BUYSIDE (cover story), summer 2004

DIAMONDS in the ROUGH

In their search for value, institutional investors slip into the pink sheets

BY BEN MATTLIN

On a Friday afternoon in early June, Tom Wobker is talking animatedly about local mining companies in his office at Pennaluna & Co., a Coeur d'Alene, Id.-based securities broker-dealer and pink sheets market maker. One in particular merits special excitement: Sterling Mining (SRLM), a century-old silver producer with 12,000 acres under exploration in the U.S. and Mexico.

A year ago, Wobker recounts, the company's stock traded at 52 cents, but; after signing an agreement to develop the neighboring Sunshine Mine, it stock soared 950 percent in six months to close 2003 at $10. As the story continued to evolve, Sterling got as high as $14 in February before sliding back to $7 -- hanging onto a 650 percent gain.

A home run like Sterling doesn't come often, but such volatility is characteristic of pink sheet stocks. For many professional investors, the up-and-down ride has made these securities anathema until relatively recently, when even the most discriminating money managers embraced the pink sheets as never before. What's given these obscure, unregulated, illiquid shares a new level of respect from even the buy side? Does the shift signify some deeper change in the capital markets? Perhaps most importantly, what possibilities and perils remain in, among and between the pink sheets?

SPECULATIVE FERVOR

To be sure, this isn't the first upswing the pinks have enjoyed. Interest in these stocks surged about five years ago, when the overall market was nearing its record highs -- in other words, just before the bubble burst. "When the overall market is going up, investors tend to be more speculative," asserts Ron Schwartz, who heads pink sheet and Over-the-Counter (OTC) Bulletin Board trading at Schwab Soundview Capital Markets, a leading market maker in bulletin-board traded stocks for both institutional and individual investors. "If people have confidence in equities, they're more likely to take a chance on these types of securities."

Historically, an influx of capital into unlisted stocks like those on the pink sheets is associated with heightened speculative fervor. Overconfident retail investors throw caution to the wind, generally pushing valuations beyond appropriate levels (which serves as a pretty good indicator of an imminent correction). What's unique this time, however, is that this time the institutional investors are getting actively involved.

"Earlier this year, looking at the volume of small stocks being traded, I was afraid we were heading for a wildly speculative market with big, dangerous swings and everybody trading anything in a kind of frenzy," confides Greg Ballard, chief operating officer and co-founder of Knobias Holdings, a market tracking firm in Ridgeland, Miss. "Now it's clear this is more at the institutional level, which implies greater stability."

The dangers inherent in pink sheets stocks go beyond intimations of irrational exuberance. Pinks aren't subject to the same requirements as regular listed securities. There's virtually no regulatory oversight. Research about them is almost nonexistent. And pink sheet shares are so thinly traded they can be difficult or impossible to sell. "There's certainly more risk in the pink sheets," says Nick Ponzio, president and CEO of Jersey City, N.J.-based OTC market maker Hill, Thompson, Magid & Co. "This is the most speculative area of the market and you have to be willing to assume that extra level of risk. But the rewards can be far greater."

EXERCISING CAUTION

On top of these risks, the pink sheets have a checkered past and reputation. For decades, this was the market netherworld of penny stocks, populated by companies that couldn't get on an exchange, hawked by the brokerage equivalent of snake-oil salesmen as "too cheap to resist." Even today, many pink sheet stocks still trade for cents per share, and few are priced at over $5.

The pink sheets acquired their name from the color of paper on which the stock lists have been published every trading day since 1913. They comprise a separate and distinct entity from the similar, oft-confused OTC Bulletin Board, although some stocks appear on both. While the OTCBB is owned by the parent organization of the Nasdaq Stock Market and the American Stock Exchange -- the National Association of Securities Dealers (NASD) -- the pink sheet listings are owned by independent player Pink Sheets LLC.

Neither the OTCBB nor the pink sheet listings are exchanges, which goes a long way to explain the notorious lack of liquidity at this end of the market. These securities are figuratively traded over the counter in private transactions, so both Pink Sheets and the OTCBB are actually quotation services that list otherwise unlisted stocks. Unlike Nasdaq and the New York Stock Exchange, these agencies don't extract fees from the issuing companies they list and assume no responsibility for their securities. Instead, they make their money from the broker-dealers who make a market in the stocks.

