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I've posted a number of micro cap value ideas on the blog recently. Companies this small tend to trade "over the counter" (OTC), i.e. on the pink sheets or other venues that are not exchanges.

This is something that has negative connotations. Stocks are generally traded OTC because they are unable to meet an exchange's listing requirements or because they are unwilling to pay listing fees and conform to the exchange's regulations.

I was reading a study, "Do investors overpay for stocks with lottery-like payoffs? An examination of the returns on OTC stocks", that looked at how these OTC stocks do over time. The study finds that most OTC stocks are money losers, which I agree with, although this is emphatically not true about the deep value situations that we look at on this blog. [For example, Conrad Industries (OTCPK:CNRD), which has risen over 40% since I first posted about it.]

The sample in the paper covers the period from January 1, 2000 through December 31, 2008. They found that

[T]he median total cross-sectional return in our sample is an astonishing -97%. [ ... M]ore than half (53.8%) of the stocks in our sample lose more than 95% of their value over the sample period. 84.8% of the stocks have negative total returns. The table also shows that 117 stocks have more than a ten-fold increase in value. But this is only 1.8% of the stocks in the sample - far too small a fraction to make up for all the stocks that become nearly worthless.

This is actually good news from the perspective of a value investor trying to find underpriced companies on the pink sheets. A distribution that is so lopsided will cause many investors to shy away from the market completely. The study authors even recommend this:

"In the aggregate, investors in the OTC markets lost about one hundred and eighty billion dollars over our sample period ... We think the size of the capital loss in the OTC market along with the very substantial negative annualized rates of return we document suggest that individual investors are well advised to stay far away from OTC stock markets, unless they possess substantial ability to gather fundamental information ... "

Many of the market participants are there to buy stock promotion scams. Also, there is a very large fraction of retail investors that buy and sell securities, including OTC stocks, with out any regard to valuation whatsoever. Concepts like capital structure and cash flow multiples are outside of their experience. This leaves the actual value investments ignored and unloved!

For example, as Gannon puts it, there can be a company on the pink sheets that is

"an old, family controlled company with tons of retained earnings in some mundane business ... If it's hoarding cash, it's usually doing it for the same reasons a big cap company hoards cash. Management has few options in the existing business and doesn't know much about putting money to work elsewhere. They aren’t doing right by shareholders. Paying the cash out would be better. But they probably aren’t criminals either. They’re probably just humans running a no-growth business that throws off more cash than they can use."

This was basically the story with Conrad, and with George Risk (OTCPK:RSKIA), and a number of other microcaps that are net current asset value plays. So, we will continue to look for profitable companies on the pink sheets with huge margin of safety (thanks to very low enterprise values) and low valuations.

Source: A Look at the Returns on OTC Stocks