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    Building a Screen for Reasonably Priced ADRs

    by John Bajkowski

    Building A Screen For Reasonably Priced ADRs Splash image

    Recent market volatility has helped reinforce the importance of portfolio diversification among different kinds of assets, industries, and securities. One tactic to ensure that you are investing in different kinds of securities is to add some degree of exposure abroad—investing internationally.

    Individual investors can easily access the foreign markets via international mutual funds. Direct investment in foreign-traded stocks is difficult and costly for the individual investor. However, if you want to invest in individual stocks, an excellent route overseas is to purchase shares of international companies in the form of American depositary receipts (ADRs). A depositary receipt is a negotiable certificate that is issued by a U.S. commercial bank and represents shares of a non-U.S. publicly traded company. They are priced in U.S. dollars and owners avoid many costs associated with direct foreign investment, such as international settlement, global custody, foreign brokerage, currency conversions and multi-currency accounting. Dividends are also paid out in U.S. dollars.

    This article explores the characteristics of ADR stocks and how a growth-at-a-reasonable-price screen could be applied.

    Some Background

    While the world markets are moving more in concert, ADRs are usually highly correlated with their home stock market. Performance of the ADR will mirror very closely that of the underlying stock traded on a foreign exchange. For U.S. dollar-based investors, ADRs are also subject to the same currency risk as the underlying stock in the foreign market when the value of the dollar changes relative to the native currency. For example, if the U.S. dollar appreciates against the Japanese yen, the real return to a U.S. dollar-based investor will be less than the return to a yen-based investor because of the stronger dollar. The investment priced in yens will purchase fewer dollars. This currency risk makes the returns on ADRs more volatile.

    Vitals and Statistics

    ADRs are issued by U.S. banks that function as a depositary for the actual shares in the non-U.S. company. There are various classes of ADRs:

    • Level I–Not listed on a U.S. exchange, but traded in the over-the-counter (OTC) market;
    • Level II–Existing foreign shares are U.S. exchange listed, offering greater visibility and liquidity than Level I ADRs; and
    • Level III–Highest profile form of ADR. Level III ADRs involve making a public offering on a U.S. exchange.
    According to the Bank of New York, the world’s leading depositary bank for ADRs, there are currently over 1,400 ADRs from over 60 countries available to U.S. investors. Most of these are Level I, indicating that they are not listed, but trade over-the-counter. AAII’s fundamental screening software program, Stock Investor Pro, currently tracks 550 ADRs, of which 469 are exchange-listed.

    Table 1. Sector Breakdown: ADRs VS. Non-ADRs
    Sector ADR
    (%)
    Non-ADR
    (%)
    Basic Materials 10 6
    Capital Goods 5 5
    Conglomerates 2 0
    Consumer Cyclical 6 5
    Consumer Non-Cyclical 6 3
    Energy 5 4
    Financial 10 16
    Healthcare 8 11
    Services 24 22
    Technology 17 24
    Transportation 3 2
    Utilities 3 2

    Table 1 presents an industry breakdown of ADR stocks tracked by Stock Investor versus non-ADR stocks. Sectors such as basic materials and conglomerates have greater than average ADR representation, while finance, healthcare and technology have a stronger non-ADR presence.

    ADRs have generally been represented by the most widely held, actively traded non-U.S. issues and are mostly categorized as mid- and large-cap stocks. These types of firms have traditionally become ADRs for two reasons: first, to enhance their image as a world-class stock while increasing company exposure and, second, to satisfy the need for raising equity capital in markets outside of the firm’s home country. Bayer, Canon, Gucci, Honda, Nokia, and Sony are just a few examples of prominent ADR issues.

    The 550 ADRs in Stock Investor Pro are spread throughout 46 countries. Thirteen of these countries have only one or two stocks representing their country in the U.S. markets, while other countries have dozens of stocks listed in the U.S. The greatest concentration of ADRs comes from well-developed countries including the United Kingdom, Japan, France, Netherlands and Germany.

    ADR Quirks

    It is important to understand a few minor quirks that are characteristic of ADRs before performing any quantitative screen.

