BI > MAY 2004

Worldly Choices

Overseas Investment Opportunities Grow

With global economies increasingly interdependent, it shouldn't surprise us that large numbers of foreign-based corporations have sought access to capital in the United States by listing their shares as American Depositary Receipts. At the same time, American investors have shown increased interest in ADRs, which remain one of the simplest ways to buy and sell international stocks.

ADRs are not actual shares of stock, but certificates representing shares. They're handled just like stocks, though. An ADR may represent one share, several shares or a fraction of a share, so its price may differ from that of the stock it represents.

ADRs gained widespread attention in the 1990s. They're nothing new, however. The first ADRs were set up in 1927 by the U.S. bank now known as J.P. Morgan Chase & Co. to facilitate trading in Selfridges Retail Ltd., the British department store chain.

The Bank of New York is the largest American administrator of ADR programs. The financial institution reports that in 2003 more than 2,000 ADRs issued by companies in 79 countries were available to U.S. investors. About 500 of them are listed on the New York Stock Exchange, American Stock Exchange or Nasdaq National Market. Others are available on the over-the-counter market. ADR trading in the United States held up relatively well through the bear market. Although dollar volume fell as share prices dropped, share volume climbed steadily (see graph below). Investors traded 33.1 billion shares of exchanged-listed depositary receipts in 2003, up 3 percent from the previous year. Those shares were valued at $630 billion, up 14.5 percent from 2002.

Click to enlarge.

Reasons To Invest

A classic argument in favor of international investing is that it reduces risk from business cycles, as the economies of different countries ebb and flow. When U.S. stocks have been in retreat, for example, overseas markets have often looked attractive in comparison. Investing geographically -- owning both domestic and foreign equities -- helped smooth out portfolio returns.

That historical argument appears to have broken down, however. In recent years U.S. and foreign stock markets have moved roughly in tandem. Experts can't agree whether this tendency marks a permanent change or global markets will resume fluctuating in different directions (see foreign stock indexes, below).

Regardless, investing overseas still can provide opportunities for diversification. Rather than focus on the economies and stock markets of individual countries or regions, investors can search for companies in particularly strong overseas industries. One example might be the Israeli software industry. Another is semiconductor manufacturing in Eastern Asia.

Investing Overseas

Once you decide to diversify with international stocks, you're faced with the question of how to build that portion of your portfolio. Many investors opt for mutual funds that focus on international stocks, or they buy global funds holding the shares of both domestic and foreign companies. Those who invest in both ADRs and international mutual funds may need to fine-tune their size diversification, though, since ADRs tend to be issued by large corporations. Mutual funds that focus on small- and mid-cap stocks therefore might be preferable.

Exchange-traded index funds -- ETFs -- have become a popular alternative. Traded like stocks on major exchanges, ETFs typically have much lower costs than comparable mutual funds. Barclays Global Investors is the dominant player in this market with its iShares. It has issued almost 30 index funds that concentrate on the stocks of particular countries or regions.

Investors who are nervous about dipping their toes into the sea of global stock opportunities can still participate by seeking out domestic companies that derive much of their revenue from exports. Bolder investors can trade in foreign stocks directly, using either U.S. brokerages with international connections or foreign-based brokerages that accept business from Americans.

ADR Essentials

ADRs have several inherent advantages for international investors. Beate Melten, manager of investor relations for Mexico-based cement producer and ADR company Cemex S.A. de C.V., covered those advantages and other ADR basics when she spoke at the 2003 Better Investing National Convention in Norfolk, Va., last fall.

Beate Melten

Citing industry statistics, Melten noted that individual investors in the United States have taken more interest in overseas opportunities. In the early 1990s, she said, institutions owned most of the foreign equity purchased in this country. Individuals held about 12 percent.

In 1994, however, the percentage of individual ownership doubled and has stayed in the mid-20s ever since. Individual investors held 25 percent of all international equity in 2003.

A similar pattern occurred with ADRs. In 1991 ADRs constituted about 15 percent of all international equity held in the United States by both individuals and institutions. The proportion peaked at 39 percent in 1999 and stood at 35 percent in 2003.

