Avoid These Small Cap Investments


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If you've ever gotten an e-mail tipping you off to "a hot stock that will double tomorrow," thought about buying it but passed, you should probably be thankful.

More times than not, these unsolicited stock pitches are thinly disguised schemes to pump up the price of a stock so the people hyping the stock can dump their shares to you, and move on.

Many of these scams involve stocks that trade on the Pink Sheets or over-the-counter bulletin board stocks (OTC.BB), which is an ideal place for such things because it is a nearly unregulated computer network that matches buyers and sellers. As authorities have clamped down on stocks listed on the New York Stock Exchange and the Nasdaq, it has driven more scammers to over-the-counter stocks.

There is one classification of Pink Sheets and OTC stocks that ARE legit however - and most of these include foreign listed stocks that investors can purchase through U.S. market makers. I want to clearly distinguish between these stocks, and many others that are not established and dependable businesses, and that use opaque markets to take advantage of unwitting investors.

Fellow analyst, Kevin McElroy recently pointed me to an article that discusses the stock returns of OTC stocks. The article examines a recently published paper titled `Do Investors Overpay for Stocks with Lottery-Like Payoffs? An Examination of the Returns on OTC Stocks'.

Authors Bjorn Eraker and Mark Ready examined returns on 11,260 Pink Sheet and OTC Bulletin Board stocks over the period 2000 through 2008. The results were staggering. Here are some of the highlights:

  • Over the sample period, dollar volume of trading in U.S. OTC markets was about $820 billion, with a net loss in capitalization of $180 billion. An investor following a market capitalization-weighted buy-and-hold strategy would have lost 42% over this nine years.

  • The average total return per stock (from the first to last price observation) is about -40%. The median total return is -97%. While 130 stocks have more than a ten-fold increase in value, this 1.8% of the sample is much too small to make up for all the stocks that become nearly worthless. (See the histogram below.)

  • There is little difference between the average performances of delisted and never-listed stocks.

  • Among individual OTC stocks, future returns relate:

    • Positively to initial price, meaning that the cheapest stocks tend to have the lowest future returns.
    • Negatively to prior-month return, possibly indicating mean reversion or pump-and-dump manipulation.
    • Negatively to dollar trading volume, possibly indicating a substantial amount of fraudulent pumping.

The following chart, taken from Eraker and Ready's paper is a histogram of total cumulative returns for OTC stocks between the years of 2000-2008. Basically, the histogram shows that during the sample period, 52 percent of OTC stocks lost over 95 percent of their value, and 83 percent ended with negative total returns.

Only 1.2 percent, or 130 OTC stocks, increased in value by ten times or more. Notice the heavy weighting to the left side, or LOW end, of the 'Total Returns' axis.

With this evidence, why would you ever consider buying a Pink Sheet or OTC.BB stock? The probability of success appears heavily weighted against you.

To buy stocks on these markets, it is imperative that you do a little extra homework and figure out if the stock trades on a foreign exchange and is indeed a legitimate and dependable company. If so, it's Pink Sheet or OTC listing is worth consideration.

If the stock ONLY trades on the Pink Sheets, or OTC, you should do more homework to figure out why the company hasn't yet achieved listing on a major exchange. Because there are certain criteria to achieve a major listing (like minimum share price) some stocks will likely qualify at some point, and these ones may be worth your consideration.

However, many only trade on the Pink Sheets or OTC because they are garbage investments that are not worth your investment dollars.

So next time you think about investing in that sure-fire biotech, or alternative energy stock, listed on the OTC, stop and think about your chance of success. Do your extra homework to qualify the company as a worthwhile investment - you'll be glad you did.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing Stocks
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