Trading in the Pink Sheets and the OTC Bulletin Board (OTCBB) used to have two speeds – slow and slower. Indeed, Anthony Martinez, senior vice president of trading operations at BrokerageAmerica, a market maker in OTC securities, says it was a constant headache. "You had to call around on the phone to find the quotes," he remembers, "and then you had to write them down on a ticket."
The OTC and the Pink Sheets were once ignored by many professional traders. Now, "they're crackling with activity. These markets have become exciting and invigorating," says Nick Ponzio, president & CEO of Hill, Thompson, Magid, & Co., a Jersey City-based market maker in OTC and listed securities.
Ponzio says activity in the Pink Sheets and the OTC Bulletin Board often foreshadows strong performance in other marketplaces. "You see things jumping in the energy field or the small-caps, then you'll often see the same happening later in the large exchanges," he explains. "The Bulletin Board and the Pink Sheets often act as incubators."
So Ponzio says his firm isn't simply betting on individual stocks. Instead it is looking at these two sometimes maligned marketplaces for hints on what sectors are about to turn around.
Until recently, the OTC marketplace was extremely mechanical. For sophisticated traders, this was a sore spot.
Today, the market for these unlisted equities has made huge technical advances. And that has attracted the notice of the big boys. Mutual funds are helping to overcome the problem of these kinds of stocks. Pink Sheet and Bulletin Board entries generally have been thinly-traded and widely misunderstood. Nevertheless, they get around. These illiquid stocks have also been known to show up in mainstream markets such as Nasdaq and the New York Stock Exchange.
Trading on the Bulletin Board and Pink Sheets is contributing to the bottom line at some of the largest dealers on Wall Street. For example, Knight Trading Group reported a 60 percent increase in Bulletin Board volume in October.
"For truly illiquid stocks, the demand for commitment of capital – for actual market-making services – tends to be high," says Ian Domowitz, managing director of Investment Technology Group, which operates the POSIT crossing network.
Still, demand for these risky vehicles is one thing, an understanding of how they work is another. Traders need to appreciate the precarious business of trading in the largely unregulated markets of the Pink Sheets and Bulletin Board. "There's a great degree of risk trading these kinds of names," Ponzio says, "but the rewards can be great."
And for many of those hardy traders who negotiate the netherworld of illiquidity, there's no substitute for the personal touch. "It's a relationship business," says Jack Norberg, chairman of Standard Investment Chartered, a Costa Mesa, CA-based money manager that specializes in closely held, thinly-traded equities. "We don't have high-end electronic trading systems. You've still got to press the flesh." Norberg attends annual shareholder meetings and buys shares directly, in private transactions, and typically holds them until management repurchases them. To Norberg, his unlisted stocks are like "rare coins, antique cars, exceptional paintings and other collectibles."
Market Capitalization
To be sure, the value of stocks traded on the Bulletin Board and the Pink Sheets pales in comparison to the total market capitalization of NYSE and Nasdaq stocks. The Pink Sheets says it handles between $200 million and $300 million per day in stock trades. However, traders still find the OTC marketplace attractive in part because of the opportunity to make a spread.
A recent favorite was J.G. Boswell Co. (BWEL), the world's largest cotton and tomato grower, with some 200,000 acres of actively farmed land, primarily in Corcoran, California, and another 50,000 acres in New South Wales, Australia.
"The company is practically 100-years-old but always very careful about who is let in," says Norberg. "I kept showing up at shareholder meetings until I was invited to invest." Norberg acquired shares in 1997 at approximately $150 each, split adjusted. Trading recently at $400, Boswell is "the best at what it does," says Norberg.
Many others would find Norberg's world difficult. Still, speculative stocks are like their more liquid counterparts in one key respect.
"They're governed by the same best-execution rules," says Ron Schwartz, managing director in charge of Bulletin Board and Pink Sheets trading at UBS Capital Markets. "The difference here is how and where their trading information is delivered."
