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Financial
ADR's
Placing Your Bets Abroad
Now is the time to take a less parochial approach to investing by diversifying globally with American depository receipts. The world beckons…
As the dust from the protracted U.S. recession begins to settle, many investment strategists are trying to convince Americans to take a less parochial approach to stock investing. Instead of staying completely infatuated with the domestic equity market, they are urging individual investors to start diversifying abroad. As they point out, the U.S. represents only around 45% of the global marketplace, and the rest of the world beckons. Foreign securities can mitigate risk by offsetting losses in one country with gains in another.
That's true, but how can U.S. investors burned during the last market blowout add some international flavor to their portfolio without Sir John Templeton by their side? After all, finding the right investment and then avoiding expensive transaction costs—such as settlement and custodial fees—is not easy.
One way is to turn to American depository receipts, or ADRs, a fancy name for shares in foreign companies that not only trade on their local stock markets but also trade their "receipts" on one of the major exchanges in the U.S. ADRs grant shareholders ownership of these foreign shares and all dividends and capital gains. "The beauty of these instruments—which are held by custodian banks such as Bank of New York, Citibank, and J.P. Morgan Chase—is that they allow investors to diversify their portfolios internationally in dollar currency," says Alvin Rodolfo, director of European ADR trading at SG Cowen Securities in New York.
First issued in 1927 by Morgan Guaranty, ADRs are listed and trade on U.S. exchanges such as the NYSE and Nasdaq. About 70% of this total, or 330 of them, are listed on the New York Stock Exchange. Many ADRs also trade over the counter (OTC). Brokers can access information about OTC securities through the National Quotation Bureau's "pink sheets" or the OTC Bulletin Board. Trading is conducted through market makers in that particular security.
Since the beginning of the year, trading in ADRs has been steady and the S&P ADR Index—a benchmark that represents 263 multinationals with a total market cap of $3 trillion—has inched up around 2%. The uptick is being spurred by the bumpy rally we've seen in the U.S. equity market. It's also due to the decline of the dollar against other currencies, especially the euro. And there's an added attraction: Many ADRs are priced in foreign currencies, and when those currencies strengthen against the greenback investors can reap some additional price gains.
"Investors like the fact that ADRs tend to have higher dividend payouts, and they trade relatively cheaper in price-to-earnings multiples than U.S. securities," according to Vivian Lewis, editor of the newsletter Global Investing in New York. "They also allow an American investor to round out their portfolio in certain industry sectors, like goldmines, that might not be well represented by domestic companies."
"Even more important is the fact that many high-quality foreign companies are trading at historically low valuations and there are really great opportunities for savvy investors in this marketplace," says Ronald Saba, a principal at NorthRoad Capital Management in New York. "Now is the time for individuals to be greedy."
How much cash investors decide to allocate to ADRs depends on a host of factors. Among them: their risk tolerance toward foreign investing, and the degree to which their lifestyle requires they have some international assets. According to David Blitzer, managing director of Standard and Poor's and chairman of the firm's S&P Index Committee, right now investors should consider targeting 10% to 20% of their portfolio to foreign investments, which could include a mix of ADRs. Hot markets: Australia, Spain, and the U.K.
Investing 101
It's important for investors to fully understand the mechanics of ADR investing. ADRs follow their home indexes and have inherent currency risk. Each ADR can represent one, more than one, or a fraction of underlying shares. This relationship between the ADR and the ordinary share is referred to as the ratio. While most ADR programs are established with a one-to-one ratio (that is, one underlying share equals one depository share), current ADR programs have ratios ranging from 100,000-to-one to one-to-100. Make sure you understand the ADR ratio to ensure there are no nasty surprises.
Afterwards, you should go through the same process in investing in an ADR as you would with any offshore stock. That is, you need to understand what the company does and have a view of its short- and long-term investment prospects.
To pick promising ADR investments, Saba suggests a best-in-class, value-oriented investment strategy. That entails doing some smart financial and fundamentals analysis. The two main things the money manager looks at are a company's return on equity (ROE) and its price-to-earnings multiple (P/E) over the next 12 months. "The goal is to find businesses that have a good return on equity that are priced inexpensively relative to their financial productivity," he explains. At NorthRoad Capital, the average return on equity for companies in the global portfolio is 19%, and their forward price-to-earnings multiple is 13.5%. "That's as good as we've seen in many years and should translate into strong returns over time," says Saba, the former portfolio manager of Lazard Freres's large-cap global and international select portfolios who now co-manages assets of $350 million for individual and institutional clients.
In addition, investors must look at a company's business fundamentals to make sure their returns are sustainable over the next five years. They must assess the quality of its operations, management team, financial structure, products, and services.
Often that means understanding a company's industry, since each has its own nuances. For example, when looking at energy companies it's important to look at how diversified their earnings streams are, since most operate two lines of business—oil exploration and product refining. Well-managed companies are efficient and have a well-balanced business model.
An example is BP, a company in NorthRoad Capital's portfolio. The $180 billion global giant has been able to sustain a good ROE because of its strong track record in oil exploration and development, as well as refining. "BP has currently replaced 175% of its production with reserves," notes Mary Jan Klocke, director of North American shareholder marketing. "This compares favorably to a range of 50% to 120% for BP's main competitors." In addition, management has a good track record of managing costs. It's not surprising that over the past 20 years its dividends have increased an average of 4% per year above inflation.
