Quality Companies Move to the Pink Sheets

Published by Buyside

For most public companies, being “in the pinks” has been a stigma to be avoided at all costs. Savvy investors viewed these stocks as a “pink flag” signifying that the company was in trouble. And for years, the pink sheets were inhabited primarily by over-hyped and often worthless penny stocks foisted off on unwitting investors looking for that one cheap investment that was going to make them wealthy. Others were troubled companies  just passing through on their way to oblivion.

But a change is taking place. In recent months, trading volume in pink sheet stocks has increased dramatically, surpassing volume on the soon-to-be-disbanded OTC Bulletin Board. While still nowhere near the tremendous trading volumes of the NYSE or Nasdaq, trading in pink sheet stocks has approached 300 million shares a day. It’s important to keep that figure in perspective; on a recent day in late May, the value of all those trades was slightly more than $100 million, or about 33 cents per share. In contrast, volume on New York’s Big Board has averaged more than 1.4 billion shares daily.

“When the bulletin board is gone, many small companies will have no place to go but the pinks,” says Andrew Berger, editor of Walker’s Manual of Unlisted Stocks, which claims to be the only definitive guide to quality pink sheet companies. Walker’s book delivers detailed research on what he believes are the 500 best companies listed.

Analysts with Walker’s Manual comb company Web sites, look for news and annual reports, and talk to company officials. Even so, there is often relatively little information available. These are very small companies, typically between $5 million and $50 million in revenues, emphasizes Berger.

The public U.S. markets are becoming a far less hospitable place for these small companies than they were just a few years ago. The many new regulatory, auditing and board requirements imposed by Sarbanes-Oxley add tens if not hundreds of thousands of dollars to the cost of being an SEC-regulated public company. Not to mention the foreboding requirement that a CEO must personally guarantee his company’s financial statements, and is subject to large fines and even imprisonment if someone fudges the sales figures.

Then too, the scandals on Wall Street have forced significant cutbacks in analyst coverage. Always an issue for smaller companies, there is now even less coverage than before, unless companies choose to buy it themselves. More and more, executives of small companies, already hammered by a weak economy, find themselves asking whether it is worth it to continue to be publicly traded. Increasingly, they are deciding that it is not. Every week, it seems quality companies announce their decision to de-list and become pink sheet stocks.

The Last Stop
And today, Enron (ENRNQ.PK), WorldCom (WCPMQ.PK) and Global Crossing (GBLXQ.PK) are among the denizens of the pink sheets, too. Part of the pink sheets’ image problem is that it remains the last stop for delisted, usually financially destitute companies on their way to liquidation. In fact, there are seven classes of Enron stock listed there.

Technology companies no longer able to meet Nasdaq listing requirements — especially the $1 minimum price, although the market has waived that standard in recent months — have found themselves in the pink sheets in the past couple of years. But Berger is skeptical, warning that for most, “it’s just a stop on the way to the bottom.” Experts warn that there are lots of troubled companies in the pink sheets, and while there may be opportunities there, it’s a highly specialized area.

OTCBB Unplugged
Experts agree one more force is likely to drive even more companies to pink sheet status. Nasdaq is working on a plan to phase out the Over-the-Counter Bulletin Board market, currently populated by several thousand small companies, in favor of a new “Bulletin Board Exchange,” or BBX. The BBX is currently scheduled to launch next year.

The popular OTC Bulletin Board is an electronic trading service operated by Nasdaq. It began requiring companies traded over the service to file regular financial reports in January, 1999; before that, many “non-reporting” companies populated its rolls. Many of the higher-quality stocks to be found there issue annual reports, quarterly financial statements and press releases announcing material events that may impact their prices, even though they are not required to do so, and even maintain investor-friendly investor relations departments.

The Price of Being Public
But now, Nasdaq is preparing to up the ante. In an effort to remain solvent, the Nasdaq market plans to charge an annual fee of $5,000 for listings on the new BBX exchange. In addition, companies that choose to be included on the new exchange must meet a new, tougher series of regulatory requirements that are very similar to those imposed by Sarbanes-Oxley on SEC-listed companies. National market listing fees are expected to triple.

All that paperwork can be very expensive — as much as $150,000 to $300,000 a year, according to Greg Ballard, chief operating officer of Knobias Holdings, which provides detailed financial data on some 13,000 U.S. companies to both professional and retail investors. Knobias started out offering hard-to-find data on bulletin board and pink sheet companies, and later expanded its service to include companies traded on the major exchanges, too.

“The companies are like, ‘Whoa, wait a minute, why would we do this?’” Berger says. And they’re moving on down. As of June 4, some 3,949 companies were listed exclusively in the pink sheets (a figure that increased by more than 100 in two weeks), and just 437 on the bulletin board. Another 3,092 were quoted on both, according to statistics posted at www.pinksheets.com.

Ballard finds the turnaround to be somewhat ironic; Knobias added coverage of the NYSE- and Nasdaq-listed companies when interest in smaller firms waned during the Internet boom. Today, he says, there’s a great deal of increased interest because his firm is one of a select few that offer data on pink sheet firms.

Small company executives will have to choose between the unregulated, relatively inexpensive pink sheet lists, and the more onerous requirements of the new BBX exchange. Those who see few benefits associated with the cost and regulatory burdens of the public exchanges are likely to migrate to the pink sheets, experts say.