Displaying Data
The OTC Bulletin Board displays data on some 3,200 unlisted securities, as well as about 230 corresponding market makers, at otc.com. The OTCBB is an independent service of Nasdaq. As of press time, Nasdaq was considering spinning it off. The Pink Sheets, on the other hand, is a privately-owned partnership. It provides quotes on 4,500 unlisted stocks – at pinksheets.com – and on most of the OTCBB stocks as well.
Neither the OTCBB nor the Pink Sheets is a stock exchange. These services simply quote trading data for stocks that don't qualify for exchange listing. They maintain no oversight of or other business relationships with member companies. Fees are paid to the Pink Sheets and the OTCBB by the market makers to quote stocks, and, separately, to advertise their services. Despite the Wild West quality of these marketplaces, both have become popular.
The overall volume of Pink Sheets and Bulletin Board trading has been rising dramatically, and mutual fund managers are getting in on the action. In part, that's a repercussion of the dot-com bust. "Institutions already owned some of these stocks before the companies went bankrupt and were delisted," says Martinez at BrokerageAmerica. "A lot of these companies fell from grace but they're still trading in this arena."
The Pink Sheets and Bulletin Board include some stocks that do not qualify for listing on the Nasdaq or NYSE. Some companies select the Bulletin Board and Pink Sheets over a listing on the NYSE or Nasdaq. Stocks kicked off the NYSE or Nasdaq, for inadequate financial reporting and low share prices, often turn up on the OTCBB and Pink Sheets.
Yet some unlisted stocks are unlisted by choice. They might be small, family-run or emerging businesses that prefer to avoid filing fees. Then there is Nasdaq, which lists its own shares on the Bulletin Board and also quotes them on the Pink Sheets (NDAQ). Now Nasdaq is eyeing a listing of these shares on Nasdaq itself at the same time as it prepares an offering of $100 million in stock. There are also common and preferred shares, limited partnerships, American Depositary Receipts and other securities listed in the OTC markets. Some trade for pennies. Others change hands for hundreds of dollars a share. Examples of this are LAACO (LAACZ), the family-run operator of the Los Angeles Athletic Club, California Yacht Club, and Storage West self-storage facilities, which was recently trading at around $530.
Since "pinks" and "bullies" are both unlisted securities that are highly speculative, there is a tendency to confuse the two. But there are differences between the "pinks" and "bullies."
Quarterly Reports
OTCBB companies must file quarterly financial reports with the Securities and Exchange Commission. This is the same standard for stocks on major exchanges. OTCBB market makers are required to report all transactions within 90 seconds. They can use Nasdaq's Automated Confirmation Transaction Service, or make a phone call to Nasdaq. Since 1999, OTCBB companies that aren't current in their filings get dumped. However, they can remain on the Pink Sheets.
Pink Sheets was started in 1904 when the National Quotation Bureau began printing information about unlisted stocks on pink paper. They have no filing requirements. Practically any fly-by-night company could be included. By contrast, the Bulletin Board was created by the SEC in 1990 as a result of the Penny Stock Reform Act. The law was intended to clean up the market for unlisted stocks.
Messaging System
Total share volume on the OTCBB catapulted some 60 percent in the 12-month period ended August 31, 2004, to an average of two billion shares traded daily. By December 2004, the Pink Sheets' electronic trade messaging system, Pink Link, launched about 18 months earlier, was handling 40 percent of the total share volume of Bulletin Board stocks traded.
Pink Link trading volume currently amounts to 60 billion shares a month, according to Cromwell Coulson, chairman of Pink Sheets LLC. "We have significant business in not only Pink Sheets securities but Bulletin Board stocks as well," he says. "Trading activity is happening."
Why is the business "happening?" There are plenty of reasons why it should not be growing. The business is dangerous, risky and has had a somewhat shady reputation. And who wants the headaches of trading dicey stocks? One key in helping traders use these stocks has been the various transaction service providers.
These order management systems automate much of the trading and reporting process. For Pink Sheets and OTCBB stocks, traders have to document that they've called around and obtained competing prices from at least three brokers. The idea is to find the best quotes for their customers. "Our order management system automatically captures three quotes," says Martinez of BrokerageAmerica.
