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 there are many landmines are along the way. Therefore, 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 the term 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.
OTC Markets are divided into three tiered markets: OTCQX is the highest quality-controlled tier for meeting ongoing financial and disclosure requirements. OTCQB is the venture stage requiring an annual verification and management certification process. The last tier, OTC Pink, is the lowest, speculative market tier. There are no required financial standards or disclosure requirements in the pink market. The difference in the three levels is denoted by the volume and quality of information provided to investors.
Stocks Listed on the Pink Market
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. Since 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 Pink Market 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 its own hierarchy 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 the following ways:
- SEC reporting standard in which companies are in compliance with their SEC reporting requirements. Most OTC Pink companies do not follow this standard.
- U.S. bank reporting standard in which companies are in compliance with their bank regulator reporting.
- 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.
- 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 Three Tiers of Pink Stocks
This tier 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.
This tier is used for companies with financial reporting issues, companies in bankruptcy or 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.
This tier 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 “stop” sign for investors. This category includes defunct companies that have ceased operations as well as 'dark' companies with questionable management and market disclosure practices. Stocks labeled with the stop sign are not willing to provide information to investors and should be treated with suspicion. Their securities should be considered highly risky.
How to Analyze Pink Stocks
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 narrow 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 reduce 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 determining the strength of the team while 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.