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The Truth About Price Differences Between ADRs and Their Home Shares

ADRs trade at a premium to share prices in their home countries for more reasons than being overvalued.

More questions from readers, this time about numbers that don't seem to add up.

Malik Jaffar asks about Taiwan Semiconductor (TSM) - Get Free Report . Shares of the company sold in the U.S. through ADRs, or American depositary receipts, are "sinking to levels that look attractive on paper right now." However, Jaffar says that the ADRs are trading at a higher price than the shares sold in Taiwan. That, he deduces, could mean Taiwan Semiconductor is actually too expensive on the U.S. market because the ADR price usually will move toward parity with the home price.

Like many tech companies, Taiwan Semiconductor has had a rough year. Adjusted for a May split, it is down 45% this year. Taiwan Semiconductor's decline can be attributed to a number of factors, including the impact of slowing global growth on sales and concerns over the potential for conflict between Taiwan and China.

But let me focus on the second issue, the difference between the price between the ADR and the home share.

Theoretically, there should be no such disparity. ADRs are certificates representing a certain number of shares of a foreign company that are deposited in a bank here. The bank has bought the actual shares, but investors here trade the ADR certificates that represent those shares, not the actual shares. ADRs were created as a convenient way for U.S. investors to access foreign companies, and for those companies to have access to U.S. capital. The price of the ADR is supposed to be the same as the underlying share.

However, there is often a difference between the two prices. There are essentially three situations in which an ADR might trade at a premium or discount to an underlying share, says Tom Sanford, a vice president in the ADR department at the Bank of New York, the largest holder of ADRs.

First, investors might pay a premium for less risk with the ADR. In many emerging markets, for example, where settling trades can be an exasperating process, investors might feel more comfortable buying an ADR than trying to buy a local share. Because there is more demand for the ADR, the price will go up.

Second, differences in liquidity between the two markets can explain the price discrepancy. "Wherever there is more liquidity, it will drive the price," says Sanford. "The other market will have to catch up." That in fact will usually occur as arbitragers, typically large, institutional investors, try to play the disparity.

The third situation that could trigger a price difference between an ADR and a local share is a restriction on the number of shares that can be owned by foreigners. With a limited number of ADRs available, demand in the U.S. can boost the price over that of the home market.

That is the major reason for the higher price of Taiwan Semiconductor in this country: Taiwan has significant restrictions on foreign ownership of stocks and on the size of the ADR program. Thus, the higher price of the Taiwan Semiconductor ADRs is not necessarily a signal the stock is too expensive; it's just that there is a limited number of ADRs available.

Theoretically, it is possible for a retail investor to try to take advantage of the premium or discount, just as professional arbitragers do. That won't be possible in a situation involving Taiwan, where there are limits on foreign ownership. But it is difficult for the retail investor to identify those arbitrage opportunities and take advantage of them before the big guys do, not to mention the expense and difficulty of buying shares in foreign markets directly.

"You should buy ADRs for the same reason you buy U.S. stocks -- because they are either growth or value," says Sanford. "Trying to play an arbitrage will probably backfire 99 times out of 100."

David Kurapka's Global Portfolio column appears Mondays, Wednesdays and Fridays on TSC. In keeping with TSC's editorial policy, he does not own shares in any companies or mutual funds mentioned in this column. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send it to David Kurapka.