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How To Play The OTC Pink Stocks

Kristina Zucchi, CFA

Playing in speculative stocks can be both frightening and extremely rewarding. Unlisted stocks that trade over-the-counter can potentially provide the huge “pop” investors desire, but many landmines are along the way. So, not getting “blown up” is critical to achieving a huge portfolio return. In the past, unlisted stocks were quoted on the Pink Sheets. The daily bid-ask paper quotes were eventually replaced, giving broker-dealers the capability to electronically trade and quote prices, so Pink Sheets no longer appropriately described the quotation system. A name change occurred in 2008 from Pink Sheets to Pink OTC Markets, and again in 2011 to the current name of OTC Markets Group.

The OTC Markets are broken into three tiered markets: OTCQX is the highest quality-controlled tier meeting ongoing financial and disclosure requirements. OTCQB is the venture stage with current reporting to a U.S. regulator. The last tier, OTC Pink, is the lowest, “speculative” market tier. The difference in the three levels is denoted by the amount and quality of information provided to investors.

OTC Pink Stocks
OTC Pink, the most speculative marketplace, can still trade some high-quality companies, which for one reason or another are unable to release audited up-to-date financials. For instance, a company undergoing an extensive accounting review may fall on the OTC Pink because it lacks audited financials. But there are also some worthless companies. Because a wide range of companies are listed, each with a unique profile and level of public information, investors need to be even more diligent when selecting stocks from this market.

Stocks listed on the OTC Pink can be either foreign or domestic. They range from fairly strong companies with more in-depth levels of disclosure and regulatory filings to defunct companies and even scams. Domestic companies that list on the OTC Pink often fail to meet one or more listing requirements, although some of these companies are strong, going concern entities. In contrast, many worthless companies are on the list too. Due to the wide range of companies, the OTC Pink has created a tiering system so that investors can more readily judge the business and financial strength of the potential investments. There are three levels based on degree and timeliness of available information. Companies can provide information in three ways:

  1. U.S. reporting standard in which SEC filings or current periodic reporting requirements are completed. Most OTC Pink companies do not follow this standard.
  2. International reporting standard in which non-U.S. companies can provide the same information in English as they do for their home listing on a qualified non-U.S. exchange.
  3. Alternative reporting standard, which is used for companies that do not follow SEC filing but still need to publish basic information to be listed according to Exchange Act Rule 15c2-11. This information is based on the OTC Pink Basic Disclosure Guidelines.

The OTC Pink Three Tiers are as Follows:
OTC Pink Current Information includes companies with publicly available filings made on the OTC Disclosure and News Service by complying with the OTC Pink Basic Disclosure Guidelines. It is important to note that companies are placed on this tier based on compliance with the required level and timeliness of disclosures, and not based on the strength of operations and business soundness.

OTC Pink Limited Information is used for companies with financial reporting issues, companies in bankruptcy or companies in economic distress, as well as companies unwilling to meet the OTC Pink Basic Disclosure Guidelines. To be placed on this tier, companies must have made an SEC filing or have released financial information within the past six months on the OTC Disclosure and News Service.

No Information is the lowest level of disclosure. These companies either have no disclosure of information, or the released information is more than six months old.

Lastly, the OTC Pink has added an additional “warning” signal for investors called the Caveat Emptor. The skull and crossbones symbol used to signal this warning is placed on securities to warn of potential scams, failure to comply with disclosure rules (such as with corporation actions in a timely manner) or other questionable or fraudulent activity.

Making Investment Decisions
Analyzing OTC Pink stocks is an extremely important component of making investment decisions. Technical analysis may be extremely limited and difficult given the nature of the trading and quotation service, since there is no central "exchange" for the securities. This means securities that trade on the OTC Pink have broker-dealers who must communicate and trade directly with each other. This can result in stocks that have less liquidity or wide bid-ask prices. Therefore, fundamental analysis should be performed.

Weeding through the thousands of OTC Pink Stocks to find the hidden gems is made easier by the information tiering system. Devising stock screens is a good way to dwindle down the number of potential candidates. Depending on investment objectives, a top-down screen based on company size, industry, domicile and select financial data, such as level of revenues or profits, can be used.

After the initial top-down screen, investors can apply a more bottom-up approach. Starting with common household names and moving down the narrowed list of stocks, investors can then screen based on financial ratios such as price to sales or enterprise multiple if screening on the Current Information tier, and depending on the stage of the company and information available. One problem that may be encountered is that this information may not be uniformly presented or available, so some legwork is necessary to put it all together.

With the narrowing screens complete, looking for a catalyst for each name will further taper the list of candidates. Catalysts can include any positive news that may propel the stock higher such as a pending legal announcement, a clinical trial, the release of past-due full financial information at the conclusion of an accounting review, a new product, or pending merger or acquisition activity.

By the end of this process, individual stock analysis is needed. Because these companies, in one way or another, have more limited disclosures than the ones filed with the SEC, contacting company management is a critical component to analyzing the business operations and stock potential. Much information can be gleaned from conversations with management teams, and ascertaining the strength of the team and following your “gut” in whether to trust the company is invaluable.

The Bottom Line
The OTC Pink offers a variety of investment candidates including many good companies waiting to be discovered. Recently, the OTC Pink has worked hard to improve the service by tiering companies based on level and timeliness of information. This helps investors steer clear of the defunct and toxic companies that are often no more than scams. This tiering system provides a starting point from which to do fundamental analysis to find strong, healthy companies with potential catalysts that may provide incredibly high returns. Just like any other investment, the key is in doing rigorous homework, and in particular, talking to company management teams, to identify valuable investments.