Melten attributed much of that interest to the simplicity of owning depositary receipts and their equality with U.S. stocks. ADRs are traded in dollars, they're quoted in dollars and they fall under the same regulations as U.S. stocks, she said.

"Also, if they pay dividends, those dividends are paid to you in U.S. dollars," she said.

Another benefit of ADRs is greater accounting transparency, Melten said. Financial reports are timelier and more detailed than those of many other foreign-based companies. Also, annual reports for exchange-listed ADRs must be in English. An annual report may, however, measure results in the home country's currency and use accounting different from accepted U.S. standards.

"If you want to look at the company as if it were a U.S. company . . . you go to something called a 20-F," she said. In the annual 20-F, accountants for the ADR company restate results to match requirements for a U.S. company -- generally accepted accounting principles, or GAAP.

Although they aren't the same as SEC 10-K reports, 20-Fs can provide investors with a lot of useful information. You can ask the company for its 20-F or find it posted on the corporation's Web site.

More ADR Considerations

Since they're treated the same as U.S. stocks, ADRs share in the tax breaks that Congress adopted last year (see Tax Matters, below). In addition, ADR transactions tend to cost less in commissions and service charges compared with international stocks purchased directly.

Packaging shares as ADRs is an expensive process, as is getting ADRs listed on U.S. stock exchanges. Listed ADR companies therefore tend to be large corporations with reputations for quality.

With that quality comes more investor demand and greater market liquidity. In addition, a substantial number of ADR companies offer dividend reinvestment and direct stock purchase plans.

Beate said there are no particular risks distinctive to ADRs. That doesn't mean international investing is without risk, however.

For one thing, fluctuating currency rates can introduce volatility into total returns. If the value of the U.S. dollar declines, for example, dividends and capital gains from your foreign holdings will be worth more. The opposite is true when the dollar strengthens against the currencies where your companies are located.

Just like stocks, currency rates are bound to fluctuate; currency risk therefore shouldn't be of that much concern to the long-term investor.

Tracking financial results and generating Stock Selection Guides for non-ADR foreign companies can be tough. Reports may be less frequent and less timely than those from U.S. corporations, making it difficult to track progress. The fact that results may be reported in the local currency -- and language -- can add to the challenge.

NAIC member Ivan Hodiny described the sorts of problems an investor can encounter buying stocks directly on local exchanges.

"I live in Singapore and invest a little around the region," he wrote. "For other countries like Indonesia, Thailand, Korea and Japan, I invest through mutual funds, because getting data for individual companies is just impossible unless, of course, you ask for them through your brokers.

"Even so, it takes them months to respond, and the data oftentimes aren't usable. Here they can't give you a projection of earnings per share five years out like Value Line does. The furthest I can get for sales and EPS projections is one to two years."

Scouting for Candidates

Fellow NAIC investors can indirectly offer some direction. ADR companies have appeared for years in BI's annual Top 200 list of stocks held by investment clubs.

In the April 2004 survey, for example, the list included five ADRs: BP p.l.c.; Cemex S. A. de C. V.; Elan Corporation, plc; Flextronics International Ltd.; and Vodafone Group Plc. Six appeared in the survey each year from 2001 to 2003. The annual numbers were lower in the 1990s -- four in 1994, three in 1995, 1996, 1997 and 2000, and one in 1998 and 1999.

Investors who make it to NAIC's upcoming national conventions can learn more. ADR companies have traditionally had a strong presence at the national meetings.

For example, at this year's CompuFest in St. Louis, four of the 10 corporations that have signed up to make presentations are ADR companies. International companies will also have a strong contingent on hand for November's Better Investing National Convention in Phoenix. Of the 35 businesses that have so far reserved booths, six are overseas companies.

Yet another avenue is to review the holdings of actively managed international mutual funds (see "Research Zone"). Bear in mind, though, that such a list may be out of date by the time it's published.

English-language news publications and their Web sites are another source if you're seeking prospects and studying overseas industries and economies. For example, India has The Economic Times, which provides free content. You can link to recent news about specific companies you're researching. Another source is Business Today, one of that country's best-known financial publications. The relatively inexpensive subscription buys you online access.

