Tired of paying ridiculously high multiples for a stake in hot growth companies only to see their share prices get clobbered? There are alternatives. While the NASDAQ market was taking a recent beating--down almost 20% from its high in May--another section of the over-the-counter market was quietly chugging along, seemingly immune from earnings disappointments and fickle investors.
Hidden among the shadows of celebrated NASDAQ superstars such as Microsoft is a less well-known part of the OTC market, the "pink sheets." They're a compilation of the bid and ask prices of some 20,000 stocks, most of which aren't listed on any exchange. Often associated with bankrupt firms and penny-stock scams, the pink sheets are also home to some 300 bona fide moneymakers that have been trading at discounts to their book value in relative anonymity. Many are household names such as mapmaker Rand McNally and Houlihan's Restaurant Group.
ILLIQUIDITY. These companies are all but ignored by the professional investment community, and many outfits want to keep it that way. Although most have had a public offering, families and officers control much of the stock, so they're not eager for new shareholders. A dearth of information and lack of liquidity are why many of the stocks are undervalued, says Binkley Shorts, senior vice-president at Wellington Management in Boston.
Until recently, learning anything relevant about these closely held, thinly traded companies has been next to impossible. "These aren't companies you can just ask your average broker to investigate for you," says Edward McLaughlin, a professional investor in Vero Beach, Fla.
Now, however, a reference book is available that sifts through the junk that litters the pink sheets. It offers investors a window into this oft-murky market. Walker's Manual of Unlisted Stocks (800 932-2922, $75) contains four years' worth of financial details on 500 companies that list their stock in either the pink sheets or on the OTC bulletin board, a real-time quotation service for 5,500 companies. "None of these companies is under any obligation to report to the Securities & Exchange Commission (SEC). But if they don't, they can't list on any of the major exchanges," says Peter Salmon, the NASDAQ's assistant director for trading and market services. In addition to per-share data--such as price-earnings ratios, book value, and dividends--the guide lists the market maker for each issue and tells whether a regular stockbroker or pink-sheet specialist is required. More than half of the companies in the book don't report to the SEC, so you won't find their financials in databases such as the SEC's EDGAR.
While publisher Harry Eisenberg, a CPA in Lafayette, Calif., has done the legwork, even becoming, in some cases, a shareholder in the nonreporting companies to gain access to their data, he cautions readers that the book is only a starting point. It's a secondary source, so you'll need original financial statements and reports to make sure the data is up to date. Many of these companies look good on paper, but because they're insular and secretive, they can be prone to malfeasance or reversals of fortune. "You have to take a hobby approach to investing in this area," says Jack Norberg, a pink-sheet specialist and president of Standard Investment in Tustin, Calif. "This is not for the passive person."
Indeed, the traditional investment rule applies: Buy only what you know. Shorts, once the manager of a mutual fund that specialized in OTC stocks, says investors should consider this area only if they have a thorough understanding of the company and find doing all the required research "fun." For example, a race-car fan might want to check out International Speedway Corp., which runs racing events at major tracks.
LOCAL BANKS. How else can you discover these low-profile companies? Trade publications are a good source of ideas. Local business journals often carry quotes of bulletin board stocks, most notably some of the 10,000 banks that trade in the OTC market. Walker's Manual lists 60 small community banks with strong balance sheets and exceptional earnings, says Eisenberg. For example, Lancaster National Bank returned more than the average for small-bank stocks in 1995. But its stock traded at only four times earnings and 58% of its book value at yearend.
Whether you choose to look into an unlisted local bank or a company within a certain industry, you can narrow your choices using the indexes in Walker's. Here, companies are ranked by a number of measures, including market capitalization, p-e ratio, price-to-book value, and compound revenue growth.
Once you find a stock that appears undervalued, don't take Walker's word for it: Call the company. Some may readily send you information. Others may be less cooperative--or even hostile. If so, be wary. "It's a big problem if management doesn't have any interest in husbanding the interest of minority shareholders," says Shorts.
The more knowledgeable you are, the better protected you'll be against the biggest risk associated with these investments: illiquidity. Finding buyers isn't the problem. "When shares become available, it's like throwing a handful of chicken feed into a coop: Everyone dives for it," McLaughlin says. Even more worrisome is the steep spreads between the bid and ask prices. "Many are bid-only market orders, so the stock creeps up in price without a transaction ever taking place--as market makers try to trump each other's bid," Norberg says.
"GET RICH." Without the proper information, first-time investors may not only pay a higher price for the stock but may also get less for it when they eventually sell. "The trading aspect is so difficult it's beyond the experience of most individuals and even most brokers," says Charles Royce, who manages two closed-end mutual funds, Royce Value Trust and Royce Micro-Cap, which hold 5% of their assets in OTC stocks. One way to protect yourself: Never put in an open order to buy at market--because you'll often end up paying more. Also, you're more likely to get a good price at the end of the month, when market makers update the pink sheets, says Eisenberg, who has 15% of his net worth in these investments.
Once investors understand the risks, they may discover what prominent value strategists such as Mario Gabelli have long understood. "These aren't necessarily `feel-good' stocks, where you buy them and watch them go up. But if you do it right, these really are get-rich stocks," Gabelli says. He should know. In 1993, Michael Ferrucci, director for corporate finance at Barclay Investments in Providence, heard there was a block of stock available in Providence Journal Co. Privately owned since the early 1800s, the newspaper had evolved into a multimedia conglomerate--exactly the type of media play Gabelli specialized in. Even though there was a huge spread between the bid and ask prices, he suggested Gabelli buy the shares. Three years later, the stock has returned in excess of 85%, and Gabelli believes it's still undervalued. "After going public in June, the stock is up 21%--despite the market being hammered," Ferrucci says.
Granted, few investors have Gabelli's contacts or resources. But that doesn't mean they can't learn from his experience. By sticking to an industry he knew well, Gabelli was able to ascertain that despite the big spread, the company was exceptionally undervalued.
Remember that unlisted companies are long-term plays. The stocks often don't trade every day--but then they're not subject to short-term influences. Think of it this way: You won't be tempted to watch the ticker, and your stomach won't rise and fall with the stock market, either.