This type of global investing can be a kick for value hunters. With the whole world as their shopping mall, opportunity can be spotted almost anywhere. Take Coca-Cola FEMSA in Mexico. With EBITDA margins of almost 31% last year, it is the most profitable bottler in the world. In the past ten years, consolidated revenues for FEMSA, which is the holding company, have grown at a compounded rate of 9.2% in U.S. dollar terms. Clearly its management model is working brilliantly. That's why its ADRs listed on the New York Stock Exchange had over a 28% return on equity over the past 12 months.
But as with any other type of investing strategy, investors must be aware of some of the inherent risks when placing their bets abroad. Dividends on ADRs are paid in U.S. dollars and are generally taxable, just like dividends on U.S. shares. In addition, corporate taxes may be withheld by the ADR company's local country government. The caveat: Depending on individual circumstances, foreign taxes withheld might be applied as a credit against U.S. taxes, or tax reclaim opportunities may be offered.
ADR investors should also look for creative ways to optimize returns. One tactic is to keep an eye on IPOs. New listings can signal future acquisitions. Investors who watch the ADR market may be able to anticipate a company's intentions. Using ADRs, they can engage in merger arbitrage, buying local shares or ADRs of companies they think might become M&A participants.
The upshot: Thinking global while acting local has its rewards. As Sir John Templeton once wrote, "it's the far-reaching thinker" who usually becomes a successful investor. One who often takes the international road that is far less traveled.
BP was created on Dec. 31, 1998, by the merger of Amoco Corp. and the British Petroleum Co. Following that transaction, the company was renamed BP Amoco. On April 14, 2000, BP acquired the Atlantic Richfield Co., and in July 2000 BP acquired Burmah Castrol. To signify the single entity that has successfully been created through these combinations, the name of the company was changed to BP p.l.c. with effect from May 1, 2001.
Today BP is one of the world's leading oil companies on the basis of market capitalization and proved reserves. Its main businesses are exploration and production; gas, power, and renewables; refining and marketing; and chemicals. Exploration and production activities include oil and natural-gas exploration, field development, and production, together with pipeline transportation and natural-gas processing. Gas, power, and renewables activities include marketing and trading of natural gas, natural-gas liquids, liquefied natural gas, and solar and renewables. The activities of refining and marketing include oil supplying and trading, as well as refining and marketing. Chemicals activities include petrochemicals manufacturing and marketing. The group provides high-quality technological support for all of its businesses through its research and engineering activities.
BP operates in more than 100 countries and has over 100,000 employees worldwide. Currently more than 70% of its capital is invested in Organ-ization for Economic Cooperation and Development (OECD) countries, with just under one-half of its fixed assets located in the U.S. and around one-third located in the U.K. and the rest of Europe.
Growth Strategy
The company's goal is to create value from a distinctive set of opportunities, biased toward exploration and production, through a disciplined approach to investment within its established financial framework. Consistent with this strategy, and based on a thorough review of its assets and opportunities, BP intends to increase its investment, excluding acquisitions, to $14 billion to $14.5 billion in 2003, focusing on creating six new oil and gas profit centers, while divesting $3 billion to $6 billion. The company expects its annual investment level, excluding acquisitions, to move toward the $12 billion to $13 billion range by 2005.
You probably know that FEMSA is the largest beverage company in Latin America, with sales of $5 billion in 2002. You maybe aware that its soft drink subsidiary, Coca-Cola FEMSA, has ranked as the most profitable Coke bottler on the planet, with EBITDA margins of 30.7% in 2002. Or you may have read somewhere that nobody exports more cans of beer to the U.S. than FEMSA Cerveza does.
But did you know that FEMSA's consolidated revenues have grown at a compound rate of 9.2% in U.S. dollars for the past ten years? Were you aware that its consolidated operating profit has risen even faster, at a compound rate of 15.5% in U.S. dollars for the same period? In fact, FEMSA has grown its operating income at a faster rate than any beverage company in the Standard & Poor's 500 Index. And had you noticed that it has achieved these goals while maintaining one of the healthiest balance sheets around?
 The oustanding growth FEMSA has experienced last year will be further bolstered by a number of strategic moves that the company has made over the past few months. The most important, finalized last May, was the acquisition of Panamerican Beverages Inc., the largest Coca-Cola bottler in Latin America. Now Coca-Cola FEMSA has operations in nine Latin American countries and is the largest Coca-Cola bottler outside the U.S.
This landmark deal will assure that the continuing consolidation in the industry works to the advantage of FEMSA. More than 110 years of successful history validate FEMSA's confidence in overcoming any challenges this new combination may bring.
Deploying a diversified portfolio of more than 45 beverage brands, FEMSA is clearly positioned to capture the lion's share of the fast-growing beverage market in the Americas.
As further opportunities for innovation and integration occur, FEMSA will continue to analyze the potencial for extracting more value from its operations, for the benefit of both the company and the shareholders.
BP www.bp.com/investor_centre
FEMSA ir.femsa.com
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