For a broader look at the Eastern scene, there's Asia Inc. Full access is subscription-based, but the magazine's Web site offers plenty of free content. Again, if you don't mind paying for a subscription, the Wall Street Journal offers online access to stories from its English-language Asian and European editions.

Editor's note: Companies and references are cited in this article for study purposes only; no recommendations are intended.

Tax Matters

If you're investing overseas, you'll want to become familiar with some tax considerations affecting dividends. The Jobs and Growth Tax Relief Reconciliation Act of 2003, signed into law May 23, 2003, provides a break for many international investors.

ADRs and other foreign shares listed on U.S. stock exchanges are treated the same as domestic shares for federal income tax purposes. For most investors, the tax on dividends is no more than 15 percent. Similarly, the tax on long-term capital gains is capped at 15 percent.

Some countries withhold taxes on stock dividends paid to investors living outside their boundaries. When the withholding is more than 15 percent, you may be able to request a refund of the difference. The paperwork that's involved may prove cumbersome, however.

More than four dozen nations have signed treaties with the United States, however, to prevent double taxation of individuals who live in one country but receive income from another. The treaties peg withholding to the U.S. tax rate. So even if companies headquartered in those countries aren't listed on U.S. exchanges, their U.S. shareholders still experience withholding at 15 percent.

In September 2003 the U.S. Treasury Department published a list of qualified countries -- Notice 2003-69 -- naming 52 nations that have signed tax treaties and met related requirements. Four economically strong Asian locations -- Hong Kong, Malaysia, Singapore and Taiwan -- are conspicuously absent, however.

Some observers suggest these tax breaks make ADRs and other qualified stocks more attractive to international investors. That's an added incentive for overseas companies to set up ADRs.

Shareholders who have seen taxes withheld from their overseas dividends can apply for a foreign tax credit or a deduction when they file their federal income tax returns. (Applying for the credit generally makes more sense, since you get more back that way.) A taxpayer who reports no more than $300 in foreign tax withholding ($600 for a couple filing jointly) can file for the credit on Line 44 of Form 1040. For larger amounts, file for the credit on Form 1116. An instruction booklet for Form 1116 is also available. (For full details on these and other tax angles, consult your tax adviser.)

Similarly, investors in international mutual funds should check the Form 1099-DIV tax reports they're sent to learn whether fund managers have listed a proportional share of withheld taxes. If a 1099 form does show such withholding, you can file for a foreign tax credit. (Foreign tax credits don't figure into the picture if your fund shares are held in IRA accounts, of course.)

For More Information -- Online Resources

Editor's note: Companies and references are cited in this article for study purposes only; no recommendations are intended.

The Web sites of major players in ADR administration are good destinations for international investors:

• The Bank of New York
• J.P. Morgan Chase
• Citibank
• Deutsche Bank

The Bank of New York, for example, shows ADRs broken down by region, country, industry, American stock exchange and other criteria. The site also provides news and educational articles. For background on trends in ADRs, see the bank's Depositary Receipt Market Review 2003," above right. For general background, see "The Global Equity Investment Guide: The Case for Investing in Depositary Receipts."

Fortune publishes an annual directory of leading foreign businesses -- the Global 500 -- that can be a useful tool for prospecting. The feature is published each year around the third week of July. Online access isn't free, but an interested investor could buy a newsstand copy or order a trial print and online subscription at nominal cost around the time the next Global 500 comes out.

Click to enlarge.

Major Foreign Stock Indexes

U.S. Global Investors, Inc., a family of no-load mutual funds, offers several regional reports at its Web site. Recent topics included the investment environments of China (PDF), Eastern Europe (PDF) and Russia (PDF). The site also provides links to relevant articles in major financial publications.

For a discussion of ADRs that offer dividend reinvestment, see "Reinvesting Dividends Abroad: "ADRs Through DRIPs Are a Growing Trend,"" DRIP Investor, Sept. 10, 2003.

A search of the NAIC online archive will lead to several articles about international investing published in Better Investing over the past 10 years. The topic was addressed in cover features, for example, in three of the past four years:

• "The World of ADRs," May 2003.
• "How You Can Diversify: International Investing," May 2002.
• "Own Your Share of America and the World," June 2000.

Kevin Lamiman is associate editor for BetterInvesting Magazine.