    Share statistics for ADR companies—including price-earnings ratios, earnings per share growth rates, and shares outstanding—may be difficult to interpret unless you understand the per share conversion ratio and the inconsistent reporting of quarterly financial statements.

    The conversion ratio indicates the number of shares of the underlying foreign security that are equivalent to one ADR share. For example, for an ADR that has a conversion ratio of 10-to-1, a single ADR share represents 10 shares of the underlying foreign stock. This ratio varies from ADR to ADR. Toyota Motor Company’s conversion ratio is two, Sanyo’s ratio is five and Teva Pharmaceutical’s is one.

    When looking at per share data such as the earnings per share figure, you must determine if the figures are presented on the basis of the underlying common stock or the ADR. The issue becomes important when determining price-related ratios such as the price-earnings multiple. ADR share prices need to be converted if the reporting basis is in underlying shares in order to calculate meaningful price ratios. The reporting of this data may vary between data vendors, so be sure to check this before making any assumptions. The per share figures in Stock Investor Pro are presented on a per ADR basis.

    Another consideration is the currency, and language in which the annual report and financial statement are presented—native language and currency, or English and dollars. Large multi-national firms may prepare their statement in a number of formats and currencies. Unilever PLC presents its primary annual report using euros in both Dutch and English. It also produces a summary financial statement in English in which its financials are presented in pounds sterling and U.S. dollars.

    Foreign companies do not file annual 10-Ks with the SEC, instead they file 20-Fs, which include an annual report and financial statements. This is the first year that foreign companies must file their reports electronically with the SEC. Standards for filing of quarterly reports by foreign firms vary. While there is a trend toward releasing financial statements on a quarterly basis, some foreign firms only report intra-year performance on a semi-annual basis, not quarterly.

    Table 2. ADR Country Breakdown
    Country ADR Listings
    (%)
    Country ADR Listings
    (%)
    United Kingdom 18 New Zealand 0.9
    Japan 8.6 Russia 0.9
    France 6.2 Taiwan 0.9
    Netherlands 5.8 Austria 0.8
    Germany 5.6 Greece 0.8
    Mexico 4.9 Luxembourg 0.8
    Brazil 4.7 Norway 0.8
    Australia 3.8 Belgium 0.6
    Chile 3.8 Denmark 0.6
    Hong Kong 3.4 Indonesia 0.6
    China 3 Peru 0.4
    Ireland 2.6 Philippines 0.4
    Switzerland 2.6 Portugal 0.4
    Italy 2.3 Venezuela 0.4
    Sweden 2.3 Antigua 0.2
    Argentina 1.9 Bermuda 0.2
    Israel 1.9 Canada 0.2
    India 1.7 Columbia 0.2
    Spain 1.5 Dominican Republic 0.2
    South Africa 1.3 Ghana 0.2
    Finland 1.1 Hungary 0.2
    Singapore 1.1 Papua New Guinea 0.2
    South Korea 1.1 Poland 0.2

    The ADR Screen

    The ADR screen within Stock Investor and Stock Investor Pro follows an approach seeking growth at a reasonable price coupled with strong and improving price momentum. The initial criteria in the ADR screen establish the ADR data set with requirements of ADR classification and listing on the New York Stock Exchange, American Stock Exchange, or Nasdaq. Exchange listing helps to ensure a more liquid market and improved flow of financial data. These two criteria narrow the starting universe from 8,732 to 469 stocks.

    The GARP Approach

    There are a number of approaches that seek attractively priced stocks. A common technique used to locate stocks exhibiting growth at a reasonable price (GARP) employs a criterion that combines a low price-earnings ratio with support from solid earnings growth.

    The ratio of the price-earnings ratio to the earnings growth rate (PEG ratio) is often used to measure the balance between value and growth. The PEG ratio provides an indication of how the market values the firm relative to its earnings growth rate. When a firm’s price-earnings ratio is high relative to earnings growth, its price has high expectations built into it relative to what the firm has been able to produce in earnings—and therefore might be overvalued. The flip side—finding undervalued stocks—occurs when the PEG ratio is low and the investor is able to purchase growth at a reasonable price. A firm with a low price-earnings ratio may not be a bargain if the company has poor earnings growth prospects or is very risky. Firms with higher growth prospects are attractive if you do not pay too much for the earnings. As a general rule of thumb, firms with PEG ratios near 1.0 are considered fairly valued, those with lower ratios may be undervalued, and those with higher ratios may be overvalued.

