By: Polux Díaz
Director of the Program Master’s Degree in Finance, ITAM
When a Company wishes to grow and does not have the necessary means to make it happen, it should resort to the capital markets. You can be obtain funds there in two ways: with debt by obtaining a bank credit or by issuing some kind of bond in the market and the second is by issuing stock. A severe problem found when using this last method is the few means investors may have to acquire shares of the Company in the Mexican market, but this does not mean that the Company is in bad conditions or that its shares are not attractive, it is simply due to the fact that the number of investors that can acquire shares in a market like the Mexican is low, so they may not be willing to acquire more shares either because their funds are invested or simply because they may think is not attractive enough to acquire them.
What to do in such a case? You can always decide to try to use another security that is not a debt instrument. However, such a decision could get a company into trouble because it forces the market to accept something it does not want. There is another alternative quite unexplored by Mexican companies: to issue stock in a market that is not the “Mexican” exchange; a market that is full of different kinds of investors and where they are hungry for different instruments (depending upon the risk-return profile they may offer); for example the U.S.A. market.
What is an ADR?
The right way for Mexican companies to be listed in the New York Stock Exchange is with American Depositary Receipts (ADR). The way to do it is to contract with a “sponsor” bank where the stocks issued are deposited and in exchange the bank issues the ADRs. Since often the Mexican stock prices when converted to U.S. Dollars are very low as compared to market prices, the ADRs have an aggregate rate that can be 10 to 1. This means that each ADR issued represents 10 shares. Thus, the price is more appropriate for the market. There are four different kinds of ADRs that can be issued in the United States; Table 1 shows its main characteristics.
Table 1
Characteristics of the ADRs traded in the United States.
You can appreciate that both Level II and also Level III refer to public ADRs, while Level I and 144ª refer to private issuances.
What Are The Advantages Companies Have When They Use ADRs?
There has been a great deal of debate as to whether the use of ADRs has an advantage both for companies that use them and also for the stock market in general. Companies ask themselves the following question: Why should I invest up to US$2,000,000 to issue stock in another country? With all the follow-up given to public companies by financial institutions in the United States, how much more will I have to spend to generate information? Is there really a difference in issuing in the United States, asides from raising capital?
Apparently, there are several benefits associated to the issuance of capital when using ADRs, and although the literature is not definite on its conclusions, it does leave the door open for Mexican companies to assess the use of this instrument not only as another way to obtain funds, but also because of the potential associated benefits.
Perhaps the most important and also the most controversial benefit is the fact that apparently, when companies use ADRs, their value increases. Doidge, Karolyi and Stulz (2004), find that the q of Tobin (Tobin-q), a generally accepted measure as representative of the creation of value is 16.5% higher for companies that are listed in other markets as compared to those that have presence only in their local market. However, this is debatable since Miller (1999) finds that this effect exists, but it greatly depends on the place selected to issue ADRs (United States vs Europe), the way it is done (if it uses or not a public level) and finally the local market where the issuing Company is located. For Miller, only companies that issue in the NYSE and do it using Level III ADRs (raise new capital), shall be the ones that will increase their value.
This improvement is not only in the perception of value, it is apparently also in the stock price. And the big question is Why?. What makes these companies have better prices than similar companies that do not have ADRs? The answer seems to be very simple: How these companies are perceived, improves significantly when ADRs are used in other markets. Since the information disclosure rules are (generally) much more strict in the United States than in other countries such as México, when the firms issue Level II and Level III ADRs, the companies bind themselves to disclose much more information than their local markets demand they do. Since this has been done voluntarily, the market interprets this as a good signal and rewards them by acquiring their shares. Consequently, they are quoted at a higher price than similar companies that do not have ADRs.
And this is one of the advantages that impacts not only the company that issues the ADRs but also the entire market. The more companies issue ADRs, in the United States and in other developed markets, the more information that will be present in the market, and in general it will be more transparent. Consequently, new companies will want to issue in the local market, etc. One can appreciate how a virtuous circle has been created and it has excellent repercussions in the country.
