In Part 1 of my Primer on International Investing, I discussed the benefits and risks involved in investing in foreign companies. I am an individual retail investor. I educated myself about foreign stocks by reading online and sometimes the hard way by first investing in a foreign stock and then understanding what it meant to do so. In this article, I want to share a few key aspects that may help fellow U.S.- resident investors looking to invest in foreign stocks.
- Terminology: ADS stands for American Depository Share, which is the actual underlying share of the foreign company. Each ADS can represent any number of original shares (including fractional number) of the foreign company. For example, each ADS can represent 1 share of the foreign share, or half of the foreign share or two shares of the foreign share. ADR is the American Depository Receipt, which is the certificate that represents ownership of the ADS. Most people use the terms ADR and ADS interchangeably without being incorrect. On the other hand, ORD, which stands for Ordinary Shares, represents the underlying shares of the foreign company trading on their home market. Some brokers in the U.S. allow trading of these foreign shares in U.S. dollars itself. These are available on the OTC pink sheets and their ticker symbol is 5-letters with the last letter as "F" which stands for "foreign". A good example of such a stock is Samsung Electronics, which one of the world's largest electronics company. Samsung does not have an ADR but the ordinary shares can be traded under the symbol (SSNLF.PK) where the "F" indicates that it is a foreign ORD share.
- Levels of ADRs: There are three levels of ADRs. Level I is the simplest and most convenient way for a company to provide its shares to be traded in the U.S. It is simple and convenient for the foreign company because the regulatory requirements are least and the company is not required to publish financial results in accordance with U.S. GAAP. Examples include Royal Ahold (AHONY.PK), GDF Suez (GDFZY.PK) and Yara International (YARIY.PK). Level II ADR brings the company under SEC regulation. The company is required to file Form 20F every year which is similar to the Form 10-K for American companies. Further, the company is required to publish financial reports in accordance with the U.S. or International GAAP. Only Level II ADRs can be listed on a U.S. stock exchange like NYSE or Nasdaq. Examples include Unilever (UN), Deutsche Bank (DB), Siemens (SI), Sanofi (SNY), and Total (TOT). The highest level is Level III which is used when the foreign company raises capital in the U.S. markets. The foreign company has to file Form F-1 which is the offering prospectus for the shares. These companies tend to provide the largest information since they have raised capital from U.S. markets. Examples include ArcelorMittal (MT), Santander (STD), Syngenta (SYT), Taiwan Semiconductor (TSM) and Wipro (WIT).
- Unsponsored ADR: The different levels of ADRs discussed above are all sponsored by the foreign company, i.e., they designate a bank to manage the depository receipt and act as the transfer agent. However, there are unsponsored ADRs too, where the foreign company has no formal arrangement with any depository bank. Instead, a bank itself buys a chunk of foreign shares and then allows U.S. investors to buy and sell shares on the OTC grey market. Most of the ADRs traded in the U.S. are unsponsored since the foreign company may not be able to justify the costs and effort involved to sponsor even a Level I ADR program. There are more than 1200 unsponsored ADRs with some strong names like BMW (BAMXY.PK), ThyssenKrupp (TYEKY.PK), Vivendi (VIVHY.PK) and Heineken (HINKY.PK).
- Trading Platform: Some of the foreign stocks, as explained above, are listed on the NYSE and Nasdaq. However, most of them are traded in the grey market known as Over-The-Counter (OTC), also known as Pink Sheets. Traditionally pink sheet tickers indicate weak and troubled stocks, but while this is perhaps true for the American stocks, it is not necessarily true for foreign stocks. In fact, some of the biggest global companies are traded OTC, like Nestle (NSRGY.PK), which is the world's biggest foods and nutrition company, BMW, which is the world's biggest luxury vehicle manufacturer, and many more. Sometimes the foreign company just does not want to deal with the regulatory requirements of being listed on the NYSE or Nasdaq. I personally do not exclude foreign companies from my consideration just because they trade on the OTC Pink Sheets. I consider each company on its own merit.
- Financial Information: One of the best sources of information for a foreign company is the company's own website. Most foreign companies have an excellent investor relations website that gives various financial reports and past dividend information. In fact, I personally exclude most companies whose websites lack information and those that do not provide access to dividend history in less than five mouse clicks. For quick reference to financial numbers and for making list of investment candidates, I use the websites of Depository Receipt managers BNY Mellon and J.P. Morgan. These two sites contain a wealth of information for an investor looking to invest in ADRs.
- Dividend Cadence: Most U.S. companies pay quarterly dividends. However, most foreign companies pay an annual dividend after the end of the financial year, when the profits have been determined. Some of the foreign companies do pay quarterly dividends while some other companies pay an interim dividend and then top it off with a final, annual dividend. Lack of regular quarterly dividends can affect investors who desire regular income from dividends. It can also upset the effective dividend yield in the first year or two of investment if one misses the ex-dividend date for an annual distribution.
- Tax Treatment: ADRs are treated similarly to U.S. stocks by the IRS for income tax purposes. This means that the capital gains/losses and dividends are taxed at the same rate as U.S. stocks. ADRs also do not attract any taxes on capital gains in the home market of the foreign stock. However, as discussed earlier, a withholding tax may be imposed on the dividends before distribution. The withholding rate is different based upon the foreign country. Most investors can claim credit for foreign taxes paid at the time of filing IRS Form 1040, with or without Form 1116. However, there are implications of holding the stock in a tax-advantaged account since foreign taxes paid cannot be reclaimed. (I plan to write an article and discuss foreign dividend withholding taxes in greater detail at a later date.)
Some U.S.-resident investors may benefit from holding foreign stocks in their portfolio. Even though buying ADRs appears intimidating, it really is quite similar to investing in U.S. stocks. One gets better with time and practice. I hope that this two-part primer will help you get started in building a successful international stock portfolio. I am looking forward to an active discussion about all aspects of investing in foreign equities.