Big risks, big gains fight it out on over-the-counter market
On the nightly news you hear the Dow Jones industrial average mentioned as a barometer of investment activity. This blue-blooded group of New York Stock Exchange (NYSE) stocks has chalked up a respectable 4.5 percent gain in 1985. But some of the biggest profits this year have been made in the over-the-counter (OTC) stock market:
Since January the OTC industrial average has jumped 13.5 percent. Of course, many of the stocks did poorly in 1984. Nonetheless, this is a sterling performance for a stock market sometimes derided as merely a nursery for motley start-up companies.
Of all the types of mutual funds, small company growth funds have been the top performers in 1985, says Patricia Ganley, managing editor of United Mutual Fund Selector. Why? These funds are stuffed with OTC stocks -- typically about 50 percent of the fund.
Trading volume in OTC stocks has hit record highs. From January through mid-March the number of shares traded on the over-the-counter NASDAQ system hit a record 72 percent of the volume on the Big Board (NYSE). Just 10 years ago NASDAQ trading volume was less than one-third of NYSE volume.
Unlike the NYSE or the American Exchange, the OTC does not actually have a physical location. It is primarily a telephone network. The OTC market is actually a ``bigger'' stock market in terms of the number of companies participating. The NYSE lists the stock of some 1,540 companies. The OTC comprises tens of thousands of companies.
Trading in the 4,200 most active OTC stocks is recorded and disseminated via NASDAQ (National Association of Securities Dealers Automated Quotation system). Set up in 1971, this computerized network provides recent prices to dealers who buy and sell OTC stocks.
Dealers once called around or checked the latest ``pink sheets'' to dig out the best prices on all OTC stocks. Now, the cream of the OTC stocks land in the National Market System, a subset of the NASDAQ stocks. Dealers can tap into computer terminals for up-to-the-minute price quotes and trading volume on some 1,600 stocks. A listing of NMS stocks appears in most daily newspapers.
For stocks not in the NMS or NASDAQ system, recent prices can be harder to come by and financial information scarce, especially if it is a new company.
Most companies issue their first stock in the OTC market. Consequently, the OTC is generally known as a place for young, undiscovered firms. The risky ``penny stocks'' (inexpensive shares in new companies that may be no more than scribbles on a napkin) are part of the OTC family.
The start-up company segment is largely responsible for the OTC market's reputation for riskiness or inferior quality stocks. In the past, fewer traders and less computerization made the OTC more difficult to match buyers and sellers, says Ralph Wanger, portfolio manager of the 15-year-old Acorn Fund. About half of this Chicago-based mutual fund is made up of OTC stocks.
But Wanger says the OTC market is very liquid now, ``And at no time was the stock traded on over-the-counter better or worse than that traded on the New York Stock Exchange.
``The quality varies all over the lot -- reflecting the totality of American business. You have some of the finest companies in the world. And there are stock certificates that should be used to line the bottom of bird cages.''
The NYSE has the advantage of stricter listing standards, he agrees, noting it will delist a company that has severe problems. ``But by the time they delist it, you will have probably lost 95 percent of your money.''
While there are many freshly hatched companies, the OTC market has its share of large established enterprises. For example, Apple Computer and MCI Communications are top firms in their respective industries. And the OTC market has long been home to many major banks, most insurance companies, and most of the bond market (corporate, municipal, and US government).
For investors, the process of buying or selling OTC stocks isn't much different from an exchange-listed stock. As with any stock, call your broker and place the order. Usually the broker handles OTC trades as any exchange-listed share. ``As far as I'm concerned it's the same. I call [a trader] upstairs and he plugs into the market,'' says William Bovey, a broker at Moseley, Hallgarten, Estabrook & Weeden Inc.
But often the price you pay for a trade is figured differently and may be negotiable.
Normally, you would buy ``Bizco'' stock at its trading price and then pay a set commission fee based on the number of shares. Some of the larger brokerage houses will do this even with OTC stock. However, in OTC trades, commissions may be flexible and are buried in the price of the stock.
For instance, if you buy 50 shares of Bizco stock, you may pay $20.50. The asking price or wholesale price of the stock -- what your brokerage house paid to get the stock from another dealer -- was $20. The extra 50 cents per share is the commission fee.
If the brokerage you call ``makes a market'' in Bizco stock (buys and sells the stock for its own inventory), there may be some leeway in price. Suppose the brokerage bought the stock at $17 and needs to unload it. If the asking price is $20, the broker may mark it up only 1/4 point or even sell it at $20, especially if you're a good customer. The broker and trader, who split the commission, decide how much to mark up the price.
If Bizco stock is widely traded, the spread between what dealers pay and what you pay will be small. The National Association of Securities Dealers suggests dealers limit their markup to 5 percent. (at 5 percent you would pay $21 for a $20 stock). But if you are trying to sell or buy a company that has a small following, the spread could be several points per share.
Also, getting a quote and information on a small OTC company can take more time. ``Sometimes I can't get a quote immediately on an OTC stock. If it's not on the National Market System or pink sheets, then I may not be able to check the price for an hour or two,'' says E. F. Hutton broker Michael M. Spencer. ``There is less information generally available.''
Lack of information can be an advantage. Some investors don't mind taking the risk of buying a company that has not been analyzed thoroughly by the major brokerages. They'd rather find their own latter day IBMs or Xeroxes and wait until Wall Street discovers it.