One of the more interesting effects seen with the ADRs is the one related to liquidity and volatility in the local market. Intuitively, one could think that the ADRs provoke a reduction in the liquidity and an increase in volatility. This is because when you have two markets where the same good is quoted, if one wishes to sell the position it has in a stock and in the local market the prices are high, it can always go to the United States and sell the equivalent in ADRs, and this causes a reduction in liquidity. Regarding volatility, since the stocks are in the U.S. where they are subject to many external shocks, some of them could be “contagious” to the stocks in the local market and this causes an increase in volatility. It is interesting to see that both effects seem to be mitigated by the competition between the two markets, and thus the spread between the purchase price and the selling price is smaller; therefore, the result is an increase in liquidity and a decrease in volatility (Domowitz, 1998).
There are many intrinsic benefits in issuing ADRs. One of them is that when the company needs money and since there is a great deal of information about it, it will be easier for the market to correctly value the instruments that it will issue, and the result of this is that its capital cost decreases slightly (Doidge, Karolyi y Stulz, 2004). But the true gain comes from the fact that the capital markets are open when the firm needs them, and it will not have to pay an over-cost that companies that do not have ADRs, have faced.
Everything Seems Perfect, but …
As can be seen, there are many advantages to the issuance of ADRs, specially when they are Level II and Level III. The literature supports this kind of instruments and apparently there are many gains for the companies and for the market in general. Therefore companies should issue ADRs, frequently without even needing the capital but rather due to all the additional benefits they may have. But, don’t go so fast! Are these really only gains? There is no evidence against them
Fernandes and Ferreira (2008) made an investigation of companies that have their equity listed in several markets and their conclusions are interesting. When the emerging economies are analyzed, they have found that the advantages mentioned in this article are true, but apparently this is true provided the companies come from more developed markets. When emerging economies are analyzed, apparently the advantages are not seen and thus the result is entirely the opposite. They say that the market’s “informative environment” (everything that leads to analyze the financial information: the analysts, the rating agencies and even the investors themselves) is deteriorated because those “educated” investors (or institutions) migrate to markets where ADRs are traded, and this causes that investors that have less analysis capacity, stay in local markets. This, instead of improving the valuations and perceptions of the company, causes a completely opposite effect. All that has been mentioned above regarding the volatility, liquidity and valuation is reverted, given the fact that the market participants do not have the capacity to adjust their estimates because the company’s capital is being traded in several markets. The result is smaller valuations, capital cost increases in capital and in the operating costs of the Company.
Conclusions
The issuance of ADRs in the American market represents a formal alternative for companies to obtain funds. It can give them a solution they did not have, access to cheaper capital and at the end to have secondary repercussions that impact their cost of capital and the general perception in the market. But it seems that this only happens if the Mexican financial market improves the information efficiency terms and the number of participants of those companies that are listed in it and also of the investors that participate in it.?
References
Doidge, Craig ,Karolyi, A., Stulz, R. (2004). “Why are foreign firms listed in the U.S. worth more?”. Journal of Financial Economics 71, 205-238.
Domowitz, I., Glen, J., Madhavan, A. (1998). “International Cross Listing and Order Flow Migration: Evidence from an Emerging Market”. Journal of Finance 53 (6), 2001–2027.
Fernandes, Nuno, Ferreira, M. (2008). “Does International Cross-Listing Improve the Information Environment”. Journal of Financial Economics 88, 216-244.
Miller, Darius. (1999). “The market reaction to international cross-listings: evidence from depositary receipts”. Journal of Financial Economics 51, 103-123
Pagano, Marco, Roell, A., Zechner, J. (2002). “The geography of equity listing: why do companies list abroad?” Journal of Finance 57 (6), 2651-2694.