The Downside
Despite the promises of automation, there could be a downside. Richard Repetto, an analyst at Sandler O'Neill & Partners, notes that as automation becomes more widespread, it could hurt the profitability of trading in OTCBB stocks.
Nevertheless, it's widely assumed that Pink Sheets and OTCBB trading require some human intervention. But advances in technology have made big changes.
For instance, Pink Sheets' Pink Link offers electronic order negotiation and executions. If a broker doesn't make a market in a security, the order can be routed to one that does and then executed by the market maker with the best price.
Pink Link works with the Pink Sheets' Electronic Quotation Service (EQS) to deliver order and execution reports across Pink Sheets' OTC Dealer Software, or a FIX 4.2 connection. The Dealer Software gives traders access to quote montages, dynamic tickers and multiple watch lists. OTCQX, an Internet-based application, enables traders to see, update, and respond to prices electronically. EQS data is also available to subscribers of otcquote.com. Real-time Pink Sheets quotes can be viewed via Bloomberg and Reuters, and displayed on broker dealers' own Websites.
"A lot of the trading of unknown, unloved, illiquid stocks has migrated to the Pink Sheets," says James Brodie, managing director at Carr Securities Corp., a Port Washington, N.Y.-based Pink Sheets market maker. "The execution cost to dealers is cheaper than it is on the bullies." (Carr has been a passive investor in the Pink Sheets LLC.)
To Brodie, the process of matching bid and ask prices works like a funnel. "The two sides often start out far apart but finally come together somewhere in between," he explains.
Brodie concedes that counterparties can be difficult to find. "For the smaller odds-and-ends pieces of stock," he says, "the trading is usually fully automated. The bigger pieces still tend to be transacted over the phone, but you can get an indication through the electronic system of how big you should bid and how much the other guy has to sell."
Perhaps it's not surprising, then, that many of these thinly-traded, high-risk companies are being gobbled up in private placements. "Some companies can only raise capital through direct placements," says Greg Ballard, chief operating officer and co-founder of Knobias Holdings, a Mississippi-based market tracker. The recent popularity of thinly-traded stocks has become the focus of some of the biggest players in the industry. For example, there is Archipelago's ArcaEdge, an alternative trading platform for OTCBB shares.
"All the good things about electronic trading are embodied in it: speed, transparency, anonymity and access to other liquidity points," says Mike Cormack, president of Archipelago Holdings.
Large block trades, which can be executed directly by the buyer and seller, can be split into smaller trades over the course of a day or two. "It's a more labor-intensive process," says Cormack, "but we have order types that are designed for institutions to trade larger sizes and conceal the size of the trade they're trying to accomplish."
In late-November 2004, for instance, ArcaEdge crossed a million shares of Celerity Systems (CESY), a Knoxville, TN-based business development company with a typical display size of 5,000, at $0.0019. In the same month it also crossed 25,000 shares of Owens Corning (OWENQ), the construction-materials supplier headquartered in Toledo, OH, at $5 each. Owens Corning's typical display size is 500 shares.
In the high-tech, high-priced realm, ArcaEdge transacted 20 shares of the satellite-based digital-media provider XM Satellite Radio Holdings (XMSRZ), of Washington, D.C., which has a typical display size of just one share, at $2,873.62.
Yet, despite the platform's success, Cormack agrees that human intervention is still sometimes needed. And he acknowledges the value of market makers. Indeed, because the spreads between bid and ask are typically so wide for these illiquid OTC securities, traders and market makers stand to earn a great deal for their services. Though POSIT isn't involved in Bulletin Board or Pink Sheets stocks, it is active in small-cap, illiquid Nasdaq equities.
For these, Domowitz insists, a crossing network like POSIT is helpful because it's an inexpensive, anonymous and confidential mechanism for locating liquidity. Those seeking to move large blocks – say, several hundred times average daily volume – of thinly-traded securities can do it without advertising their intentions.
That's important when trading these risky equities. Any kind of trading information that goes public can immediately impact share pricing.
