In the financial world, there are generally two types of publicly traded companies. There are those that are traded on the NYSE, NASDAQ, or other large exchange, and then there’s…the other companies. These other companies still issue stock, but that stock trades “over the counter.” That means their securities are traded via a broker-dealer network rather than through one of the large exchanges.
These OTC securities are also known as “pink sheets,” due to the color of the paper their listings were once printed on, and many also qualify as “penny stocks,” since they trade for under a dollar a share. Whatever you call them, they’ve not always had the best reputation. Unscrupulous brokers and traders have long seen their cheap prices, lack of public data, and poor liquidity as an invitation to use them in pump-and-dumps and other schemes.
That’s all changing now thanks to OTC Market Group and the SEC. OTC Market Group has made great strides in classifying and providing transparency for OTC securities, and the SEC has significantly increased its regulation of OTC markets.
The result of these efforts is that more investors are interested in OTC securities and see them as viable investment opportunities. To introduce these new investors to the OTC world, I’ve put together a list of the five most common types of company that trade over the counter.
Some start-ups need the capital that going public provides but don’t have the financial track record, balance sheet, or large enough compliance department to jump through the hoops required to be listed on a large exchange. A lot of these companies turn to the OTC markets to raise funds.
Finding the next big tech company listed among the pink sheets is every investor’s dream. The truth is that most OTC growth companies never fully pan out, but who doesn’t like a longshot or two in their portfolio?
Some large foreign companies actually trade OTC in the US, simply because they are already listed in their home country and don’t feel the need to pay all the compliance costs that come with also being listed on the NASDAQ or NYSE in the US. Examples include Nestle, Heineken, and Air Canada (incidentally the worst airline I’ve ever flown).
This unfortunate group is made up of once-prominent companies that fell on hard times and were delisted by their stock exchange. Companies can be delisted for a number of reasons, but the most common is that their stock prices fall to the point that they no longer meet minimum price or market cap requirements. Other reasons include bankruptcy or failure to make required filings.
These companies still have securities out there to be traded, despite their delisting, so they end up trading OTC. There is the occasional redemption story among these types of companies, but more often than not they remain in OTC purgatory or go out of business.
Some businesses are small by design. Either due to management’s lack of ambition or just the niche nature of the business. These companies also need capital from time to time, but they will never rise to the thresholds required to be listed on the NYSE. They will be traded OTC for as long as they’re a going concern.
OTC shell companies were a big target in the SEC’s latest attempts to regulate OTC markets. A lot of shell companies listed on the pink sheets are no longer engaging in whatever their original business was but still have assets. The company is more or less dormant but they still have a quoted price.
Who would ever buy such securities? No one, unless they were duped. Shell companies are notorious for being used in pump-and-dump schemes because there’s very little available public information about them, but they still seem to be a legitimate business. The fraudsters can use this blank canvas to paint any sort of rosy picture they want in order to drive up the price. By the time everyone else realizes the stock is worthless, the scammers have already cashed out.
As a result of these market manipulations, the SEC is now requiring far more disclosure from shell companies. If the shell companies don’t comply, it will no longer be legal for anyone to provide price quotes for them, essentially destroying the market for their stock.
How to buy OTC Securities
OTC securities are pretty simple to buy, especially if you already have a brokerage account. Most, but not all, brokers allow you to purchase OTC stocks just as you would any listed stock. OTC Markets Group maintains a list of regulated OTC brokers that offer OTC securities. Always double-check that list before trusting a new broker.
Before you make an OTC transaction,the SEC requires your brokerage firm to inform you of the additional risks associated with OTC stocks.
Risks and rewards of buying OTC Securities
Before you invest in OTC securities, you should always keep in mind that penny stocks are penny stocks for a reason. Before that stock hit the pink sheets, the mainstream financial world had taken a look and decided to put their money elsewhere. To find that diamond in the rough, you will have to be right where everyone else was wrong.
If you’re looking at more short-term gains by day-trading, that too carries additional risks. OTC stocks are still very easily manipulated by scam artists, despite the great strides taken by the SEC. They also suffer from liquidity and transparency issues.
In short, there is significantly more risk with trading OTC stocks than with trading listed securities, no matter how you trade them. Do not start trading OTC securities without carefully analyzing the risks and rewards.
So what about those rewards? Risk goes up, reward goes up, right? Indeed, but those who made their fortunes over the counter by legitimate methods had one thing in common—they understood how the OTC market works. Do your research, and perhaps you’ll also find your fortune among the pink sheets.