The Use of ADRs in Mexican Companies: Is It Worthwhile To Try It?
By: Polux Díaz
Director of the Program Master’s Degree in Finance, ITAM
When a Company wishes to grow and does not have the necessary means to make it happen, it should resort to the capital markets. You can be obtain funds there in two ways: with debt by obtaining a bank credit or by issuing some kind of bond in the market and the second is by issuing stock. A severe problem found when using this last method is the few means investors may have to acquire shares of the Company in the Mexican market, but this does not mean that the Company is in bad conditions or that its shares are not attractive, it is simply due to the fact that the number of investors that can acquire shares in a market like the Mexican is low, so they may not be willing to acquire more shares either because their funds are invested or simply because they may think is not attractive enough to acquire them.
What to do in such a case? You can always decide to try to use another security that is not a debt instrument. However, such a decision could get a company into trouble because it forces the market to accept something it does not want. There is another alternative quite unexplored by Mexican companies: to issue stock in a market that is not the “Mexican” exchange; a market that is full of different kinds of investors and where they are hungry for different instruments (depending upon the risk-return profile they may offer); for example the U.S.A. market.
What is an ADR?
The right way for Mexican companies to be listed in the New York Stock Exchange is with American Depositary Receipts (ADR). The way to do it is to contract with a “sponsor” bank where the stocks issued are deposited and in exchange the bank issues the ADRs. Since often the Mexican stock prices when converted to U.S. Dollars are very low as compared to market prices, the ADRs have an aggregate rate that can be 10 to 1. This means that each ADR issued represents 10 shares. Thus, the price is more appropriate for the market. There are four different kinds of ADRs that can be issued in the United States; Table 1 shows its main characteristics.
Table 1
Characteristics of the ADRs traded in the United States.
You can appreciate that both Level II and also Level III refer to public ADRs, while Level I and 144ª refer to private issuances.
What Are The Advantages Companies Have When They Use ADRs?
There has been a great deal of debate as to whether the use of ADRs has an advantage both for companies that use them and also for the stock market in general. Companies ask themselves the following question: Why should I invest up to US$2,000,000 to issue stock in another country? With all the follow-up given to public companies by financial institutions in the United States, how much more will I have to spend to generate information? Is there really a difference in issuing in the United States, asides from raising capital?
Apparently, there are several benefits associated to the issuance of capital when using ADRs, and although the literature is not definite on its conclusions, it does leave the door open for Mexican companies to assess the use of this instrument not only as another way to obtain funds, but also because of the potential associated benefits.
Perhaps the most important and also the most controversial benefit is the fact that apparently, when companies use ADRs, their value increases. Doidge, Karolyi and Stulz (2004), find that the q of Tobin (Tobin-q), a generally accepted measure as representative of the creation of value is 16.5% higher for companies that are listed in other markets as compared to those that have presence only in their local market. However, this is debatable since Miller (1999) finds that this effect exists, but it greatly depends on the place selected to issue ADRs (United States vs Europe), the way it is done (if it uses or not a public level) and finally the local market where the issuing Company is located. For Miller, only companies that issue in the NYSE and do it using Level III ADRs (raise new capital), shall be the ones that will increase their value.
This improvement is not only in the perception of value, it is apparently also in the stock price. And the big question is Why?. What makes these companies have better prices than similar companies that do not have ADRs? The answer seems to be very simple: How these companies are perceived, improves significantly when ADRs are used in other markets. Since the information disclosure rules are (generally) much more strict in the United States than in other countries such as México, when the firms issue Level II and Level III ADRs, the companies bind themselves to disclose much more information than their local markets demand they do. Since this has been done voluntarily, the market interprets this as a good signal and rewards them by acquiring their shares. Consequently, they are quoted at a higher price than similar companies that do not have ADRs.