"If the full size of an order is published, it could affect the price that the stock trades at," warns Mark Madoff, director of trading at Bernard L. Madoff Investment Securities, which doesn't trade unlisted stocks.
That impact depends partly on the ratio between the published order and the average volume the stock trades in a day, he explains.
If the stock trades five million shares per day, for example, a 10,000-share order isn't likely to have much impact on the valuation. One that trades only 100,000 shares per day, though, could be significantly impacted by a 25,000-share order.
ITG offers pre-trading analysis through its Triton product, to help determine the ideal way to execute a small-cap trade. "Triton helps clients determine what the best methodology for trading might be, based on their own input, the liquidity of the stock, the tone of the market, all kinds of variables," says Chris Heckman, ITG's managing director in charge of sales and trading.
Portfolio Manager
The level of aggressiveness varies. For instance, if a portfolio manager wants to implement a small-cap transaction as efficiently as possible, but not necessarily as urgently as possible, he might follow a longer time-horizon. "Our execution tools will parcel out orders quickly or slowly, depending on the desired outcome," says Heckman.
Often, the best way to disguise orders is to parcel them out throughout the trading day. Here's one approach: Some portions might be routed to an ECN. Another part might go through ITG's Triact algorithm, which essentially functions like POSIT without a time limit.
The effort to transact seemingly ever-shrinking trading sizes can be difficult, according to Heckman. "It's incredibly frustrating to be in markets where execution is always in smaller increments," he says. Without crossing technology, speculative-equity investors would be forced to "represent themselves in multiple liquidity pools, and organize their days so they don't miss liquidity whenever and wherever it becomes available."
Sometimes that liquidity can even be found on the NYSE. Surprisingly, some high-risk, speculative stocks can be found there, too. For example, Lucent Technologies, the Murray Hill, N.J.-based network-infrastructure developer and one-time darling of the tech boom, is still listed on the NYSE though it trades at the valuation of a penny stock.
It is not, however, thinly traded. At just under $4 a share recently, it traded some 50 million shares daily. Yet the NYSE's portion of that trading volume had actually fallen below 50 percent in recent times. Typically, NYSE's market share in the trading of its own stocks is closer to 80 percent. Some investors, who trade Lucent despite its volatility, tend to use electronic trading services, including online brokerage accounts and ECNs.
The secrecy of breaking up large orders is a two-edged sword. "For small-cap securities, the published quote isn't necessarily indicative of the full interest," says Madoff. "A large order of a small-cap stock might require the technical wherewithal of a human trader and/or somebody who is familiar with the historical trading patterns of that stock."
One reason: Only a human expert can know, "where there may or may not be interest, and evaluate that level of interest," Madoff says. "A smart trader needs to probe where interest might be."
Hidden Pockets
The search for hidden pockets of liquidity can be aided by an understanding of the particular security's trading history. "An institutional player who was a buyer of a stock yesterday," says Madoff, "might still have an interest in buying it today."
So, given this potential for repeat business, Pink Sheets and OTCBB liquidity can become more plentiful.
"There are more intranets between different market centers than ever before," says BrokerageAmerica's Martinez. Illiquid stock trading is dramatically changing. The days of slow and slower may soon be nothing but a bad memory. -reporting by Ben Mattlin
There's Silver in Them Thar Hills!
The opportunities for big gains – and the extraordinary degree of risk – largely define the market in speculative stocks. Penny stocks are the most volatile. For instance, take Sterling Mining Co. (SRLM). Traders who in June 2003 snapped up shares of the 100-year-old silver producer based in the small town of Wallace, Idaho, at $0.52 a share, might have held their breath when it soon signed an agreement to develop the neighboring Sunshine Mine. Shortly afterwards, rich silver deposits were unearthed. Sterling stock catapulted to $14 by February 2004, before slipping to $5 more recently. Patience also rewarded those who snatched up shares of pioneering e-tailer CDnow in the summer of 2000, at about $2 a share – off nearly 90 percent from its high. Then German media giant Bertelsmann AG bought the company for just over $3 per share, a 50 percent profit for the stalwart. -Ben Mattlin