For investors with an interest in accurate corporate reporting, there is one critical difference between the two types of OTC listing. Unlike companies listed in the pink sheets, OTCBB companies file quarterly financial reports with the Securities and Exchange Commission (SEC), just like their counterparts on the major exchanges. Companies that don't stay current with their SEC filings are removed from the OTCBB, but they can remain on the pink sheets. This makes the pink sheets the most shadowy, least overseen tier of the stock market.

Companies usually gravitate toward the pink sheets because they don't qualify for listing on the major exchanges. Some fall below $1 per share for more than 90 consecutive trading days (120 days if an appeal is filed), while others don't have enough in tangible assets or fail to meet other SEC requirements. However, although many bankrupt or otherwise distressed companies end up on the pink sheets -- Enron Corp. (ENRNQ), MCI (MCIA) and Healthsouth Corp. (HLSH) are all there, after being ignominiously delisted -- that doesn't necessarily make the pinks the dustbin of the capitalist system.

In fact, some companies deliberately choose to keep their shares out of the exchanges. Perhaps they want to save on the expenses of exchange and filing fees, or they prefer to limit the number of shares outstanding to maintain a degree of control. Some unlisted stocks eventually advance to the major exchanges, while others never even try.

"There's a tremendous number and variety of companies on the pink sheets," says Schwab's Schwartz. "Many are in their infant stages and don't qualify for the big exchanges. This is an inexpensive way for them to raise capital. Others prefer to remain unknown. Still, investors need to be extremely cautious and do their homework."

INSTITUTIONAL HOMEWORK

Despite the potential perils, many pink sheet aficionados contend that these securities are actually more appropriate for institutional investors than individual investors. "Sophisticated institutional investors have the know-how and resources to evaluate these companies thoroughly," argues Walter Carucci of Carr Securities Corp., a broker-dealer in Port Washington, New York. "If they do their own research, which is essential in an unregulated environment like the pink sheets, they can find real values."

Research on these generally smaller companies and thinly traded stocks can be hard to come by, but Carucci points out that some pink-sheet-listed companies voluntarily file financial data with the SEC and even those that don't frequently post financials on their websites. "The Internet is a relatively inexpensive way for companies to keep shareholders informed," he notes. "Many pink sheets companies can't afford full-time investor relations, but they do feel a responsibility to their shareholders."

Another good starting point Carucci likes is Walker's Manual of Unlisted Stocks, an annual compendium of OTC securities. Savvy investors might also check an issuing company's credit rating or even visit its operating centers, although only institutional investors have the clout to get regular access to management, competitors, customers, suppliers and other industry sources. "Doing your own research is adding value for yourself," Carucci explains. "You've got to be fully aware of what you're buying or selling, especially with the pink sheets."

MODERNIZING THE PINK SHEETS

None of this manages to answer the question of why money managers are suddenly so willing to make the effort to dig down into these stocks. What's made the traditionally forbidden zone of the pink sheets so attractive?

Part of the answer is that it's gotten easier to gather background research on companies like these. Recent upgrades to Pinksheets.com put more data at any computer user's fingertips. That's largely thanks to Cromwell Coulson, CEO of Pink Sheets LLC, who spearheaded the past several years' efforts to make the Pink Sheets more useful, timely, interactive and robust.

Coulson is dedicated not only to improving the website's array of services for investors and market makers but also to increasing the background data and news flow that the listed companies themselves voluntarily provide. "More tools and technology to get the issuers to provide more information to potential investors," he pledges. "After all, it's beneficial to the issuers, too. Their shares will trade better if there's more information available."

This state-of-the-art electronic prowess is especially surprising since as recently as 1997, anyone who wanted the latest quotes on pink sheets stocks had to get the information by phone. When Coulson's company took over from National Quotation Bureau, it was with a goal of converting what was mainly a publishing operation into a technology-driven data provider. Two years later, the organization was offering quotes online in real time, and in 2000 it launched its new Web portal with expanded information about the securities, the companies issuing them and many of the brokers who trade them. Last year, it introduced electronic trade messaging.

Clearly, the modernization campaign is having some success. Between April 2003 and April 2004, the number of stocks quoted on the pink sheets system rose 60 percent to 44,000, Coulson says. Granted, fewer than a quarter of those are traded with any regularity, but considering that the number of OTCBB-traded securities fell by 12 percent over the same time, it's still a healthy sign. Whether having more companies brings more investors or it's the other way around is a chicken-and-egg conundrum, but there's no doubt that either factor fuels the other.