And this is one of the advantages that impacts not only the company that issues the ADRs but also the entire market. The more companies issue ADRs, in the United States and in other developed markets, the more information that will be present in the market, and in general it will be more transparent. Consequently, new companies will want to issue in the local market, etc. One can appreciate how a virtuous circle has been created and it has excellent repercussions in the country.
One of the more interesting effects seen with the ADRs is the one related to liquidity and volatility in the local market. Intuitively, one could think that the ADRs provoke a reduction in the liquidity and an increase in volatility. This is because when you have two markets where the same good is quoted, if one wishes to sell the position it has in a stock and in the local market the prices are high, it can always go to the United States and sell the equivalent in ADRs, and this causes a reduction in liquidity. Regarding volatility, since the stocks are in the U.S. where they are subject to many external shocks, some of them could be “contagious” to the stocks in the local market and this causes an increase in volatility. It is interesting to see that both effects seem to be mitigated by the competition between the two markets, and thus the spread between the purchase price and the selling price is smaller; therefore, the result is an increase in liquidity and a decrease in volatility (Domowitz, 1998).
There are many intrinsic benefits in issuing ADRs. One of them is that when the company needs money and since there is a great deal of information about it, it will be easier for the market to correctly value the instruments that it will issue, and the result of this is that its capital cost decreases slightly (Doidge, Karolyi y Stulz, 2004). But the true gain comes from the fact that the capital markets are open when the firm needs them, and it will not have to pay an over-cost that companies that do not have ADRs, have faced.
Everything Seems Perfect, but …
As can be seen, there are many advantages to the issuance of ADRs, specially when they are Level II and Level III. The literature supports this kind of instruments and apparently there are many gains for the companies and for the market in general. Therefore companies should issue ADRs, frequently without even needing the capital but rather due to all the additional benefits they may have. But, don’t go so fast! Are these really only gains? There is no evidence against them
Fernandes and Ferreira (2008) made an investigation of companies that have their equity listed in several markets and their conclusions are interesting. When the emerging economies are analyzed, they have found that the advantages mentioned in this article are true, but apparently this is true provided the companies come from more developed markets. When emerging economies are analyzed, apparently the advantages are not seen and thus the result is entirely the opposite. They say that the market’s “informative environment” (everything that leads to analyze the financial information: the analysts, the rating agencies and even the investors themselves) is deteriorated because those “educated” investors (or institutions) migrate to markets where ADRs are traded, and this causes that investors that have less analysis capacity, stay in local markets. This, instead of improving the valuations and perceptions of the company, causes a completely opposite effect. All that has been mentioned above regarding the volatility, liquidity and valuation is reverted, given the fact that the market participants do not have the capacity to adjust their estimates because the company’s capital is being traded in several markets. The result is smaller valuations, capital cost increases in capital and in the operating costs of the Company.
Conclusions
The issuance of ADRs in the American market represents a formal alternative for companies to obtain funds. It can give them a solution they did not have, access to cheaper capital and at the end to have secondary repercussions that impact their cost of capital and the general perception in the market. But it seems that this only happens if the Mexican financial market improves the information efficiency terms and the number of participants of those companies that are listed in it and also of the investors that participate in it.?
References
Doidge, Craig ,Karolyi, A., Stulz, R. (2004). “Why are foreign firms listed in the U.S. worth more?”. Journal of Financial Economics 71, 205-238.
Domowitz, I., Glen, J., Madhavan, A. (1998). “International Cross Listing and Order Flow Migration: Evidence from an Emerging Market”. Journal of Finance 53 (6), 2001–2027.
Fernandes, Nuno, Ferreira, M. (2008). “Does International Cross-Listing Improve the Information Environment”. Journal of Financial Economics 88, 216-244.
Miller, Darius. (1999). “The market reaction to international cross-listings: evidence from depositary receipts”. Journal of Financial Economics 51, 103-123
Pagano, Marco, Roell, A., Zechner, J. (2002). “The geography of equity listing: why do companies list abroad?” Journal of Finance 57 (6), 2651-2694.