Income investors are engaged in a constant search for stocks offering yield, safety, and attractive pricing. In recent years, foreign stocks have become much more visible to U.S. investors as a suitable avenue for a portion of their stock holdings, offering all of the above listed attributes, plus allowing for more diversification in their portfolios. Note that for purposes of this article, only foreign stocks trading as American Depository Receipts (ADRs) on U.S. exchanges are being considered.
While there are a number of issues to be aware of in owning these stocks (ADRs), an investor would do well to consider them for a portion of his/her holdings – failure to do so will result in ignoring some of the largest, most profitable, highest yielding companies in the world. In these times of absurdly-low fixed income rates, the income investor cannot afford to ignore a promising income asset class.
Before I begin, in the interest of full disclosure, note that I am not a financial professional nor am I certified in any way as a financial advisor. Further, I want to point out that I'm not necessarily recommending the stocks (ADRs) discussed, at least not in this article, but presenting them as representative of foreign stocks available as ADRs, to illustrate the points being made here, that foreign stocks present issues beyond what an investor must consider with domestic stocks. That said, I do in fact maintain a list of stocks I would consider as an income investor, which includes some of the stocks mentioned. If interested, you can click on my Seeking Alpha profile to get a link to my blog/website.
Moving on, I will first touch on the highlights of some issues to be aware of regarding these stocks (ADRs), then I will get into the “meat” of the article by “drilling down” further into two specific issues unique to ADRs: currency risk and foreign tax withholding. I will share what I’ve learned from both experience and research regarding some specific stocks, including anecdotal results of a couple of recent inquiries to brokerages regarding ADR withholding. I will then wrap up by providing a table showing some of the most significant ADRs that I am aware of, some of which I either own currently or have owned in the past, plus others I have considered. The table will summarize what I’ve learned about these companies regarding dividend currency issuance and foreign tax withholding.
A few general observations regarding foreign companies to be aware of are:
These companies often pay dividends on an annual or semi-annual schedule, not the quarterly schedule that most U.S. firms adhere to. Further, if paying semi-annually, the two payments are not necessarily the same, and also are not necessarily six months apart. The firms often regard the first dividend as an initial installment of an annual dividend, with the second payment making up the balance of the promised annual payout.
Dividends are not generally considered by foreign firms to be as “sacred” as U.S. firms consider them to be. If times get tough, these companies usually will not hesitate to reduce or eliminate their payouts. For the mega-cap firms I would consider, I wouldn’t worry too much about this. Like U.S. firms, if they have a history of dividends, they will try to avoid cuts. Further, as we saw during the financial crisis, U.S. companies under duress will cut or eliminate dividends readily if survival is at stake. (Or maybe even if not, since if “everyone else is doing it”, it makes it easier to do! Probably an unfair accusation, but sometimes during the financial crisis it seemed like this to me.)
Financial data is not as readily available on foreign firms as it is for U.S. firms, both in terms of analyst coverages, and in terms of data available on brokerage and other financial websites. Be especially wary of website presentations (other than the companies' own websites) of dividend and yield data, because what is shown may not be correct going forward. This is occasionally true for U.S. firms also, but is more likely for foreign firms which have less regular dividends than U.S. firms. When anticipating a specific dividend, be sure you are relying on an announcement from the company as to the amount, ex-dividend date, and payment date, which is the most reliable source for this data. As far as analyst coverages and availability of research reports goes, the larger companies are usually covered, so this is not a problem for the largest foreign companies, which are the ones that an income investor will usually be considering. .
Like any stock investment, the foreign stocks should be evaluated considering all the usual data points, such as financial strength and debt status, dividend payout ratio, dividend history and commitment, current share pricing and yield obtainable, analysts’ opinions, business prospects, earnings, and on and on.
Now let us consider two risk factors unique to dividend payments from foreign firms: currency risk and foreign government tax withholding. In both cases, there is little or nothing the investor can do to eliminate these elements, but the investor can investigate before buying and make a reasoned judgment whether to proceed with the investment. That is certainly preferable to being surprised by a dividend coming through after you have invested that is considerably less than what you were expecting.
First, consider currency risk. In most cases, foreign firms determine the dividends to be paid in terms of the currency of the host country where the firm is based. For example, companies based in countries in the European Union, such as Italy and France, will usually declare their dividends in Euros. For companies in Norway, dividends are declared in Norwegian Krones. For firms based in Canada, dividends are set to be paid in Canadian dollars, and so on for all the other countries. The ADR holder doesn’t have to worry about what to do with “Krones” suddenly showing up on the brokerage statement, but the holder does need to be aware that the dividend will be converted from the host nation currency to U.S. Dollars, based on a predefined conversion schedule or rule. The best source for determining the original dividend issuing currency and conversion rule is to review the companies’ website. A Google search on the company name will usually give it to you, or another quick way to get there is to use the MSN Money website – enter the company symbol to get the quote and summary page, then select Profile from the column on the left of the page, then select Website, usually shown as the last line under the Company Address section. Of course, each company’s site is different, but most will have a section for Investors. After that, you have to be a sleuth. Try to find sections relating to dividends, shareholder FAQs, or whatever you can find that looks promising. Press releases announcing upcoming dividends are a good information source, just be prepared to wade through a few to get to one pertaining to dividends. If all else fails, you can try contacting the company’s Investor Relations department. The contact numbers and/or email addresses will hopefully be provided on the website.
