International Superstar Stocks: The ABCs of ADRs

As more and more investors look abroad for investment ideas, we have put together a series that seeks to illuminate some of the risks and rewards related to international investing. Over the next four days, we hope to uncover a few international superstars.

It's too expensive.

"What's too expensive?"

Everything. The whole dang U.S. stock market.

Sure, we're no longer seeing "bubble" valuations out there. But the average S&P 500 company still trades at a price-to-earnings ratio (P/E) of 18.4, and is expected to grow just 12.5% per annum over the next half-decade. Divide the P/E by the growth rate, and the venerable "PEG ratio" tells us that the market at large is overpriced by 50% -- 1.5 times more expensive than the ideal 1.0 ratio. These days, you have to look long and hard to find a decent company for sale at a reasonable price.

Or perhaps you just need to look far.

Go East, young Fool
Although many U.S. stocks are looking pricey, you can still find plenty of profitable companies sporting more reasonable prices. They're just not in the United States. To find them, you need to look abroad.

Name almost any U.S. company, and there's very likely a foreign company in a similar line of business whose stock sells at a significant discount. For example:

U.S.company

P/E (ttm*)

Foreign analogue

P/E(ttm*)

Discount

Boeing (NYSE: BA  )

23.5

Embraer

18.2

23%

Citigroup (NYSE: C  )

10.9

ING Group

7.6

30%

DaimlerChrysler (NYSE: DCX  )

18.8

ToyotaMotors

14.0

25%

Dominion Resources (NYSE: D  )

25.7

United Utilities

20.1

22%

General Electric (NYSE: GE  )

19.7

Philips

9.6

50%

SBC Communications (NYSE: SBC  )

20.8

FranceTelecom

10.1

51%

Average discount

34%

*Trailing 12 months.
Data provided by Capital IQ, a division of S&P.


Now, obviously, the discounts aren't always as glaring as those above. In fact, it took me a good half hour or so of research to locate these most glaring examples of pricing discrepancies between U.S. and foreign markets. I've picked these examples to show you that if you do the research, you can still find bargain-priced stocks.

34% off sale in all departments
Perhaps more interesting than the deepness of these discounts, though, is their breadth. You can quite literally find high-quality, bargain-priced stocks in almost any industry you like. Look again at the industries represented above. We've got aerospace stocks. Telecoms. Utilities. Banks. And that's just scratching the surface. If there's a field of business you want to invest in, there's probably a foreign stock for you.

One thing that all of the above companies have in common -- in addition to their cheapness -- is their accessibility. Through the magic of ADRs, it takes you no more effort to invest in these international bargains than it does to buy a share of IBM or Cisco.

A-D-What?
ADR -- short for "American Depositary Receipt."

I repeat. A-D-What?
Ah. Well, let's begin at the beginning. The concept of an ADR is both complex and simple. If you're in the mood for the complex version, just click right through to JPMorgan's website and peruse to your heart's content. But the simple version goes like this.

A stock represents your right of ownership of part of a company. That right can be in the form of a paper stock certificate that you frame and hang on the wall of your den, or it can be in the form of your discount broker telling you, on your Web access page or in your quarterly portfolio statement, that "you own 100 shares of XYZ Corp."

An ADR is just another way of representing your right to ownership of a stock -- this time, a foreign stock. When you own an ADR, you own the rights to foreign stock that, in turn, give you rights of ownership to part of a foreign company. ADRs were created so that an American investor in, say, Volkswagen, wouldn't have to worry about the details of German laws regulating the export and import of stock certificates every time she bought or sold Volkswagen shares. Thanks to ADRs, Volkswagen share certificates never have to leave Germany. Rather, a U.S. bank issues "receipts" for those shares -- ADRs -- in the United States, and those ADRs trade here.

What's in the box?
Speaking of shares, there's one quirk of ADRs that gives investors fits -- figuring out just what makes up an ADR. Unless you know how many shares a given ADR represents, you can be misled by data on financial websites -- which sometimes give information on the price, dividend, etc., of a single foreign share, and other times on the ADR representing one or more shares.

One Nokia (NYSE: NOK  ) ADR represents one share of Nokia, for example. But this 1-to-1 ratio doesn't hold true for all companies. A single Vodafone ADR represents 10 shares of Vodafone floating around back in London. Likewise, one Ericsson ADR plays stand-in for 10 Ericsson shares back in Stockholm. But further east, it takes two shares of Nissan or Toyota to make up a single ADR floating on the U.S. Nasdaq or NYSE. If you're confused about what lies within a given ADR's "box," however, just go to the adr.com website, search for the ticker, and pull up the A:O ratio, which tells you how many underlying shares the ADR represents.

A word to the Foolish
Let me leave you with one note of caution. ADRs make life simpler for individual investors. Because you can buy and sell an ADR with the click of a mouse, it's tempting to think of an ADR as "just another stock." It's not.

Or at least not always. Some ADRs are of extremely high quality, representing companies whose financials are beyond reproach. But other ADRs represent little more than the foreign equivalents of Enron: shell companies with questionable accounting, shady management, and who-knows-what manner of skeletons inhabiting their corporate closets. So it pays to be cautious when investing internationally -- as it does domestically. (Let's not forget that Enron was a U.S. company.)

But you can minimize your risks by buying only "Level II" and "Level III" ADRs (the adr.com website also gives information on ADR levels). Both of these levels meet the requirements for listing on U.S. exchanges, and so should be at least no less "safe" than your average S&P 500 stock.

Want to play it safer still? Mathew Emmert, lead analyst for our Motley FoolIncome Investor newsletter, has a particular fondness for high-dividend-paying, low-cost companies such as United Utilities and France Telecom. Every month, Mathew searches the globe for value-priced dividend payers. His next pair of picks is due out Thursday, and if you sign up for a 30-day free trial, you can be among the first to learn what companies he's recommending next. To expand your investing horizons, just click here.

And to learn more about our coverage of international investing, click here.

For related Foolishness:

Fool contributorRich Smithowns shares of Nokia. Vodafone is a Motley Fool Inside Value recommendation. JPMorgan is a Motley Fool Income Investor recommendation. SBC Communications and Embraer are Motley Fool Stock Advisor recommendations. The Motley Fool'sdisclosurepolicy has no rivals.


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