In the Pink: OTC Stocks Offer Peril Along With Potential Profit

By Justin Sharon  AUG 02, 2012 12:45 PM

Among the illiquid microcaps sit some of the biggest and most prestigious companies on earth, including Rolls Royce.

 


MINYANVILLE ORIGINAL The unlikeliest characters, it appears, can resist everything except the temptation provided by pink sheets, that often seedy underbelly of investing. It’s a corner of the Over the Counter (or OTC) market that compelled Larry Wilcox, none other than Erik Estrada’s upstanding law-enforcement sidekick in the hit '70s TV show CHiPs, to commit a crime. Meanwhile, one Michael O’Brien Pickens was earlier arrested for pilfering some $300,000 of ill-gotten gains from a similar securities fraud, never mind that -- as his father is a billionaire -- he surely didn’t need the money.

If pink sheet stocks and their ilk often conjure up images of unscrupulous snake oil salesmen peddling worthless "pump and dump" issues to unsuspecting widows and orphans in shady back-office boiler rooms, the reputation is not entirely undeserved. Many of these equities are indeed illiquid micro caps whose financials are at best an educated guess and often downright deceptive. They are very much buyer beware and at your own risk, and any get-rich-quick delusions are quickly disabused.



Strange Bedfellows

Yet the OTC market is also home to some of the biggest and most prestigious companies on earth. These include Rolls Royce (RYCEY), that byword for luxury that last month reported a profit of almost $1 billion. Riding right alongside it in the fast lane is Bentley and Lamborghini owner Volkswagen (VLKAY), having just announced its own 18% profit increase. Even before bidding goodbye to the Bs, we encounter British Sky Broadcasting (BSYBY), France's BNP Paribas (BNPQY), and German car giant BMW, formally known as Bayerische Motoren Werke Aktiengesellschaft (BAMXY). (Any headache arising from trying to spell that one can be quickly alleviated with an aspirin by Bayer (BAYRY), itself also quite literally available over the counter.) Deutsche Telekom (DTEGY), Nintendo (NTDOY), Nestlé (NSRGY), and Roche (RHHBY) are among many other major market caps to trade OTC while often eschewing formal American Depository Receipts (ADRs).

As this list illustrates, firmly established foreign firms often find themselves strange bedfellows under the pink sheets with financially troubled domestic companies. Taken together, these two groups combine for the overwhelming majority of the segment's top trading volume. Overseas outfits invariably opt to list OTC rather than on large exchanges including the NYSE (^NYA) as a way to cut operating expenses. An annual Over the Counter listing is typically obtainable for only about $15,000, as opposed the Big Board’s six figure sum. Along with enticing American investors, another key OTC attraction for an international organization is being able to avoid the sort of stringent red tape required by exchanges, regulations made increasingly onerous in the wake of Sarbanes-Oxley laws enacted after Enron's collapse a decade ago.

Important Distinction

Neither broad Over the Counter bulletin board shares nor pure pink sheets trade on a formal exchange, and many constituents of the former can also be found on the latter's quotation system. Yet while the terms are often tossed around interchangeably, invariably seen as a distinction without a difference, there is an important contrast to draw between these two investment Rodney Dangerfields. OTC stocks must comply with certain minimal listing requirements and file assorted financial forms with entities including the Securities and Exchange Commission (SEC), although these stipulations are certainly less stringent than those enforced on either the Nasdaq (^IXIC) or NYSE.

By contrast, pinks often operate in an environment akin to the Wild West, where anything goes and oversight and corporate governance are negligible. Such securities need do little more than file a perfunctory Form 211, safe in the knowledge that they remain largely under the radar of the SEC, whose already-stretched resources are focused almost exclusively on entities with more than $10 million in assets and over 300 shareholders. On a single day this May, the agency did, however, suspend trading in a record 379 shell companies it found ripe for fraud, suggesting a longstanding "too small to jail" attitude from the Feds may be about to end.

Of course, not all companies on the pink sheets are fly-by-night penny stocks, generally defined as anything under $5 per share. Some are eminently trustworthy, but too tiny to trade elsewhere, or demoted by famous firms, temporarily or otherwise, after falling from favor. Iconic American outfits that have been booted from major exchanges to pink sheets purgatory after dropping below minimum listing requirements include post-bankruptcy incarnations of Eastman Kodak (EKDKQ) and General Motors (GM), which in 2009 traded as Motors Liquidation Company under ticker (MTLQQ.PK). (Any stock symbol ending in ".PK" serves as a scarlet letter indicating it's a pink.) 

Born 99 years ago in 1913

The pink sheets began life in 1913 as a daily price and information directory published, as the name implies on pink paper, by the National Quotation Bureau. Each page contained scores of stocks in alphabetical order, with the publication eventually running to more than 300 pages. It was basically a book where many stories abruptly ended in Chapter 11, such was the dire financial predicament of many protagonists on its pages. Each morning, over 2,000 financial professionals received the latest edition, a Herculean undertaking in a pre-Internet era. Indeed, until Nasdaq arrived on the scene in the early 1970s, the periodical was the only reliable resource for OTC equities.

A century later, approximately 10,000 stocks continue to trade on the pink sheets, although the process is, of course, now unrecognizably automated -- and its corporate parent embarked upon a major re-branding effort last year. In an effort to remove any taint of pink slime and aim for at least the appearance of increased exclusivity, privately held Pink OTC Markets morphed into OTC Markets Group in early 2011. The company is presided over by one Cromwell Coulson, a distinctly blue-blood-sounding CEO and onetime trader for Carr Securities who purchased it fifteen years ago.