SIFTING GRAINS OF SAND

Pink sheets stocks might make a better fit for institutional investors than individuals because of the time commitment involved. Operating in the pink sheets uses up time in two ways: First, unearthing hidden values in that ocean of 44,000 stocks can be a tedious process, and when you find your gem, the relative lack of liquidity means you may have to hold onto it for a very long time. Market makers can help, of course, but depending on the size of your investment it can be difficult to find a buyer.

As a result, these investments reward (and even require) patience above all else. "There are opportunities to buy quality businesses in the pink sheets," declares Frank Hawrylak of New York investment firm Tweedy, Browne Co., "particularly if you are a patient investor."

One such patient investor is fund manager Jack Norberg of Standard Investment Chartered, a Costa Mesa, Calif.-based investment banking and brokerage firm specializing in "closely held, thinly traded value equities," says Norberg. "Our average hold time exceeds six years. It's a little like buying a house." He only discards a security if management decides to go private or tenders a viable buyback offer, or if there's a merger. "More often than not, I have no exit strategy. Management makes the decision for us through a corporate event."

Since he's sinking his money into these stocks for the duration, Norberg searches for companies that will pay a decent dividend -- ideally, greater than the 10-year Treasury yield -- over the long haul, as well as long-term capital gains potential. His favorite companies are OTC by choice because they don't need access to the wider capital markets and may in fact intend to buy back all remaining shares. Meanwhile, they repurchase shares periodically and keep the number of shareholders down. Norberg also looks for long-term sales growth of over 10 percent annually, consistent earnings growth with "excellent prospects for the future" and valuations that are well below book value. "Sometimes it's like walking on the beach looking for buried treasure," he admits. "You have to cull through a lot of junk before you find a gold watch or even a quarter."

Two pink sheets stocks he likes are LAACO (LAACZ) and J.G. Boswell (BWEL). LAACO owns and operates the Los Angeles Athletic Club, the California Yacht Club in Malibu and the Storage West self-storage facilities throughout the West. Based in Los Angeles, the company is 80 percent owned by the Hathaway family that founded it a century ago. At a recent $525 per share, it's certainly no penny stock. Yet with a market capitalization of approximately $95 million, Norberg says it's "an extremely well-run, well-managed and shareholder-friendly company." He's been a shareholder for more than 20 years.

Alternatively, J.G. Boswell is the world's largest cotton and tomato grower with some 200,000 acres of actively farmed land, primarily in Corcoran, Calif., with another 50,000 acres in New South Wales, Australia. Headquartered in Pasadena, Boswell also has extensive real estate developments in San Diego and Colorado Springs, Colo. "The company earned $40 million per year for the past five consecutive years," Norberg says. Another non-penny stock, shares were recently priced at $400.

SELL-SIDE INTEREST GROWING

With sticker prices like these, these stocks are plainly not for everybody. Nevertheless, it's not surprising that sophisticated investors with the resources to seize the hidden opportunities are crowding around to get in on the action. Ballard, the market tracker at Knobias, reports institutional investors are increasingly entering into private placement deals with pink sheets companies -- especially via Private Investments in Public Equity (PIPEs). "Sometimes it's the only way these companies can get financed," he observes, "selling their equity to institutional investors privately, outside the market, at a discount."

If the trend holds up, it indicates investors' confidence that there's sufficient volume and liquidity to support the kind of quick trades that characterize PIPE deals.

"In the past six months, three or four large sell-side firms have decided to expand their trading in the OTC space," Ballard adds. He won't reveal the details, but says the motivation is simply that brokerage firms can no longer ignore the fact that OTC trading can be profitable. What's more, he says, the sell side may begin considering pink sheets companies as potential investment-banking clients.

At this point the future of the pink sheets, like the securities themselves and the companies they represent, is mostly a matter of speculation. Still, there's no question that if enough institutional money plays in this space, it will go a long way toward providing a base of liquidity and reducing the underlying risk. Clearly, the fear of fraud that made these securities taboo for investment professionals is already diminishing -- though perhaps for simpler reasons. "You look at Enron and WorldCom, and you realize you don't have to be in the pink sheets to find fraud and risk," says Ballard.