Lecture 6

ADRs & Global Industry Analysis

Investment Analysis

American Depository Receipts (ADRs)

• An American Depository Receipt (ADR) is a dollar-denominated negotiable certificate representing a specified number of shares in a foreign corporation.

• ADRs are issued by US banks and consist of a bundle of shares of a foreign corporation that are being held in custody overseas. ADRs are listed in the US and traded like regular stocks on the NYSE, AMEX and NASDAQ.

Investment Analysis

American Depository Receipts (ADRs) (cont’d …)

• The foreign entity must provide financial information to the sponsor bank. The ADR can be cancelled and redeemed for its underlying shares at anytime.

• The advantage of ADRs is that they reduce administration and duty costs on each transaction. The disadvantage of ADRs is that they do not eliminate the inherent currency and economic risks associated with the shares of a foreign currency.

Investment Analysis

Types of ADRs

There are three different types of ADR issued:

1. Level I: This is the most basic type of ADR, used by foreign companies that either do not qualify or do not wish to have their ADR listed on an exchange. Level I ADRs trade solely on the over-the-counter market and are an easy and inexpensive way for a company to gauge interest for its securities in North America. Level I company ADRs are not required to comply with SEC registration and reporting requirements.

Investment Analysis

Types of ADRs (cont’d …)

• Level II: This type of ADR is listed on an exchange or quoted on any official US stock exchange, including the NYSE and NASDAQ. Level II ADRs meet the registration requirements of the SEC, but they also get higher visibility trading volume. The company must report an annual reconciliation of earnings and shareholders’ equity from its country’s national accounting standards to US GAAP, as well as quarterly statements.

• Level III: This is the most prestigious of the three types in which an issuer floats a public offering of ADRs on a US exchange. Level III ADRs enable the issuer to raise capital and gain visibility in the US financial markets. The reporting requirements for Level III ADRs are the same as they are for Level II.

Investment Analysis

Reasons for Issuing ADRs

There are four reasons why a company may want to list its securities abroad:

1. It may desire a broader diversification of its capital sources across international boundaries.

2. Concern over takeovers by domestic competitors is minimized by global diversification of the company’s shares.

3. In the case where a company wants to raise additional external financing, exposure to broader capital markets provides access to additional resources.

4. Listing a company abroad provides additional advertising opportunities for the company’s products and services.

Investment Analysis

Reasons for Issuing ADRs (cont’d …)

ADRs provide a means of obtaining international diversification with relative ease. Generally, it is more costly for large institutional investors to purchase ADRs than to directly purchase the securities in the local market, since the local market may provide more liquidity. When evaluating the cost tradeoff of using ADRs or directly purchasing the shares in the primary market, the investor looks at price levels, transaction costs, taxes and administrative expenses.

Investment Analysis

Trading Costs of Listed Shares v/s ADRs

Unilever (US) (UK) shares are listed in Frankfurt (XETRA) and on the NYSE. A German investor purchases 100 shares of UK in Frankfurt at €51.45 per share. The broker in Germany charges a 0.10% commission. Simultaneously, the investor’s US broker quotes Unilever US ADRs on the NYSE at an ask price of $60.60, net of commissions. The exchange rate in US dollars per euro is 1.1700. Determine whether it is cheaper to purchase the shares of UK in New York or in Frankfurt?

Investment Analysis

SOLUTION

• The purchase price of 100 shares listed on NYSE is $6,060, to pay for the purchase, the investor will need to exchange Euros for US dollars at a rate of $1.1700 per Euro for a total Euro purchase of:

$6,060= €5,179

$1.17/€

• The cost of purchasing the 100 shares of UK directly from Frankfurt is the purchase price plus the 0.10% commission:

€51.45 x 100 x 1.0010 = €5,150

• A savings of €29 per 100 shares would be realized if the shares were purchased directly in Frankfurt as opposed to buying the ADRs in New York.

Investment Analysis

Global Industry Analysis

Country Analysis

Expected real economic growth is the most important variable to analyze in a country analysis because it has the most significant influence on the risk and returns in national equity markets.

Investment Analysis

Global Industry Analysis (cont’d …)

Analysts are interested in forecasting expected economic growth in the short run and the long run:

• In the short run, the focus is on forecasting the stage in the business cycle and therefore, expected short-term economic growth.

• In the long run, the focus shifts to expectations of sustainable economic growth as measured by growth in per capital gross domestic product (GDP).

Investment Analysis

Global Industry Analysis (cont’d …)

Business Cycle• The short-term goal in identifying the current stage in the business cycle is

to forecast the turning points when the economy moves from one stage to another and then invest in those sectors or industries that are expected to perform best during that stage.

• In most cases this is difficult to do with any degree of success, which is why analysts most often focus on long-run forecasts of sustainable economic growth. However, there are opportunities to earn excess risk-adjusted returns for the analyst who can identify and exploit the various stages of the business cyclic better than others can.

The concept of business cycles will be discussed again in next lecture under industry analysis and number and classification of the cycles will differ. The

following is based on Calverley (2003)

Investment Analysis

Attractive Investments in Various Business Cycle Stages

Investment Analysis

Business Cycle Stage Description Attractive Investments

Recovery Economy begins to recover from recession

•Cyclical Stocks•Commodities

•Other risky assets

Early upswing Consumer confidence improves; economic growth rate increases

•Stocks•Real Estate

Late upswing Peak growth rate; also knows as “boom” period

•Bonds•Interest-sensitive stocks

Economy slows Declining growth; interest rates fall

•Bonds•Interest-sensitive stocks

Recession Low point of economic growth; government eases monetary

policy stimulate growth

•Stocks•Commodities