreign Stocks from the USA

When a company's ordinary shares (ORD) are based in another country, and are home to a foreign country's stock exchange (such as the Tokyo or London Stock Exchange), and trade in a foreign currency, how can you easily invest in these non-US equities?

The answer may be ADRs (American Depository Receipts), which can be a great way of owning shares in foreign companies. Not all foreign companies have ADRs, but those that do give you a way to trade shares in these foreign firms right here in the USA on our own exchanges like the NYSE (New York Stock Exchange) for example, and trade in US Dollars (USD).

NOTE: see my related blog about Currency Trading Basics: Understanding the Exposure Implications (on your Forex holdings) Related to Exchange-Rate Fluctuations (includes a quick-reference diagram / visual-aid for magnitude-of-move comprehension).

Understand the Implications of Underlying Currencies on ADR Share-Prices

Before trading ADRs, you need to understand how they are priced, and the impact that currency-exchange-rates may have on your investment!

ADR "shares" will represent some multiple or fraction of an ORD share. This ratio of ADR:ORD is important to understand, especially if you trying to figure out how the ADR is priced as compared to the ORD. The ADR:ORD ratio will be one of the following:
  • (1:1) — meaning, a single ADR share is equivalent to a single ORD share. E.g., Bayer AG (ADR ticker: BAY) whose ADR trades 1:1 with the underlying ORD share trading on the German Stock Exchange in Euros;
  • (1:n) — meaning it takes multiple (n) ORD shares to equal 1 ADR share. E.g., HSBC Bank ADRs (NYSE ticker "HBC") trades at a ratio of 1:5, with the underlying ORD share trading on the London Exchange in Pence (i.e., 1/100 Pounds, or a British Penny in essence)
  • (n:1) — meaning it takes n ADR shares to equal 1 ORD share. E.g., SAP AG (Ticker SAP), trades at a ratio of 4:1, with the underlying ORD share trading on the German Stock Exchange in Euros;
Though ADR prices are quoted on US Exchanges in USD, you may wonder how they come up with the price. And, this will be important for the next point I'll make, which is: the rather substantial potential impact of currency fluctuations on your ADR price.

Using HSBC (ADR: HBC) as an example, whose closing price was approx. $90.00 USD, here is how that ADR price value is arrived at from the ORD price:
  1. Start with the ORD price (in Pence) was approximately 950. I.e., 9.50 Pounds;
  2. Now, obtain the ADR:ORD ratio, which is 1:5 in this case;
  3. Obtain the currency-pair exchange rate: e.g., the British Pound (GBP) was trading at approximately $1.89 USD per GBP;
  4. Finally, perform the calculation.  Start by multiply the ORD price by the ADR:ORD ratio (5 in this case), since one ADR represents 5 ORD shares, giving us 47.5 Pounds (i.e., 9.50 x 5). Next, convert to our local USD currency by multiplying the prior result (GBP 47.5) by the current effective currency exchange rate of 1.89 USD : GBP, which yields the current value that foreign share should be worth in local currency equivalent, or $89.775 USD.
Voilá!, it really does come out to the price the ADR is trading at!

So, one thing that should become quite clear in this "lesson" is the impact of the foreign-currency-exchange-rate in the pricing of the ADR. You may choose a wonderful foreign company to invest in, but, depending on whether the dollar strengthens or weakens against the currency that foreign stock's ORD shares are priced in, you could still lose money. Conversely, a poorly performing foreign stock could make you money on your ADR holdings if the dollar tanked against the currency the ORD shares are priced in.

To make this fact clear to you: Presume you buy HSBC stock at an ADR price of $100.00/share. Even if the HSBC stock underlying ORD shares on the London Exchange never move at all, but the dollar swings downward by 2% against the pound, you will have made 2% on your ADRs, since it now takes more dollars to buy the same amount of HSBC stock ORD shares in Pounds. Likewise, if the dollar gains 5% against the pound, it takes fewer dollars to purchase an ORD share of HSBC, and you will have lost money on your ADR shares. So, be sure to keep currency fluctuations in mind when investing in ADR shares!

Useful ADR Resources

Check out foreign stock exchanges to get quotes (in base currency for ORD shares) for the stock you are researching. For example, to see HSBC quoted on the London Exchange, go here: HSBC Bank, PLC (ticker HSBA) on its native London Stock Exchange website, quoted in pence (i.e., pennies in the GBP or Pounds Sterling currency system).

A nice resource for checking out ADRs is the Bank of New York Mellon (BNY Mellon) Depository Receipts web site. They have a rather comprehensive DR directory that allows searching by region, industry, and many other criteria. It also shows ADR:ORD ratios, underlying country, and more.

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1 comment:

Anonymous said...

Thanks, I heard a lot of ADR/ORD shares, but never understand how it does work. Your explanation very clear and simple. It is explaining not just idea of this type of investment but how it works.