Finding stocks that will return higher than average is difficult, and because markets are efficient, information is readily reflected in stock prices. Investors, therefore, need to find the diamond in the rough. For this reason, some investors turn to Pink Sheets stocks to find a security that can return multiples of its basis.

Pink Sheets is a daily publication of bid-ask stock quotations for companies unable or unwilling, for one reason or another, to be listed on a major, national exchange. The Pink Sheets name came about because historically, the paper the quotes were printed on was pink. The fact that Pink Sheets is a quotation service and not an exchange requires investors to do their due diligence before trading in these over-the-counter (OTC) stocks. Investors should follow several rules to ensure the investments are sound and the purchase or sale of a stock are at expected prices.

Who Participates on the Pink Sheets?
Roughly 15,000 stocks trade on the Pink Sheets, ranging from small speculative companies to large foreign companies. Companies trade OTC for several reasons. One could be that a company fails to meet listing requirements for the major stock exchanges. Some of these companies are de-listed from the major exchanges, often for lack of financial information, or some fall off after their stock drops under $1. Another reason is some foreign companies do not want to meet the filing and listing requirements of the major U.S. exchanges when they already meet the requirements in their home country. These foreign companies would have to hire a team of regulatory and legal personnel who are experts in U.S. security law and filing requirements. This is expensive, especially considering the companies already have a similar team to handle the requirements to list in their home country. Therefore, these companies decide to list on the Pink Sheets. Household names like Nestle, Nintendo and Volkswagen are three examples of quality companies that list on the Pink Sheets.

Upsides and Downsides to OTC Stocks
There are upsides to investing in Pink Sheets stocks. One advantage is that some of the quality names like those mentioned above pay dividends and would be very sound investments. Another advantage of Pink Sheets stocks lies in their inexpensive prices. Some shares can be bought for less than $1.

In contrast, there are some downsides. Pink Sheets stocks lack liquidity and are often thinly traded, which can make them volatile. The bid-ask spread is wide, and investors need to be patient and cautious when putting in any buy or sell order. In addition, despite some of the quality companies, many are worthless. Because Pink Sheets is not an exchange, but a quotation service, it is unregulated and can therefore result in scams or other potentially harmful investments. Minimal to no transparency or fundamental information is available for many of the stocks, while some are subject to various schemes. The Pink Sheets also disallows margins and short selling, which can be either a positive or negative depending on the investor's viewpoint. As a result of the aforementioned downsides, investors need to be cautious.

Buyer Beware!
Investors should be aware of four cautions. First, most OTC stocks do not meet the minimum requirements for most exchanges and do not file with the SEC. Therefore, credible and reliable fundamental data are not available for analysis. Second, historically Pink Sheets stocks are penny stocks and are often near-insolvent companies. Third, some stocks are illegitimate shell companies set up to scam investors by issuing press releases, and having “analysts” promote the stock and issue more worthless shares. Fourth, Pink Sheets only has one requirement for a company to list - a company needs to have one market maker quoting its stock. The listing companies do not have to provide any financial information at all.

One common scam involving OTC investors is the pump and dump scheme where promoters buy penny stocks, promote and push up the prices for other investors and then dump their stocks while the late investors are stuck with worthless stock that they overpaid to own. These stocks are often promoted in spam emails or on message boards and blogs.

Trading Tips
The Pink Sheets has attempted to do away with many of the downsides associated with the service. One way is by starting a premium listing service called OTCQX. This service has three different levels of trade minimums, and companies need to meet some or all of the requirements for being listed on a major exchange, including posting quarterly and annual reports and making public all relevant information. Despite these new service levels, investors should follow some simple rules when trading on the Pink Sheets. These include doing your homework and knowing the company you are investing in. Just like when investing in any stock, investors should look for catalysts that will cause a potential investment to go up. Examples of catalysts include any upcoming news that will go in favor of a company, such as a legal battle, the potential for a merger or acquisition and a new product or service that will increase profits. Investors also need to set limits on the level of investment and sell signals. In addition, using a limit order instead of a market order should reduce the concern of volatility because the stocks are thinly traded.

Bottom Line
Pink Sheets stocks offer exciting opportunities to increase portfolio returns by large magnitudes in a short time. However these opportunities come with significant risks. Investors need to be extremely cautious and diligent with research and analysis of each investment. Setting up strict investment guidelines and using limit orders when trading will decrease the potential risks. The Pink Sheets listing is ripe with many worthless companies, some of which are pure scams. Finding the hidden gen is particularly difficult but can be very rewarding.

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