Advanced Investment Guide for U.S. Stocks: A Comprehensive Understanding of ADRs

Quick Overview of Core ADR Concepts

ADR (American Depositary Receipt) is the primary tool for foreign companies to access the US stock market. When foreign enterprises wish to list and trade on US stock exchanges, a common approach is to issue ADRs. US depositary banks issue these certificates on behalf of foreign companies, allowing investors to buy and sell them on venues such as NASDAQ, NYSE, and OTC.

In simple terms, ADR is a stock representation issued by foreign companies in the US, enabling US investors to trade international corporate stocks conveniently without opening foreign accounts or exchanging foreign currency. For foreign companies, issuing ADRs is a simpler and lower-cost alternative to direct listing.

Why Do Foreign Companies Choose to Issue ADRs?

Many internationally renowned companies like TSMC (TSM), Tencent (TCEHY) are listed domestically, but to enter the most dynamic global capital markets, they opt to issue ADRs instead of secondary listings.

Advantages of issuing ADRs for companies:

• Simplifies overseas financing processes without full listing approval
• Access to a large base of US and international investors
• Enhances global market visibility and financing capacity

Advantages for investors:

• No need to open complex foreign securities accounts
• Avoids currency exchange hassles and risks
• Trading is similar to US stocks, easy to operate

Classification and Level Structure of ADRs

Two Main Types of ADRs

Sponsored ADRs: Issued officially by banks on behalf of foreign companies, with the company retaining control and paying issuance fees. These ADRs must comply with SEC regulations, disclose financial information regularly, and carry relatively lower risk.

Unsponsored ADRs: Issued independently by banks, possibly without direct involvement from the company, traded only in the OTC market. Well-known Chinese companies like Tencent, BYD, and Meituan have most of their US stock ADRs as unsponsored, which tend to have lower liquidity and compliance standards.

Three Levels of ADRs

Based on the depth of market entry in the US, ADRs are divided into three levels:

Level 1 ADRs carry the highest risk due to minimal disclosure and lower liquidity. Levels 2 and 3 can be traded on formal exchanges with stricter regulation.

ADR Ratio Conversion and Price Calculation

It’s important to note that ADRs do not correspond 1:1 with the foreign stocks. For example, Taiwanese companies’ ADR ratios are set based on factors like stock price, exchange rate, and trading liquidity.

Overview of Major Taiwanese Companies’ ADR Ratios

For example, Hon Hai’s ADR ratio of 1:5 means 5 shares of Taiwan Hon Hai stock are equivalent to 1 US stock ADR. Investors need to calculate costs precisely based on this ratio and the current exchange rate.

Differences Between Taiwan Stocks and Taiwan Stock ADRs

The same company’s Taiwan stock and ADR differ in several aspects:

Nature: Taiwan stock is actual equity, while Taiwan ADR is a depositary receipt representing the stock.

Trading Venue: Taiwan stocks are traded on the Taiwan Stock Exchange, regulated by TWSE; ADRs are traded on US exchanges, regulated by the SEC.

Stock Code: Codes are entirely different; e.g., Hon Hai Taiwan stock is 2317, ADR is HNHA.

Investor Base: Taiwan stocks mainly target local Taiwanese investors; ADRs attract global investors.

Conversion Ratio: Taiwan stocks are 1:1; ADRs have specific conversion ratios.

Premium/Discount Phenomenon: Although their price movements are generally aligned, differences caused by exchange rates and liquidity can lead to price gaps. When the ADR’s price converted to local currency exceeds the local stock price, it’s called a premium; the opposite is a discount. Savvy investors often exploit these differences for arbitrage.

Main Differences Between A-shares and A-shares ADRs

Practical Evaluation Points for ADR Investment

Liquidity Risk

ADR trading volume is often much lower than the company’s domestic stock trading volume. For example, China Telecom’s US ADR average daily volume in March was about 145,000 shares, while the Taiwan stock’s daily volume was 12.24 million shares, showing a significant liquidity gap.

When investing in ADRs, it’s essential to assess trading depth to avoid issues with timely execution. Large companies like TSMC have better liquidity, while smaller companies’ ADRs may face wider bid-ask spreads.

Fundamental Analysis

Similar to investing in regular stocks, ADR investment requires attention to the company’s operational quality, industry outlook, and policy environment. Especially for Level 1 ADRs, which have no disclosure obligations in the US, investors must proactively review the company’s financial reports in the original issuing country.

For example, TSMC’s ADR increased by 32% in early 2023, driven by factors such as reopening expectations, strong earnings reports, and optimistic semiconductor industry prospects.

Arbitrage Strategies Based on Premium/Discount

Price differences between ADRs and local stocks create arbitrage opportunities. When ADRs trade at a premium (converted price higher than local stock price), consider selling ADRs and buying local stocks; vice versa.

A real case on March 22, 2023: TSMC’s ADR closed at $92.6. Using a 1:5 ratio and an exchange rate of 30, the converted price is NT$553.3, while the local stock closed at NT$533, creating a premium space.

Advantages of ADR Investment

Tax Benefits: Taiwanese investors can profit from ADR trading without paying income tax on gains under NT$1 million, a clear advantage over stock trading taxes.

Trading Costs: Overseas brokers’ ADR transaction fees are usually much lower than those in Taiwan, making frequent trading more cost-effective.

Diversification: ADRs open a convenient channel to invest in international companies. For example, in the electric vehicle sector, US investors can invest in Tesla (TSLA) and NIO ADRs (NIO), building a more balanced portfolio.

Global Market Opportunities: ADRs allow investors to participate in the growth of top global companies without the complexity of opening international accounts.

Risks and Challenges of ADR Investment

Currency Fluctuation Risk: ADRs settle in USD, so investors bear USD/TWD exchange rate risk. If the stock appreciates 20% but the TWD weakens against USD, the overall return may be reduced or even result in a loss—this is a core risk of ADR investing.

Liquidity Shortage: Some ADRs have low trading volume, resulting in wide bid-ask spreads, affecting entry and exit efficiency. Small international companies’ ADRs are especially vulnerable.

Operational Complexity: Taiwanese investors need to open overseas accounts, complete USD exchanges, and handle deposits, making the process more complicated than direct Taiwan stock investment. Using Taiwanese brokers to purchase ADRs simplifies the process but usually involves higher fees of 1%-2%.

Information Asymmetry: Some ADR companies have limited disclosures in the US, requiring investors to gather financial reports from the home country, increasing analysis difficulty.

Final Recommendations Before Investing in ADRs

Investors should have a deep understanding of international markets, currency risks, and specific companies before investing in ADRs. Prior to committing, it’s advisable to:

1. Assess personal risk tolerance, especially regarding exchange rate fluctuations
2. Study the company’s fundamentals and industry outlook
3. Compare liquidity and transaction costs of different ADRs
4. Use premium/discount differences strategically
5. Treat ADRs as a supplement to your portfolio rather than a core holding

Through systematic analysis and strategic planning, ADRs can be a powerful tool for US stock investors to expand into international markets.