Banking on Value
As with all fringe marketplaces, there are notable exceptions to the “typical” pink sheet company. These include the occasional quality company working its way toward a listing on one of the respected exchanges, or a thinly-traded firm owned mostly by family or employees that saw no reason to pursue the status, headaches and costs that come with being a public company. Companies with fewer than 500 shareholders, for example, are not required to file financial reports with the SEC.

Too often, companies listed on the pink sheets are tainted with what Coulson calls “guilt by association.” Is there more quality in pink sheet companies today than there was a few years ago? “I think quality is down across the board,” Coulson says.

For example, there are many community banks listed in the pink sheets. For these companies, the lack of SEC regulation is not so significant an issue as it might be with others. Everything banks do is already tightly regulated by the U.S. Comptroller of the Currency, providing a level of regulatory oversight that is far more exacting than that imposed by the SEC.

Then too, there are American Depositary Receipts (ADRs), the instrument used to trade shares of foreign companies that choose not to list their stocks on U.S. exchanges. Swiss chocolate-maker Nestlé is one of the best-known foreign companies that trades in the pink sheets.

A third category that some believe is worth exploring are preferred stocks of some major public companies that trade in the pink sheets. Tootsie Roll Industries (NYSE:TR) has a preferred class B stock (TROLB.PK) that trades only in the pink sheets.

Pink Sheet History
In 1904, the National Quotation Board (www.nqb.com) was founded to create a system for trading the stocks of small companies. Brokers listed the stocks they had to offer and their bid and ask prices on yellow and pink paper — and the market has been known ever since as the pink sheets. That tradition has only recently begun to fade into an electric pink glow. Pink Sheets LLC acquired the exchange several years ago, and in 2000 introduced an online service where pink sheet stocks can be traded electronically.

Now, as the OTC Bulletin Board fades into history, Pink Sheets Chairman and COO Cromwell Coulson hopes his exchange will replace it, becoming the preferred method of trading for companies that choose to opt-out of the more regulation-laden BBX Exchange.

“It’s going to become a more important part of the marketplace,” Coulson says. “The pink sheets will provide a better forum with more liquidity and more stocks. We now provide a better platform than the bulletin board does today, anyway.”

HIDDEN VALUE
The pink sheets’ checkered reputation can work to the advantage of careful investors, say market makers. Joseph Reilly is the resident pink sheet expert at Robotti & Co., a New York brokerage that makes a market in a number of pink sheet firms.

The very act of de-listing and moving to the pinks can cost a stock as much as half its value, according to Berger. But in the case of a solid company, often nothing has changed materially to justify that drop. And just as the stock may dive on its way into the pinks, a move out — to full listing, or through an acquisition, for example — can provide a similar bump.

Reilly grew up with pink sheets. His father was one of the founders of Tweedy Browne Co., one of the first brokerage firms to specialize in little-known value stocks found in the pink sheets. Today, Reilly is one of the few analysts who focus on the unlisted marketplace, although that could change if the pink sheets grow as expected.

Reilly likes Burnham Holdings (BURCA.PK), a Lancaster, Penn. maker of boilers and heating and air conditioning system components. The company has long been a pink-sheet favorite, and for good reason: “They pay a dividend, and they always make money,” Reilly says. The company reports its financials regularly, and has seen its stock rise dramatically this year.

He also recommends liquor distributor American Mart Corp. (AMRT.PK) for its steady growth. But here’s a company that might scare off anyone concerned about liquidity issues. As of June 1, American Mart’s stock had last traded for $299.50 per share — on Oct. 8, 2002.

Another pink sheet market maker, Jeff Herr, senior vice president of Chicago’s Howe Barnes Investments, likes Limoneira Co. (LMNR.PK), a 110-year-old grower of citrus fruit and avocados in California’s San Joaquin Valley, for its steady growth and large share of the avocado market.

Caveat Emport?
The good news is that “pink sheet companies are below everyone’s radar,” says Jay Suskind, director of trading at Ryan Beck & Co., a Florida-based, mid-size brokerage that makes a market in a number of community banks and thrifts that trade in the pink sheets. Investors aren’t competing with the interests of large institutions or mutual funds. For the most part, those groups are prohibited by their charters from trading in pink sheet stocks.

While those institutions are generally sound, Suskind offers the warning any investor considering pink sheets needs to be aware of: These are thinly traded, illiquid stocks. That may work for buy-and-hold investors, but it’s tough for those who want to be able to get in and out quickly. It’s not unusual for some pink sheet stocks to go without a single trade for weeks at a time.

Another pink sheet market maker, Tom Walker of Pennaluna, notes that trading in pinks is not for the casual investor. He believes it is better suited for fund managers and professional investors. Based in Colorado, Pennaluna specializes in mining stocks — long a staple of the pink sheet realm, and one where some of the market’s most dubious players can be found.

Another area Pennaluna specializes in, and one where there has been a lot of interest recently, is Canadian stocks. Many Canadian firms — legitimately listed and traded regularly on exchanges north of the border — use pink-sheet status to attract U.S. investors while avoiding the regulatory morass that comes with listing on the major markets here, Walker says.

“There are hidden gems there that people often overlook,” Reilly says. “But you can’t make a living trading them.” With those warnings in mind, “there are lots of jewels in the pink sheets,” Suskind says.

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