How to Manage This Hidden Risk of Investing in Foreign Stocks

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Let me ask a question. Have you bought shares of a foreign company at some point in the last decade? You might THINK you did — but chances are you actually didn’t.

Believe it or not, when you buy shares of a company that is based outside the U.S., like Alibaba (BABA) or BP plc (BP), you’re not buying the actual stock of the company.

Instead, you’re buying an American Depositary Receipt (ADR) or American Depositary Shares (ADS).

That isn’t necessarily a bad thing. In fact, I believe some of these ADRs/ADSs have incredible potential.

Take a look at Nio Inc. (NIO), which is based in China and trades as an ADR on the New York Stock Exchange. It triggered an entry to the Green Zone within TradeSmith Finance on Nov. 25, 2019, at $2.28. The stock has remained in a healthy state since that time and has been as high as $62.84 — a gain of as much as 2,656%.

Wow!

One foreign stock that I’ve been following recently here in TradeSmith Daily is Alibaba, which saw gains of 103% and 26% on its last two entries to the Green Zone!
But let’s take a step back.

I first want to explain how these vehicles work and offer a bit of insight into how to manage their different risks.

How Foreign Companies Trade on American Exchanges

Here’s how it works.

An intermediary bank buys shares of a foreign company on the local stock exchange. Let’s say Alibaba over in Hong Kong. That same intermediary then issues “shares” via ADR that represent the actual stock it owns overseas.

Think of it like an IOU for your shares. The U.S. intermediary buys shares of the foreign stock from an exchange in that country. It then issues certificates that represent shares of that stock on a U.S. exchange — but not actual shares.

An ADS represents the individual share of the foreign company’s stock within an ADR.

ADRs are listed at three different levels.

• Level 1: Shares can be traded on the OTC market. At this level, the company has minimal reporting requirements that do not include quarterly or annual reports. However, the company must publish (in English) the reports it is required to generate in accordance with the laws of the country where it is based.
• Level 2: Companies at Level 2 are required to file annual reports that conform to generally accepted accounting principles (GAAP), and must also meet exchange listing requirements.
• Level 3: Companies at Level 3 (such as Alibaba) meet stricter reporting rules similar to those followed by U.S. companies. At this level, companies can issue shares to raise capital rather than just list on the exchange.

Why You Should Care

In short, knowing the level of an ADR/ADS can help you better quantify the risks associated with investing in that company.

But let me give you a few key reasons why this matters:

• The intermediary could end the program. While it’s not very likely, either the foreign issuer or the intermediary bank can decide to terminate the ADR program for a variety of reasons. That could force liquidations or conversion to underlying shares, which could come at a high cost. This happened with Mitchells & Butlers plc (MAB), a company based in the United Kingdom, in April 2005.
• ADRs may charge pass-through fees. These banks don’t provide access to foreign companies out of the kindness of their hearts. Many charge pass-through fees, including custody fees and fees for processing dividends and corporate actions. These fees can be found in the prospectus for the listing and may be taken out of any dividend payments that the stock pays.
• ADRs and ADSs tend to have lower liquidity. ADRs often trade with lower volume than regular stocks. That can affect bid/ask spreads, which can cost you money when entering or exiting a position.
• Not all ADR or ADS issuances have the same transparency as U.S. companies. As I noted above, different ADR levels have different reporting requirements. Not all of them will provide you the same information or conform to the same reporting standards that you may be used to.
• You may not be able to vote in business matters. Because ADR holders aren’t actually shareholders, they typically don’t have the right to vote in company affairs.

All that being said, ADRs and ADSs contain several benefits.

• ADRs and ADSs trade just like stocks. Rather than setting up a separate account or filling out tons of paperwork, you can purchase an ADR or ADS just as you would any other stock, making the process much simpler.
• You don’t need to worry about currency adjustments. Intermediary institutions issue shares denominated in U.S. dollars. That relieves you of the burden to calculate differences in exchange rates between the price of shares overseas and the U.S. dollar.
• You can use these vehicles to diversify your holdings. By simplifying the (indirect) ownership process, ADRs allow you to allocate capital to foreign markets and equities.

Managing Risk

Investors and traders have many tools at their disposal to manage the risks involved in foreign markets. One of my favorites is the Health Indicator.

At the bottom of each chart, our technical analysis lets me know whether a stock is in the Red, Yellow, or Green Zone.

This is extremely helpful when I have a great investing idea based on a company’s fundamentals but need to determine the appropriate timing to act on it.

As I’ve mentioned, Alibaba is a foreign stock I’m following at the moment with some potential in the future.

But as the chart shows below, it’s currently in the Red Zone.
So for now, I’m staying on the sidelines until I get a better signal.

And, for further confirmation, I can also use our Billionaires Club model portfolio to keep an eye on what action, if any, big money managers like John Paulson and David Tepper are taking with this stock.

As I’ve promised before, I’ll be sure to let you all know when we get a clear entry signal for BABA.

In the meantime, does owning a foreign stock via ADR concern you? Why or why not? I’d love to hear from you. I can’t respond to every email, but I read them all.