For the past year and three months, I ran a newsletter focused solely on the Over-The-Counter (OTC) market in the US.
During that time, I scoured the notoriously inefficient market for companies that are meaningful and exhibit an investment opportunity. No frauds, no pump and dumps. Only companies that are of interest for the serious enterprising investor (I tip my hat to Mr. Graham).
I like to think that I looked at every company in the OTC market at least twice. I went the A to Z route a couple of times, I maintained many simple screeners, I tracked Form 25s, 15s, and much more. Given the sheer size of the market, one can't be completely sure of his/her coverage of the market, but I believe my reach is formidable.
This allowed me to gain a good overview of how the market functions and what are key factors to consider when investing. It also allowed to test my initial thesis about the market. That is that the market is investable for the dedicated investor.
I believe that my experience has supported my initial thesis. This can be best seen through analysis of my long ideas in the space. Note that two of my ideas were already acquired. HRZCA was acquired at a 747% premium and TWOC at a 14.86% premium. I do not include them in this analysis.
Performance & Volume Analysis
Note: The tickers that are shown here are public because I show them in the samples of my work. The last three are not included in the sample, but I wanted to show them in order to explain what was the issue there.
You can see that 14 stocks now have meaningful performance. Meaningful volume was present at a strong majority of stocks (43 out of 56).
Only 10 stocks now have problematic performance, however, only three of them really saw events that would completely destroy any potential upside and invalidate my thesis.
The worst performer is Premier Exhibitions (OTCPK:PRXIQ) which was a relatively complicated legal play, any investor that would analyse the thesis would understand the risk of this being severely impaired. The thesis was really based on a binary outcome.
The same goes for Bagger Dave's (OTCPK:BDVB), which was a spin-off that would either survive and the discount to tangible book would be unreasonable or they would not be able to rightsize the business and they would have to shrink considerably.
Alabama Aircraft Industries (OTCPK:AAIIQ) is similar to PRXIQ as this was (to an extent still is) a legal play that would be decided over a complicated lawsuit of the surviving entity against Boeing (NYSE:BA). The stock is also illiquid and thus the performance at one point in time is not really reflective of what is happening.
The stock that is down 36% in my view still represents an investment opportunity and fundamentals do not explain the current performance.
The stock that is down 34% is an NOL shell play, performance of these entities can be negative during the waiting period for the catalyst.
Furthermore, the stocks that have registered positive performance have rarely seen volatile trading whereby the shares would jump up and down.
This can be seen in the following table where you can see highs and lows (in %) of each stock since the initial report.
However, the fact that they are down now usually does not mean that the thesis has played out completely and investment opportunity could still be present.
Community Bank Portfolio
During my time working on the newsletter, I also created a portfolio of 20 community banks. These entities are an interesting sub-market in the OTC land which is routinely showcasing meaningful investment opportunities.
The performance of the portfolio is so far positive and showcases similar characteristics to the broader long ideas. The portfolio was built in June of this year.
As a whole, the portfolio is up by 4.85%. You can see that meaningful volume was again achieved by a majority of stocks (11 out 20). This volume was achieved in about four months which is positive.
As with the long ideas, there was little volatility in terms of the high/low performance.
Academic papers on OTC performance
My performance shows that OTC is investable and interesting returns can be harvested.
It is obvious that there is a hard limit on the size of a portfolio that can be invested here given the overall volume (rather arbitrary figures of $10 million to $15 million could be used here).
Therefore, the investability and performance aspects apply to portfolios below that size.
These results run contrary to the popular belief that the OTC market is the opposite of what my analysis has shown. Uninvestable and loss-making.
I would repeat one specific argument that is frequently used and seems solid at first glance. That is academic research.
One can point to papers such as 'Outcomes of OTC investing' by the SEC or 'Asset Pricing in the Dark'. For example, this SA author has done exactly that. These point to the absolute underperformance of the stocks in the OTC market and point out that generally, you stand to lose money.
The studies are objectively correct.
If you look at the whole market, it is no wonder that you would lose money because you are going to include the classic pump and dumps or meaningless stocks which weigh down the minority of fundamentally sound businesses.
However, no one experienced would try to invest in the whole OTC market. You need to carefully choose a minority of stocks that you want to look at. I highlighted 351 stocks in my newsletter while the OTC market counts roughly 7,000 or 8,000 US-based stocks.
By doing this selection, you are applying your own subjective view about whether the stock is meaningful or meaningless.
Academic papers are unable to do that because they would have to try to define meaningless companies or try to have a system to identify pump and dumps. I understand that they try to limit their pool of stocks through several objective measures, but these tools (volume and reporting etc.) are not helpful.
Thus, all they can do is be objective in a market where no one is. A classic problem of academia.
It should be clear that the OTC market is investable.
There are limitations for large portfolios, but for a dedicated enterprising investor with prior experience, the market presents an interesting 'pond' to fish in.
My volume and performance analysis of meaningful OTC companies should fully support this assertion.
Also, do not forget that many serious OTC investors are not incentivized to speak about the profitability of the market much.
Do you know why? Because it lessens the number of opportunities in the market. It is as simple as that. The more people will know about an interesting OTC stock, the worse in some cases as the volume is the key.
Please be sure to note that I am not saying that the OTC market is suitable for everyone whose portfolio is below $10 million.
There are many unique risks that one has to properly understand, but this is again tied to personal capabilities (prior experience, due diligence ability etc.) and circumstances (liquidity preference, portfolio etc.).
Disclosure: I am/we are long GANS, VULC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.