What is an American Depository Receipt (ADR)?

An American Depository Receipt, or ADR for short, is a piece of paper representing shares of a non-US company. It allows people in the United States to buy shares in foreign companies without complicated hassles.

Here’s how it works: A US bank buys many shares in a foreign company. The bank then issues ADRs for those shares. Each ADR represents a certain number of shares of the foreign company. The ADRs are priced in US dollars. They can be sold to investors and traded on stock markets in the US.

So when you buy an ADR, you own a share of a foreign company – but you don’t have to deal directly with foreign stock markets or currency exchanges. The US bank does all that work for you behind the scenes. Pretty handy, huh?

The History of ADRs

ADRs have been around for a long time—the first one was created in 1927 by a prominent US bank called JP Morgan. They wanted to make investing easier for Americans in Selfridges, a British department store company.

Over the years, ADRs have become increasingly popular for Americans to invest money in companies in other countries. Many well-known foreign companies, including Toyota, Sony, BP, and Alibaba, now offer ADRs.

How Do ADRs Work?

Okay, let’s break this down a bit more. It starts when a foreign company decides it wants more American investors to be able to buy its stock easily. It has to find a US bank to partner with. The company and the bank work out an agreement in which the bank creates ADRs representing the company’s shares.

The US bank then buys all of the foreign company’s shares in its home country and holds them in a safekeeping arrangement known as “custody.”

For every certain number of foreign shares they have in custody, the bank issues an ADR. Each ADR represents a specific number of the company’s regular shares. The bank then sells those ADRs to investors or other banks in the US.

The Two Types of ADRs

There are two different kinds of ADRs – sometimes, the foreign company is involved in the process, and sometimes they aren’t. Let me explain:

Unsponsored ADRs

The other kind of ADR is “unsponsored.” This happens when a US bank decides to create ADRs for a foreign company’s stock – the company isn’t involved and may not even know about it!

In this case, the US bank does all the work itself. It buys the shares, sets up the custody arrangement, and issues the ADRs without the foreign company’s active cooperation. The bank is also responsible for providing information to investors.

Nowadays, most ADRs are sponsored, but unsponsored ADRs occasionally appear, especially for smaller foreign companies.

The Nitty-Gritty Details

It’s time to get into some finer points about how this works.

Trading and Pricing ADRs

ADRs trade on US stock markets just like regular stocks. Their prices go up and down throughout the trading day as people buy and sell. You can buy and sell them through your usual stockbroker.

Many ADRs are listed on major exchanges like the New York Stock Exchange or NASDAQ. Some are traded “over the counter,” like an unofficial stock market.

When it comes to pricing, the value of an ADR is based on the value of the company’s actual shares in its home country. But it’s not always a direct 1:1 conversion—things like exchange rates and the ratio of ADRs to home country shares can also affect the price.

The ratio of ADRs to Ordinary Shares

One key thing to know about ADRs is that each one doesn’t necessarily represent just one share of the foreign company’s stock. Often, there’s a ratio, like 1 ADR = 4 ordinary shares.

The bank and the company decided on this ratio when they first set up the ADR program. It lets them price the ADRs reasonably for US investors – not too high or too low. They can also adjust the ratio later on if needed.

Regulation and Registration

In the US, the Securities and Exchange Commission (SEC) monitors ADRs to ensure everything is up and up. Sponsored ADRs have to be registered with the SEC.

Foreign companies must also provide regular financial reports, similar to US public companies, but the requirements aren’t quite as strict.

Unsponsored ADRs don’t necessarily have to be registered. However, most are now since the SEC tightened the rules recently.

Why Companies Offer ADRs

So why would a foreign company go to all this trouble? What’s in it for them? There are a few key reasons:

Tapping the US Capital Markets

The US has the biggest and most active stock markets in the world. Foreign companies can attract more investment money by making it easy for Americans to buy their stock.

Increased Liquidity for Shares

When more people are trading a company’s stock, it’s said to have higher “liquidity.” This is generally seen as a good thing, meaning there’s a ready market of buyers and sellers. ADRs can boost a foreign company’s liquidity.

Prestige and Visibility

Having ADRs on a major US stock exchange is a feather in a company’s cap. It’s a status symbol that can make the company seem more stable, prosperous, and trustworthy to investors, business partners, and customers worldwide.

Currency Diversification

When foreign companies sell stock only in their home countries, all their investment money is in the local currency. But when Americans buy ADRs, that money is in US dollars. This gives the company a nice mix of currencies, which can help balance things out.

Pros and Cons for US Investors

Okay, ADRs can be great for foreign companies looking for US investors. But what about the pros and cons for the investors themselves? Let’s take a look:

The Pros

Convenience and simplicity: ADRs trade in US dollars on US markets. You can buy and sell them through your regular broker without worrying about foreign exchanges or currencies.
Diversification: ADRs offer an easy way to add international stocks to your portfolio, helping you spread your risk across different countries and economies.
More information and disclosure: Foreign companies with sponsored ADRs must provide financial reports in English and meet specific SEC standards, which can give investors more insight.

The Cons

Foreign market risk: Even though you buy and sell ADRs in the US, their value is still tied to the company’s stock in a foreign market. Political and economic events in that country can affect the stock price.
Currency risk: When you eventually sell your ADRs, you’ll sell them for dollars. However, the company’s actual value is based on a foreign currency. If that currency has decreased relative to the dollar, your shares may be worth less than you paid despite the stock price being up. The reverse can also be true.
Liquidity and spreads: Some ADRs aren’t heavily traded. This can make them harder to buy and sell at a reasonable price. The difference between the buying and selling price (called the “spread”) can be high.
Fees: Banks charge fees for issuing and maintaining ADRs. These can sometimes eat into returns.