What you want to know is, “in what currency will the dividend originally be paid, and if in a currency other than the U.S. Dollar, what are the details of how the conversion will be handled”?. A useful website for currency conversions, to get a feel for how a given currency translates to dollars, is www.xe.com/ucc. It is interesting to see what the rates are for various currencies. Of course, the rates are constantly changing, so be aware that what you actually experience will depend on the conversion rules and the rates in effect when the conversion is done.
So what can you do with this information? Nothing in terms of remedial action, but you can at least be aware of it, and make a decision before you invest whether currency risk is enough of a concern to you that you might decide to pass on the particular ADR you were considering. If the Dollar rises significantly against the host currency, you will receive less of a dividend in Dollar terms than perhaps you were expecting. Conversely, if the Dollar falls, you will receive more (in Dollar terms) than you might have projected. Under normal circumstances, this is not usually a deal-killer.
Now, let us move on to a (usually) more significant issue impacting the return: foreign tax withholding. First, consider regular, taxable accounts versus retirement accounts, such as IRAs, and the advisability of holding foreign stocks in one or the other. Some financial advisors recommend only holding dividend stocks (at least those that pay “qualified” dividends) in general, and foreign stocks in particular, in taxable accounts, for two reasons: first, for “qualified” dividends, the investor will usually pay tax on the dividend income at the preferential rate applicable to “qualified” dividends, as opposed to an IRA, where the investor will (eventually) pay at his/her regular income tax rate when the funds are eventually withdrawn. Most would probably agree that this is outweighed by the feature of IRAs whereby the dividend will likely remain untaxed and will be compounding for (hopefully) many years before any withdrawal takes place. Also, keep in mind that preferential tax treatment of dividend income has not always been around, and it could easily be eliminated in the future. The second, more significant reason is that foreign taxes withheld in a taxable account represent foreign taxes paid by the investor, and all or at least some of the total paid can be recovered at tax time by taking a credit for foreign taxes paid. Of course, this relief can be on a considerable lag from when the tax was initially withheld. In an IRA, foreign tax credit is not allowed for foreign taxes withheld, so there is no recovery possible.
I guess my take on this recommendation is that if you have considerable resources available in both types of accounts (perhaps you are in the 1%), and you are pursuing investment strategies in your retirement accounts that are not based on dividends, then limiting holdings of qualified dividend payers and foreign firms with dividends subject to withholding to just taxable accounts is probably correct advice. On the other hand, the committed dividend investor who believes, as I do, that a stock that doesn’t pay a dividend has zero value (at least to an income investor), and who primarily only has resources available in retirement accounts, has to look beyond this advice. At the end of the day, what matters is what is actually received and the return that represents, and how that compares with available alternatives, not how much better it could be in the ideal case. To perform this analysis, you must determine with some degree of certainty what the withholding will be, in percentage terms, then calculate what the net dividend received will be. Then, to complete the analysis, consider the price at which shares can be acquired, and determine the effective yield, which can then be compared to other alternatives.
Let us consider a worst case from a withholding standpoint (Italy , at 27%), ENI S P A (E), the Italian integrated oil company. Dividends are semi-annual, and the most recent dividend was paid in September 2011. E is considerably undervalued by most traditional valuation measures, and the yield shown using Wednesday’s price, per E*trade’s (ETFC) snapshot view, which I have just now pulled up (E*trade is the quickest, easiest resource to use that I have found for this data, and is usually reliable), is 6.83%, which certainly sounds great. It just so happens that I own this stock (in an IRA), and I received the September dividend.
So how did I do? After deducting 27% from the dividend quoted, which is what I actually received after netting out the tax withheld, the (annualized) yield, again per Wednesday’s price, comes in at 5.00%. Very good, but not as good as 6.83%. So, by my calculations, E is a keeper, even though I'm not happy about missing out on 27% of the payment. The first dividend paid by E was in June of this year, and it was actually a bit higher than the September dividend, although not by enough to affect the yield more than fractionally. But note that since the first dividend was received in June and the second in September, the two dividends were therefore received during a window of just four months, even though the yield calculation assumes payouts twice a year, evenly spaced.
If you wanted to play the “dividend capture game” (which I don’t recommend!) with E, you could buy it in May before the first ex-dividend date, hold until after the second ex-dividend date in September, then sell and (assuming no loss on the sale), have an effective yield considerably greater than 5.00%, and even 6.83%, by collecting a year’s worth of dividends while only holding for four months! Wow, what a country! Italy, that is. I guess I will just have to consider the 27% the Italian government got from me that I cannot recover as my contribution to helping them with their budget crisis. (Note: I deliberately did not calculate the hypothetical "dividend capture" strategy's return, I don't want to encourage anyone to go in this direction.)
