ADRs (American Depositary Receipts) make it easy for you to buy overseas companies and provide you with an extra measure of safety that you would not get with a direct stock investment. That’s because stock certificates of a foreign company are registered in the name of a U.S. trust company or bank, which holds them for safekeeping. Then the institution issues receipts as an alternative investment against the shares. These receipts trade on U.S. stock markets just like ordinary stocks.
American Depositary Receipts, or ADRs, give you benefits. One is diversification. It’s tempting to call ADRs American Diversification Receipts. They give you industries that Canada lacks or has in short supply. This can let you earn more while reducing your risk. ADRs also let you diversify by currency.
We think ADRs have a place in most portfolios. (ADRs and U.S. stocks should make up a quarter or so of your stock portfolio, depending upon your circumstances.) We rate 16 of the 46 ADRs we follow as buys.
The ADRs we follow include companies from Belgium, China, Denmark, Finland, France, Germany, Holland, Israel, India, Italy, Japan, Mexico, South Korea, Spain, Sweden, Switzerland, Taiwan and the United Kingdom.
Some of the above are so-called ‘emerging markets’. Such markets hold the potential for faster growth. Most have younger populations than the industrial world. This adds to the demand for goods and services now. And in the future, they’ll add to the demand for financial assets.
Emerging markets are safer than they look
Investing in emerging markets raises your risk. One way ADRs let you reduce risk is through low correlations (or dissimilar stock price movements) to each other and to U.S. stocks. This can help offset the higher risk, particularly if you buy a mutual fund diversified by country. Even so, correlations tend to be closer when financial markets fall, which reduces the advantage of diversification.
Canada is at the high end of the correlation range. Our stocks tend to closely follow U.S. stocks. With 1.0 equal to perfect correlation, one study found a correlation of 0.82 between Canadian and U.S. stocks.
Stocks on overseas exchanges—particularly those in emerging markets—have lower correlations with U.S. stocks. This can let you build a portfolio that protects you from wide market swings and lets you sleep better at night.
Stocks in South Korea, for instance, had a correlation of just 0.2 with the U.S. In other words, the ups and downs of these nations’ stocks have relatively little to do with the direction of U.S. stocks and a lot more to do with domestic matters. But correlations rise when global stock markets fall. That is, diversification offers less just when you need it the most.
As well, each emerging market typically has low correlations with other emerging markets—further reducing the risk of all your ADRs falling at the same time.
Emerging markets individually pose higher risk. Then again, they also offer high potential growth. That is, a basket diversified by country reduces your risk.
Diversify in industries without Canadian counterparts
ADRs let you buy into industries you can’t buy here. For instance, Japan’s Canon Corp. has no Canadian peers. It manufactures photocopiers, printers, cameras and flat-panel display screens globally. Similarly, many of the other ADRs operate in industries with few or no Canadian counterparts.
Even when you buy ADRs in the same industries as Canadian and U.S. companies, you can comparison shop and see where you’ll get the better deal, at home or abroad. Compare General Electric to Siemens, Unilever PLC to Procter & Gamble, Sanofi to Pfizer and so on.
Keep in mind that ADRs protect you from weaker reporting rules in some overseas markets—because they must file their U.S. financial statements in English using U.S. accounting rules.
Our ADRs deliberately exclude natural resources, financial stocks and some utilities. After all, the Canadian market offers lots of resource companies, financial institutions and high-yield utilities (that face no withholding tax but instead benefit from the Canadian dividend tax credit). So our ADRs include more of the manufacturing and consumer companies that are harder to find in Canada.
One important thing is to consider all your portfolios (including your spouse’s) as one and strike a suitable overall balance. Use ADRs to add to the manufacturing and consumer sections of your portfolio and to get the benefits that ADRs can provide.
The Investment Reporter, MPL Communications Inc.
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