by David Ruff
CFA, Global Portfolio Manager
To keep from dampening cheer this holiday season I won’t discuss politics, the economy, or even the markets – although equity markets have been in a giving mood lately. Rather, in this, the giving season, I want to highlight ADRs or American Depositary Receipts, and the role they play in international investing. Advisors Capital Management (ACM) has initiated the process of creating several ADRs. We believe the availability of these newly-created, U.S.-traded securities can be thought of as “gifts” to our clients and to the investing public, in general, since investors can access high-quality, profitable, non-U.S. companies through these ACM-engendered ADRs.
What is an ADR or American Depositary Receipt? And how do they work? ADRs have existed since the 1920s and although labeled with the word “American” these securities actually provide an efficient, relatively low-cost method for U.S. investors to invest in companies based outside the United States. An ADR is a negotiable security that represents securities foreign to U.S. markets. They are created by a depository bank like Bank of New York, JP Morgan, or Citigroup. The bank purchases and holds the foreign shares and issues U.S.-traded ADRs to represent ownership in these holdings. Crudely, you can think of them as laundry tickets. You can buy and sell laundry tickets with the holders of the tickets (ADRs) having the rights to the shirts (foreign traded security). Picking up your shirt (requesting the foreign shares), cancels the ticket (ADR). There are different levels and types of ADRs with a somewhat arcane nomenclature which we won’t detail here, but generally, they are defined by their SEC registration status, on which U.S. market they trade (over-the-counter or listed exchange like the New York Stock Exchange), whether the issuer uses one or multiple custodian banks, and whether they are restricted to certain investor types. ADRs benefit U.S. investors since they trade in U.S. dollars in U.S. markets. Purchasers avoid the need to convert to a foreign currency, avoid having to transact directly on a foreign stock exchange, and avoid foreign custody fees. Issuers benefit by expanding their investor universe and from the increased visibility of their companies. More widely held securities can result in a higher valuation for the issuer shares.
Our role in this process includes identifying companies that we think are worth the ADR creation effort, convincing the company’s management of ADR benefits, and connecting the issuer with the custodian bank to facilitate the ADR creation. Issuer requirements and costs vary depending on the ADR program chosen, but generally, issuers are reluctant to have their securities trade in jurisdictions with more extensive reporting and tighter corporate governance requirements compared to their home markets. SEC-registered securities typically have more stringent anti-fraud provisions compared to other jurisdictions. For example, the Sarbanes-Oxley law stipulating personal CEO and CFO liability for financial report accuracy is relatively unique to the U.S. In coordination with the custodian bank, we educate management about these requirements and can steer them toward the relatively lower cost, more simplified reporting requirement of the ADR version known as the Unsponsored ADR. We’re not always successful in these efforts and ADR creation is not usually a high priority by the issuer’s management, nor should it be, since management should be primarily focused on running their businesses. However, when we identify an attractive investment opportunity in a foreign issuer, we strive to create the ADR for our investors. Without the ADR, non-institutional investors can probably only gain exposure to the company through a pooled investment like a mutual fund or ETF, which, of course, will have a relatively small allocation to those foreign shares.
We have a rigorous selection process focused on attractively-valued, strong balance sheets, dynamic companies exhibiting a sustainable competitive edge and generating regular and growing free cash flow. Further, our process is differentiated by attention to corporate governance issues including the alignment of management incentives to the interests of minority shareholders. Frequently, these companies are smaller, faster-growing, and have few comparable companies in the U.S. Thus, these securities provide a significant diversification benefit to U.S. investors. Airport operators, water utilities, farmed salmon producers, semiconductor technology tool makers, and construction software service firms provide a few categories of ADR investments in our portfolios without a meaningful U.S. competitor or comparable. Identifying these companies, creating the ADR, and investing in these companies is a core and differentiated aspect of our investment process.
Of course, even when we’ve done everything mentioned in the previous paragraph and successfully created and invested in the new ADR, there can still be challenges. Newly issued ADRs have limited liquidity, at least initially, with few investors cognizant of their existence. This is not an issue for ACM since we typically trade the more liquid foreign shares and have the custodian bank issue or cancel the appropriate number of ADRs. But the lack of liquidity in the U.S. market can cause temporary infrequent pricing. Indeed, a recent new German ADR with infrequent pricing did not receive a September 30th mark in several of our client custodian statements. This resulted in the undervaluation of our clients’ ADR and Global portfolios as of September 30th. Brokers and custodians using these month-end values calculated inaccurate performance on these accounts for the month, quarter, and year-to-date periods through September.
Since these are long-duration assets, such short-term aberrations do not stop us from creating and investing in new ADRs of attractive companies, but it does require more communication with our investors, consultants, and custodians. With time these short-term problems go away and are worth the pain for the long-term benefit. Ergo, we believe our ADR creation will be the gift that keeps on giving in the form of price appreciation and growing cash dividends in our client portfolios. Happy holidays, indeed.
Editor’s Note: ACM conceived ADRs can be found in the ACM Private International Strategy. The ACM International Composite has 20 years of performance history and is used by our wealth advisors to diversify risk away from U.S. domestic stock portfolios. While U.S. stocks have had higher returns than overseas equities in aggregate for the past several years, the best-performing stock market for each of the past 30 years has been located outside the United States. Depending on your risk profile an allocation of non-U.S. equities may be appropriate. Contact your ACM wealth advisor for details.
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