American depositary receipts, or ADRs, are stocks that trade on U.S. exchanges but represent shares in a foreign corporation. That means they give American investors a simple way to invest in potentially international companies. This article will give you the basics of investing in ADRs without making rookie mistakes.

Below you'll learn more about what ADRs are, how they're created, and how they're different from "regular" stocks.

A better understanding of ADRs

ADRs were created so investors could avoid the complexities of buying foreign stocks. If you want to buy a foreign stock that's not offered as an ADR, you have to exchange your U.S. dollars for foreign currency, open a foreign brokerage account, and then purchase the foreign security on a foreign exchange (which is likely in a different time zone, so you may be up all night). In addition, the exchange rate on the U.S. dollar would change throughout this whole process.

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ADRs are created when a non-U.S. company or an investor who holds the underlying foreign securities delivers them to either a "depositary" bank in the U.S. or a custodian in the foreign company's home country. For example, if I were an investor with shares of a European company (purchased on a European stock exchange), and I contacted a U.S. depositary bank (through a custodian in my home country), and I told them I'd like to exchange my foreign shares for ADRs, the bank would give me an ADR certificate that represents my foreign shares. From there, I can trade my ADR shares on a U.S. stock exchange or in the over-the-counter market just like I could trade the stocks of a U.S.-based company.

In this example, I also could give back my ADRs to the depositary bank and receive shares of the foreign company's stock again. Technically, securities of a foreign company that are represented by an ADR are called "American depositary shares" (ADS), but typically, the terms ADR and ADS are used interchangeably.

ADRs can be "sponsored" or "unsponsored." Sponsored ADRs are those for which the foreign company has negotiated directly with the U.S. depositary bank. Unsponsored ADRs, on the other hand, are set up without the non-U.S. company's cooperation. Typically, broker-dealers initiate unsponsored ADRs when they wish to establish a U.S. trading market.

Differences between ADRs and "regular" stocks

An ADR can represent a one-for-one exchange with the foreign shares, a fraction of a share, or multiple shares. This is one major way in which traditional U.S. stocks differ from ADRs. This is an important consideration, so let's go through an example.

Assume country A (the foreign country) has an exchange rate with the U.S. of $0.25, meaning one foreign currency unit is worth $0.25 in U.S. dollars. Assume company ABC Corp.'s stock trades on country A's exchange for one unit per share (or $0.25 per share in U.S. dollars). When ABC Corp. is made into an ADR, it could have 100 shares packaged into the ADR. Then, this ADR would trade on a U.S. exchange for $25.

If you don't look carefully, you may not realize that the underlying foreign stock is actually "worth" $0.25 per share, not $25. Be sure to look at the ADR's "conversion ratio," which indicates the number of shares of the underlying foreign security that are equivalent to one ADR share. For example, if an ADR's conversion ratio were 100 to 1, then a single ADR share would represent 100 shares of the underlying security.

Investors need to keep the conversion ratio in mind when analyzing per-share data such as earnings per share or the price-to-earnings (P/E) ratio, which has earnings per share in the denominator. The per-share data can be determined based on the underlying common stock or the ADR. In our ABC Corp. example, we'd need to determine if the per-share data is based on the one share of ABC Corp. (worth $0.25, or one foreign unit) or if the per-share data is based on the ADR (which includes 100 underlying shares of ABC Corp.).

ADR "levels" and how they differ

Another difference is that there are several different "levels" of SEC scrutiny for ADRs. Level 1 ADRs trade over the counter (not on American exchanges) and are the only level of ADR that can be unsponsored. Level 1 ADRs have minimal SEC reporting requirements, and they're not required to file quarterly or annual reports in compliance with U.S. generally accepted accounting principles (GAAP), which means less information is available on these securities, and it's more difficult to compare their financial metrics to those of U.S. companies that comply with GAAP.

The lower amount of reliable information makes level 1 ADRs riskier for investors. Level 2 and level 3 ADRs, meanwhile, require the issuer to register and file annual reports with the SEC. Level 3 ADRs have stricter reporting requirements than level 2 ADRs. Level 3 ADRs represent an initial public offering (IPO) on U.S. exchanges. An "IPO" is when a company's stock first becomes available to be purchased on major U.S. stock exchanges. Level 3 ADRs therefore have the added ability to raise capital through a public offering on U.S. exchanges. In order to register the public offering, the ADR is required to file a Form F-1 with the SEC, which entails additional transparency and regulation. For more information, read this page on the SEC website. 

You may pay more in fees and taxes

ADRs are subject to additional fees that traditional stocks don't carry. These are periodic service fees or "pass-through fees" that compensate the depositary bank for providing custodial services. These charges generally run from $0.01 to $0.03 per share, but you'll be able to find the specifics in the ADR prospectus.

Taxes are another area where ADRs differ from traditional stocks. ADRs are subject to the same U.S. capital gains and dividend taxes as regular stocks, but taxation by the foreign country varies. Many foreign governments automatically withhold taxes on dividends paid by companies incorporated within their borders. This generally means that a certain percentage of the dividend you receive may be withheld by your broker, depending on the foreign country's tax rates and regulations.

This can get a little complicated, as the U.S. has tax treaties with many countries, and these dictate how much tax U.S. investors pay. Additionally, the dividend taxes you pay to foreign countries can usually be deducted from the dividend tax you owe the U.S. government. In any event, it's best to consult a tax professional for the specifics, but remember that ADRs are taxed differently from traditional stocks.

Lastly, even though they trade on U.S. exchanges, ADRs are subject to the same currency risk as the underlying foreign shares. For example, if I have an ADR that represents a French company's shares, then my ADR's value will be influenced by the exchange rate between the euro and the U.S. dollar, not just the value of the U.S. dollar. This can make ADR prices more volatile.

Key takeaways

First, determine what "level" an ADR is before purchasing it. If you wouldn't purchase penny stocks in the U.S., you should generally avoid level 1 ADRs. Level 3 ADRs are the easiest to compare to U.S. stocks on an apples-to-apples basis.

Be careful when analyzing per-share ADR data, and remember that ADRs will generally track their home markets. If you hold a European ADR, the ADR's price will likely perform more in line with the overall European market than the U.S. market. These are foreign stocks, after all.

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