 

Starting in 2007, OTC Markets began segmenting its offerings into separate tiers. The top listing service, known as OTCQX, encompasses best-of-breed outfits including Adidas (ADDYY), Danone (DANOY), and Wal-Mart de Mexico (WMMVY). Some 385 firms currently qualify for this upper echelon, representing total volume of $66,822,518. Strict requirements regarding financial reporting, annual revenue, and market capitalization must all be met to merit inclusion. Further down the totem pole, we find more speculative ventures, which OTC Markets signposts with a cautionary red "Stop" warning, and here considerably more investor vigilance is required.

Skull and Crossbow

The lowest of the low are signified by a skull and crossbow logo, where outright fraud may have occurred, financial information is essentially non-existent, and investors purchase strictly at their own risk. Mr. Coulson maintains that only about 2% of total dollar volume is derived from such highly risky endeavors. Still, approximately 2,991 equities amounting to $15,993,569 in activity presently fits this bill. The marvelously misnamed 99 Cent Stuff (NNCT), last seen trading at around $0.008, and Wham Inc. (WFMC), which can be had for about $0.0352, are typical of offerings available here.

Investing in either of these two last-mentioned stocks arguably amounts to little more than glorified gambling, the investor’s version of Russian roulette. Yet instances of pink sheets delivering dreamy profits, while rare, are the stuff of Wall Street legend. One classic case involved book publisher Doubleday, acquired in 1988 for fully $4,100 per share. Only two years earlier, the stock traded for just $500, a take-out premium made all the more impressive given that the '87 crash occurred in the interim. (Such steep prices may not be what one typically associates with pink sheet equities but, because such companies often have a comparatively small number of shares outstanding, each stock can sometimes command six figures.) Any investors who owned Doubleday were indeed, in the words of a movie soundtrack from the era, Pretty in Pink.

More recently, rehabilitation hospital provider HealthSouth (HLS) suffered the indignity of a delisting to the pinks in 2003, having seen its stock sink to all of $.08 amid accusations of accounting fraud. Its shares, brought back to the Big Board once they were again above $5 at the end of its spell in the investment "sin bin," currently trade at around $22.

Lawrence J. Goldstein

A world away from the nefarious dealings of Larry Wilcox with which we began our story is another Larry, one who has conceivably done more than anyone in the investment community to unearth the hidden gems lurking among the dross. The very mystery and limited knowledge surrounding the Pink Sheets, where some illiquid stocks change hands so spasmodically the joke is they "trade by appointment only," has created an interesting and profitable specialty for some players. Among the small group of investment professionals who have build businesses by focusing on this area is Lawrence J. Goldstein. A reputation as an "analyst's analyst" at Drexel Burnham Lambert led him to found Santa Monica Partners, where the ethos is: "In niches, there are riches." Here his team digs deeply into the minutia and arcane details of so-called "neglected" and unloved companies for clients. The aim is to profit from any undervaluation that often arises from such stocks having habitually been, as the money management operation puts it, "Overlooked or ignored by otherwise intelligent investors."

Goldstein first began gathering green files on some 16,000 previously under-followed pink sheet firms while he was a researcher with Drexel in 1974, at about the time Master of the Universe Michael Milken was starting his spectacular rise (all, of course, destined to end in tears) at the same firm. While the junk bond king came to symbolize an entire era's Bonfire of the Vanities excess, by contrast Goldstein worked away in relative obscurity only a few floors away. The initial database was built on the back of copious photocopies and arranged alphabetically with, in his words, "an army of eighth graders." This was about as far removed as possible from the go-go aura of Drexel depicted in the book Predators' Ball.

Where a $3,000 Initial Investment Grew to Over $100,000

Yet the toil reaped rewards, notably with one company called Overnite Transportation, where a $3,000 initial investment at $3.50 per share eventually grew to over $100,000 when it later moved to the NYSE. (The company was eventually acquired and is now owned by United Parcel Service (UPS). The stock's name is, in fact, exceedingly ironic: It invariably takes years to become an overnight success in this sector. Indeed Goldstein himself has been known to wait half a decade before finding a seller for some pink sheet stocks, many of which tend to be relatively lumbering old-line outfits with scant trading turnover. But patience and persistence has paid off, with Santa Monica Partners having actually outperformed the S&P 500 Index (^GSPC) since its inception in 1982, the year history's biggest ever bull market began in earnest.

So are pink sheet stocks as impenetrable and dangerous as The Dark Side of the Moon, in the words of a famous title track from Pink Floyd? Or merely Missundaztood, to quote the second studio album of pop singer Pink? Probably a bit of both. Should you wish to sleep at night, pure pink sheets are probably best avoided.

They are undoubtedly risky and often speculative ventures, characterized by extreme volatility and suitable only for the most financially sophisticated. Vast differentials can occur between bid and ask prices, and market makers are often missing in action. Any potential purchaser must also be prepared to do ample amounts due diligence and homework. And heaven help the investor who buys into any excessive praise emanating on a stock from fake message boards, which tout highly hazardous securities with all the urgency of those spam email campaigns made on behalf of Nigerian banks.

That said, those who dismiss the broader OTC market entirely may be missing out on potential opportunities, especially in the form of some world class foreign companies currently hiding in plain sight. Perhaps, with the Olympics now upon us, pink sheets should be indulged in as a spectator -- as opposed to participatory -- sport. For if nothing else, as Minyanville pointed out during the depths of the financial crisis, their trading activity can often act as a reliable contrary indicator.

No positions in stocks mentioned.

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