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The ABCs of the OTC BB

Often I get e-mails about my opinion on small stocks. Of course, in many cases, I've never heard of the company (nor really want to). Most of these stocks are on the so-called Over-the-Counter Bulletin Board (OTC BB). My advice: in many cases, stay away.

NASDAQ is a major exchange, which has rigorous listing requirements. A company needs a minimum amount of assets, shareholders, float, market capitalization, market makers, etc. The NASDAQ is divided into the National Market System and the SmallCap Market, with the former having higher listing requirements.

Now, below this is the OTC BB, as well as the Pink Sheets. The Pink Sheets do not have an automated quote system (rather, trades were traditionally printed on actual pink sheets). OTC BB stocks are posted on machines.

The OTC BB market has no listing requirements. In fact, companies usually become part of this market from the "back door," that is, a reverse merger.

Here's how it works: Company X has public shareholders and trades lightly. However, the company has no assets or liabilities. It is a shell. Then, there is a private company, called Y, which wants to be public. So, it will merge itself into X, but rename the company Y. Unlike an IPO, this process does not result in any capital. But many of these companies will then attempt to raise money in private offerings (such as to high-net worth individuals), in expectation that NASDAQ listing requirements will be met. But this is a rare event.

Why should investors be wary of the OTC BB? There are several reasons:

  1. Liquidity: Since many companies do not have big Wall Street firms backing them, there is light volume in the stocks. What's more, there is little or no research coverage
  2. Regulations: The OTC BB is loosely regulated. As a result, the market is subject to manipulation. One popular technique is the "pump and dump." Investors will drive the stock price up and create a frenzy and then cash out.
  3. Hype: To gain exposure, OTC BB companies have a tendency to engage in hype. You may see many -- almost outlandish -- press releases (saying things such as "We are the next Cisco"). Also, these companies usually pay Web sites to cover their stocks
  4. Leverage: Many OTC BB companies have low amounts of cash. Thus, it is difficult for them to adequately execute on their core business
  5. Trading Restrictions: Most of the major brokerage firms have trading restrictions on their brokers, barring them from recommending OTC BB stocks (because of the high risks and potential liability exposure)

Of course, there are legitimate companies on the OTC BB. Unfortunately, it is not easy to tell. Typically, you can determine this by visiting the company or knowing the individuals personally. This actually can present tremendous opportunity. For example, this happened to me with a company called Vsource (VSRC) , which has a great product for the business-to-business space. I was able to get their new business plan several months ago when the stock was below $2 per share. Now, the stock is trading at $15-3/4. But unless you have this type of information, it is probably a good idea to focus on NASDAQ for your portfolio.