    There are a number of variations in the construction of the PEG ratio, with the most critical involving the use of historical or expected growth rates. The markets are forward looking, so a PEG ratio using expected earnings is often preferred by investors. However, only about a quarter of the exchange-listed ADRs have a long-term earnings growth estimate, thereby making the use of the ratio very restrictive. The ADR screen employs the historical growth rate in its PEG ratio, but the table of passing companies (Table 3) also reports PEG ratio based upon the expected growth rate where available.

    Therefore, the primary GARP factor in the ADR screen looks for ADRs with a PEG ratio less than or equal to 1.0, eliminating all ADRs with high PEG ratios. The screen then looks for companies with PEG ratios greater than or equal to 0.2. This minimal level is specified to eliminate companies with extreme price-earnings ratios or growth rates—values that most often prove to be meaningless. The PEG ratio screens reduce the number of exchange-listed ADR stocks from 469 to 63.

    Price-Earnings Ratio

    The table of passing companies indicates current price-earnings ratios. The price-earnings ratio, which is computed by dividing the current stock price by the firm’s earnings per share for the most recent 12-month period, provides a quick sense of the market valuation of a stock.

    Stocks trading with high price-earnings ratios are generally trading with high expectations of future earnings growth. Extremely high values may point to earnings slowdowns perceived as temporary by the market. Stocks with low price-earnings ratios generally have lower growth expectations or are perceived to possess higher risk. The price-earnings ratios for the passing ADRs range from a low of 5.4 for the Danish Internet infrastructure services firm EuroTrust A/S to 38.8 for the Japanese transportation company Japan Airlines.

    When examining a firm’s price-earnings ratio, some insight can be gained by comparing it against benchmarks, such as the price-earnings ratios for the market, for the company’s industry, and even the company’s own historical levels. The current market multiple can be found in such financial papers as the Wall Street Journal and Barron’s. Barra (www.barra.com) is a good Web source for current and historical price-earnings ratios for the S&P indexes. Industry multiples are a little bit harder to come by, but can be found in publications like Value Line Investment Survey or in software programs such as AAII’s Stock Investor Pro. As a group, the passing companies’ price-earnings ratio is slightly below ADRs as a whole and all stocks.

    Earnings Per Share Growth

    Earnings per share growth is one of the main benchmarks used for measuring company performance. The PEG ratio requires a positive growth rate. The range of five-year earnings growth rates for this group swings quite dramatically—from a low of 8.4% for German energy and specialty chemicals manufacturer E.ON AG to 83.3% for French wireless equipment manufacturer Wavecom S.A. Wavecom’s extreme value reflects the low base earnings figure of three cents five years ago. Base year figures near zero often lead to extremely high rates that are not reflective of future growth potential. In Wavecom’s case, the one analyst providing a long-term growth estimate for the company is expecting earnings to grow at a 45% annual clip over the next three to five years.

    One should look beyond the growth rate and also study the year-by-year figures to help assess validity and true trend of earnings.

    Relative Strength Rank

    The relative strength rank figure indicates how a company’s stock price has performed relative to all other stocks in the complete Stock Investor Pro universe. A rank of 50% indicates that the stock’s performance was better than 50% of all stocks. A rank of 75% reflects performance that surpassed 75% of all stocks—or performance that places the stock within the top 25% of the universe. Investors seeking stocks that show price momentum often look for candidates with strong and improving relative strength ranks. The best way to do this is to check both a short-term relative strength figure and the performance over a long-term period. A high 52-week rank coupled with a more recent low figure—say a low 13-week rank—points to a company whose relative price strength is weakening.