Now, to continue with my anecdotal story, I read somewhere that even though Italy has a standard 27% tax withholding rate, because of a tax treaty between the U.S. and Italy, U.S. holders are only supposed to be withheld at a 15% rate. Motivated to action, I inquired about this at the brokerage where I hold the E ADRs (E*trade). After a day or two, I received a response from the brokerage that the “tax was imposed by the ADR and not E*trade”, and advised “should you wish to recover these withholdings, please seek the advice of a licensed tax representative”. So at that point I gave up. I want to be clear that I’m not faulting E*trade. In fact, I like their site so much that I have two IRAs with them (to simplify things for my beneficiaries, only one beneficiary per IRA), and I hope they never get taken over, as has been occasionally rumored.
Undaunted, I tried again with Schwab (SCHW), where I have another IRA with another ADR holding, Total S A (TOT), the integrated oil company based in France. I am experiencing tax withholding on TOT dividends at a 25% rate, and the same article that motivated me to action on E also stated that the 25% withholding France normally imposes is reduced to 15% for U.S. holders. I made a similar inquiry to Schwab, and the response stated that their Dividends Department determined that “Rollover IRAs are not eligible for the favorable rate when the dividend is paid”. A key phrase here might be “when the dividend is paid”. The response went on to outline how I could pursue the matter with the depository bank and also the French custodian, to reclaim the withheld amount, but there would be fees required and in my case it would clearly not be worthwhile, to which I heartily concurred. Again, I don’t fault Schwab, they did well to investigate the matter and get back to me promptly. I like their website also, plus they have some features the others don’t. (If you are interested, the features I'm referring to are live quotes from the Toronto Exchange on Canadian stocks not trading on US exchanges, and a relative new Schwab research feature focusing on international stocks.)
As for the information source regarding favorable withholding for US holders, it is not necessarily incorrect, it may be that the favorable withholding rate mentioned is experienced with regular accounts, just not IRA’s. I don't know if that is the case, but I do know from my holdings that Canada treats taxable accounts and IRAs differently, so this proves that there are cases where the withholding varies depending upon the type of account. Canada applies a 15% withholding rate on dividends received from Canadian companies by US holders in taxable accounts, but does not withhold taxes on Canadian dividends received by US IRAs. (Based on this, I guess forgive Canada for the Canadian Trust debacle. A couple of former trusts, now corporations, that I still own in IRAs are paying almost as much as when they were trusts, considering there is no withholding now, unlike before when they were trusts.)
A useful website that lists withholding rates by country can be seen by clicking here. The website home page is topforeignstocks.com, while the link provided is to a posting in the website of a table of rates by country.
My own experiences and research findings for a number of companies I own or have owned, or that I am considering, is summarized in the table below. While certainly not all-inclusive, it hopefully is of some interest in that it is based on the “real-world” experiences of a “hands-on” investor, and provides a realistic picture of what an investor is likely to encounter, based on the sampling of ADRs I have had experience with, or at least have investigated. While most columns are self-explanatory, a couple might need clarification. The "Div Decl Curr" column refers to the currency specified when the dividend is declared. The "Actual WH%" column refers to the withholding I actually experienced. If a question mark follows the % value, it means that I haven't actually experienced that withholding, but based on my research and the company website information, the value shown is what I would expect to be withheld.
Table Reference Notes:
1 - This is a case where the country stated value (25%) and the withholding rate actually experienced (15%) differ, presumable reflecting a reduced withholding rate agreement for US holders.
2 - UN, UL are both Unilever. UL shares are not withheld, per the UK rate of 0, while UN shares are withheld at the Netherlands rate of 15%. I didn't know this way back when I bought Unilever as UN. If you want to invest in Unilever, buy UL, not UN.
3 - RDS.A, RDS.B are both Royal Dutch-Shell, with A shares being withheld at the Netherlands rate of 15%, while the B shares are not withheld, per the UK rate of 0.
4 - SNY is a new holding. It only pays annually. I have a question mark noted on the rate because even though I own it, I haven't yet received a dividend.
5 - The two companies based in Switzerland both state on their websites that US holders will only be withheld at 15%. I hope this is true, 35% would be pretty severe. I would try to get further confirmation on this before buying. Perhaps try asking the brokerage.
6 - The complete entry here is "yes - unfortunately". These Israeli telecom stocks have taking a beating lately from increased competition and other factors.
In conclusion, I recommend that the income investor should consider high-yielding foreign stocks available as ADRs for a portion of his/her income investment funds. Investigate any stocks you are interested in as outlined, and start small to confirm the returns are coming in as expected. If results are favorable, position sizes can always be increased as buy opportunities arise. As with any asset class, don't go overboard, take care to limit how much of the portfolio is exposed to any one country, and how much is allocated to ADRs in total.