Over There: Screening for Reasonably Priced ADRs

    by Wayne A. Thorp

    Investors are constantly hearing about the diversification benefits of foreign equities, but direct investment in foreign-traded stocks is difficult and costly for the individual investor.

    While individual investors can easily access the foreign markets via international mutual funds, if you are looking 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 trades like a common stock; it is issued by a U.S. 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, but may be subject to foreign withholding tax.

    It is important to understand that two factors influence the ADR price: the stock price of the security on its native local exchange, and the value of the local currency relative to the U.S. dollar.

    The ADR Screen

    A screen seeking reasonably priced ADRs is built into Stock Investor Pro, AAII’s fundamental stock screening and research database program. Stock Investor Pro currently tracks 500 ADRs, 414 of which are exchange-listed. This simple screen looks for companies trading with a low PEG ratio (price-earnings ratio divided by earnings per share growth) and exhibiting strong recent price momentum. The screening criteria used are detailed on page 33.

    Screen Performance

    The companies passing the ADR screen are posted each month on AAII.com and the performance of these stocks in a hypothetical portfolio is tracked on-line.

    Figure 1.
    Performance of ADR Screen

    The ADR screen benefited from the weak U.S. dollar and was the top specialty strategy of AAII in 2006 and the second-best performer overall, gaining 44.7%. It has also outperformed the large-cap S&P 500 index and other broad market indexes since the beginning of 1998.

    Figure 1 shows that the reasonably priced ADR approach generated a cumulative return of 261.2% from the beginning of 1998 through the end of 2006, while the S&P 500 was up 46.2% over the same period.

    Profile of Passing Companies

    The characteristics of stocks currently satisfying the reasonably priced ADR criteria are presented in Table 1.

    The ADR screen attempts to locate stocks exhibiting growth at a reasonable price (GARP) by employing a criterion that combines a low price-earnings ratio with support from solid historical earnings per share growth. As a result, the median price-earnings ratio of stocks passing the ADR screen is 15.8, compared with 19.9 for all exchange-listed stocks.

    The median historical earnings per share growth rate of the passing companies is more than double that of the exchange-listed stocks—30.5% versus 12.5%. In contrast, the median expected earnings growth rate of 8.4% is below the exchange-listed stock median of 14.3%. However, roughly 40% of all the exchange-listed ADRs do not have a long-term earnings growth estimate.

    The median market cap of $10.45 billion for the stocks passing the ADR screen is consistent with a portfolio of large-sized companies. In comparison, the median market cap of all exchange-listed stocks is $492 million.

    The relative strength index of stocks currently passing the ADR screen indicates that they have outperformed the S&P 500 by 2% over the last year, which is slightly better than the 2% by which the typical exchange-listed stock underperformed the index over the same period.

    On average, 22 companies have passed the ADR screen over the last nine years, but during extreme market conditions we have observed as many as 57 stocks passing and as few as six stocks passing.

    Table 1. Tracking Error vs. Market Capitalization and Style Difference
    Portfolio Characteristics (Median) ADR
    Price-earnings ratio (X) 15.8 19.9
    Price-to-book-value ratio (X) 2.7 2.2
    EPS 5-yr. historical growth rate (%) 30.5 12.5
    EPS 3-5 yr. estimated growth rate (%) 8.4 14.3
    Market cap ($ million) 10,449.50 491.9
    Relative strength vs. S&P (%) 2 –2
    Monthly Observations
    Average no. of passing stocks 22  
    Highest no. of passing stocks 57  
    Lowest no. of passing stocks 6  
    Monthly turnover (%) 42.4  
    Data as of January 12, 2007.

    Current Companies

    The primary growth-at-a-reasonable price factor for the ADR screen looks for ADRs with a PEG ratio less than or equal to 1.0, eliminating ADRs with high PEG ratios. The screen then looks for companies with PEG ratios greater than or equal to 0.2. This minimum level is required to exclude those companies with extreme price-earnings ratios or growth rates—values that most often prove to be meaningless. The 38 stocks currently passing the ADR screen are listed in Table 2, ranked in ascending order by historical PEG ratio.

    The median historical PEG ratio for the passing companies is 0.5, compared to 1.2 for the typical exchange-listed company. Yanzhou Coal Mining Co., based in the People’s Republic of China, has a historical PEG ratio of 0.6, which was calculated by dividing the current price-earnings ratio of 13.2 by the 22.5% historical earnings per share growth rate.

    The estimated PEG for Yanzhou is significantly higher—3.8—due to extremely lower expected annual earnings growth of 3% over the next three to five years. It is important to look beyond the growth rate and also study the year-by-year figures to help assess the validity and true trend of earnings. The current price-earnings ratios for the passing ADRs range from a low of 7.7 for Brazilian oil and gas company Petroleo Brasileiro S.A., to 43.3 for the French business software and services company ILOG S.A.

    The relative strength criteria in the ADR screen look to establish a strong relative performance group of ADRs, all exhibiting positive price momentum. In this case, the screen requires a 13-week relative strength rank that is greater than or equal to the 52-week relative strength rank. A final filter requires 13-week relative strength rank figures to be at least 50%, which means that the stock’s performance over the last 13 weeks was better than 50% of all stocks.

    Overall, the current group of companies has very strong 13-week relative strength ranks. Four stocks—Tenaris, Lan Airlines, Aluminum Corp. of China, and Logitech International—have relative strength ranks in the 90th percentile or higher. TOTAL S.A. and NDS Group, have the lowest 13-week relative strength ranks, 52%.



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

    For certain ADRs, country factors are secondary to industry factors. Industries dealing with global resources and products such as oil, chemicals, mining, forestry, machinery, and banking, react more to industry factors than country factors. Earnings changes within these industries tend to be closely matched throughout the world. Therefore, if you hold shares of U.S. gold mining firms, do not expect to achieve meaningful international diversification by adding 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 local, internal country developments. These are the areas to look to for international diversification.

    Finally, it is important to keep in mind that stock screening is only the first step in the stock selection process. The stocks passing the ADR GARP screen do not represent a “recommended” or “buy” list. Before making any investment decisions, you should gather all pertinent information and understand the investment thoroughly—including its native country and market, in these cases. It is important to perform sufficient due diligence to identify those stocks that match your investing tolerances and constraints before committing your investment dollars.

       What It Takes: ADR Screening Criteria
    • The stock must be designated as an American depositary receipt (ADR)
    • The stock must trade on either the New York Stock Exchange, NASDAQ, or American Stock Exchange (cannot trade on the over-the-counter (OTC) market)
    • The ratio of the current price-earnings ratio to the five-year historical growth rate in earnings per share (PEG ratio) is less than or equal to one (1.0) and greater than or equal to 0.2
    • The 13-week relative price strength percentage rank is greater than or equal to the 52-week relative strength rank
    • The 13-week relative price strength must rank in the top 50% of the entire universe of stocks

    Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.

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