    The relative strength criteria in the ADR screen looks at establishing a strong relative performance group of ADRs, all exhibiting positive price momentum. In this case, the screen requires a 13-week relative strength rank greater than or equal to the 52-week relative strength rank. This filter reduces the number of passing companies from 63 to 27. A final filter requires 13-week relative strength rank figures to be at least at 50%. This filter reduces the number of passing companies to the 21 displayed in Table 3, which are ranked by the PEG ratio.

    Overall the group has very strong 13-week relative strength ranks. Four stocks—Digitale Telekabel, Wavecom, Santos, and Teva Pharmaceutical—have relative strength ranks in the 90s. Banco Comercial Portugues has the lowest 13-week relative strength rank, 51%.

    Going forward, it is important to consider all of the factors that might effect performance of a given stock—company, industry, country, and currency factors. ADRs add an additional level of complexity to the stock selection process.

    For certain ADRs, country factors are outweighed by industry factors. Industries that deal with global resources and products such as mining, forestry, oil, chemicals, machinery, and banking, react more to industry factors than country factors. Earnings changes within these industries will be closely matched throughout the world. For example, if you hold shares of U.S. gold mining firms, do not expect significant added international diversification by buying the shares of a foreign gold mining company.

    On the other hand, industries that deal with consumer goods, household durables, real estate, beverages, and even business services tend to react more to internal country developments. These are the areas to look to for international diversification.

    Abroad At Home

    This initial growth-at-a-reasonable-price ADR screen is meant only to be a starting point toward further detailed analysis. Applying screens to actual stocks enables individual investors to become familiar with the interpretation of financial data and the process of individual stock selection in a fundamental analysis framework.

    Before making any investment decision, you should gather all pertinent information and understand the investment thoroughly—including its native country and market in some cases. Also, keep in mind that no one investment technique will be best in all market environments and that the techniques that worked in the past may not be as useful in the future.

    However, one investment technique discussed at the beginning of the article has an excellent track record: diversification. Maintaining a diversified portfolio of investments at a level of risk that you are comfortable with and taking a longer-term perspective are investment approaches that will prove the most valuable over time.

       Definitions of Terms
    PEG Ratio: Hist Grth —Price-earnings ratio to historical earnings per share growth. Calculated by dividing the price-earnings ratio of a stock by its annual growth rate in earnings per share over the last five years. Provides an indication of the valuation level by the market relative to historical earnings growth. A ratio below one is reason for further analysis.

    PEG Ratio: Est Grth—Price-earnings ratio to estimated earnings per share growth. Calculated by dividing the price-earnings ratio of a stock by its annual estimated three- to five-year growth rate in earnings. Provides an indication of the valuation level by the market relative to consensus estimated earnings growth tracked by IBES. A ratio below one is reason for further analysis.

    Current P/E (Price-Earnings Ratio)—Price divided by fully diluted earnings per share from continuing operations for the last 12 months. Provides an indication of the market’s expectations regarding a company’s growth prospects and risk. High price-earnings ratios generally indicate the market’s belief that that the company has strong future growth prospects and that it will achieve this growth, while a low price-earnings ratio represents the market’s low earnings growth expectations for the firm or the high risk or uncertainty of the firm actually achieving growth.

    EPS Growth Rate (5-Yr)—Annual growth rate in earnings per share from continuing operations over the last five years. A measure of how successful the firm has been in generating the bottom line, net profit.

    Rel Stgth Rank: 13-Wk—The relative price strength rank over the last 13 weeks. Indicates how a company’s stock price has performed relative to all other stocks over the last 13 weeks. A rank of 50% indicates that the stock’s performance is better than 50% of all firms, while a rank of 90% indicates that a stock has outperformed 90% of all stocks.

    Rel Stgth Rank: 52-Wk—The relative price strength rank over the last 52 weeks. Indicates how a company’s stock price has performed relative to all other stocks over the last 52 weeks. A rank of 50% indicates that the stock’s performance is better than 50% of all firms, while a rank of 90% indicates that a stock has outperformed 90% of all stocks.


    John Bajkowski is AAII’s financial analysis vice president and editor of Computerized Investing.


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