Another warning sign for the bubble: Paying more for the same stock in different markets

It is easy to find bearish investors who argue that one stock or another, or even the entire market, is priced far above its true value. Usually, this is a matter of opinion, but not in the case of SK Hynix stock, the darling of the South Korean technology industry, which was recently listed for trading in New York.

Earlier this month, the chipmaker issued, to applause, American Depositary Receipts (ADRs) — in addition to its long-standing listing on the South Korean stock exchange. Each new depositary receipt is backed by one-tenth of a share traded in Seoul, and it can be converted into the South Korean share with relative ease.

However, no sane person would choose to do so, because the shares traded in the US are trading at a significant premium compared to their price in South Korea, after adjusting for the exchange rate.

This is another sign of the excessive enthusiasm surrounding artificial intelligence stocks. Since the ADRs began trading two weeks ago, their premium has ranged from 16% to 51%. American investors are paying a high price for the convenience of purchasing the memory chipmaker's stock in New York instead of finding a broker willing to trade shares listed in South Korea. This reflects a broader willingness to pay an exorbitant price for chip stocks in general, and memory stocks in particular.

The unusual premium on American depositary receipts is exactly the kind of phenomenon that should not happen in markets. The prices of haircuts or hotel rooms, for example, can be very different from place to place because they cannot be moved. But stocks are a virtual asset that can be transferred instantly, so arbitrage traders usually exploit significant price gaps between dual-listed stocks to make a profit.

The problem is that there is no possibility of risk-free arbitrage between the shares traded in South Korea and those traded in the US. Although the depositary receipts can be converted into shares traded in South Korea, regulatory restrictions make it difficult to convert them back, and even make it impossible without the company's approval.

In a normal situation, a premium of 29%, like the one recently recorded, would lead hedge funds to buy shares in Seoul, convert them into ADRs, and simultaneously short the receipts in New York. However, the lack of the ability to convert them back leaves hedge funds exposed to heavy losses if the premium continues to grow.

Uncontrolled demand

For investors looking to purchase the stock and hold it for a long time, there is a simple choice: if you have to pay 29% more for the same asset, it is worth investing the effort and cost involved in purchasing the South Korean stock via a phone call to a broker (most large trading firms in the US do not offer online trading in South Korean stocks).

The situation for professional traders is different. From their perspective, there must be an explanation for the existence of the premium.

Part of the premium is indeed justified. In South Korea, there is a tax on stock trading, while in the US there is no such tax. In addition, trading costs in the US are lower, and custody costs for securities are cheaper. The fact that the ADRs are priced in dollars also saves American investors the need to hedge against exchange rate fluctuations. Paul Foley, head of portfolio management for the Europe, Middle East, and Africa region at Dimensional Fund, notes that depositary receipts are also more tax-efficient than South Korean stocks held in American ETFs.

All these justify a premium of a few percentage points. The ADRs for Taiwan Semiconductor (TSMC), which are also difficult to arbitrage, have a longer history. In the decade between 2010-2020, they traded at an average premium of 3.2%. As long as the premium remains relatively stable, there is no obstacle to purchasing the receipt, because it is likely that the premium will still exist when the time comes to sell it.

However, the premium on TSMC's depositary receipts surged during the post-COVID market bubble, and again when the demand for AI investments led American investors to bet on Nvidia's chip supplier. Since the launch of ChatGPT in 2022, the premium on TSMC's tracking receipts has averaged 15% after American investors proved they were willing to pay much more than their Taiwanese counterparts.

The scale of the premium on SK Hynix stock indicates uncontrolled demand for trading chip stocks in the US, even more than in South Korea, where trading driven by fear of missing out (FOMO) has long since become a phenomenon. According to UBS's HOLT valuation models, this phenomenon is also evident in regular stocks, where American technology stocks, and especially chip stocks, trade at a much higher valuation than comparable technology stocks in Asia. However, it is difficult to compare valuations. American ADRs are essentially receipts for shares traded on other exchanges, and therefore they allow for a direct comparison.

What will hurt investors?

A high premium on ADRs does not always herald disaster. In 2008-2009, the high premium on TSMC tracking receipts was due to the fact that the price of shares in Taiwan fell more sharply than the price of the receipts.

Markets are not perfectly efficient, but they are quite efficient. In the end, enough investors will realize that with a little effort, one can purchase the same stock at a much lower price in South Korea, or the company will issue additional American tracking receipts to exploit the premium, or the enthusiasm will fade.

Those who purchase the ADRs will not be hurt if the premium drops because the shares in South Korea close the gap. But they will be hurt if the company uses the shares in the US as a piggy bank, and they will suffer more if the premium shrinks because chip stocks in South Korea and the US plummet. And in the meantime, the premium can do anything, including continuing to grow significantly.

This article was translated by Globes exclusively from The Wall Street Journal.