Stay Away From These Stocks

Philip Fisher, investing legend and author of Common Stocks and Uncommon Profits, urged investors not to "ignore a good stock just because it is traded 'over-the-counter.'"

Fisher was a superb investor, and I'm certainly not going to tell anyone to ignore good stocks. The problem, though, is that his advice only makes sense for people like him: Very smart investors with either the skill or the time to dig through all the trash that trades on the Pink Sheets.

That's just not you and me
Don't get me wrong -- there are many reputable firms listed on the Pink Sheets. High-profile international companies such as Nestle and Roche, for instance, have ADRs quoted on the exchange. And some distressed businesses move from the NYSE or Nasdaq to the OTC, only to move back when they straighten out their affairs. Global Crossing (Nasdaq: GLBC) and Conseco (NYSE: CNO) have fit this latter mold in recent years.

But mixed in with these global stalwarts and will-they-come-back-from-bankruptcy stories are a generous helping of sorry businesses and a sprinkling of scams. That's why The Motley Fool has advised individual investors to avoid OTC stocks -- they're just not worth the hassle.

Pink is the new blah
It appears, however, that more people are starting to like hassles.

According to a recent Washington Post article, "The value of securities traded through Pink Sheets has ballooned in recent years, to $113 billion last year from $29 billion in 2000. ... The number of shares traded topped 1 trillion last year, up from 22 billion in 2000."

The OTC growth comes at a time when (1) individual investors are more engaged with the stock market than ever before and (2) stock-spamming (and therefore the possibility of fraud) is at an all-time high.

You see the trouble lurking here, right?
With all the new Pink Sheets action, do you think average-Joe investors take the time to read the Warning! Danger! Danger! disclaimers? For example:

"An investment in an OTC security is speculative and involves a high degree of risk. ... In some cases the liquidation of a position in an OTC security may not be possible within a reasonable period of time."

Liquidity can be a major problem. While EMC (NYSE: EMC) and Apple each trade more than $1 billion worth of stock a day, a big day for a company quoted on the Pink Sheets would only involve about $30 million worth of transactions.

Then there's the problem of just getting a handle on what you're buying ...

"Reliable information regarding issuers of OTC securities, their prospects, or the risks associated with the business of any particular issuer or an investment in the issuer's securities may not be available. As a result, it may be difficult to properly value an investment in an OTC security."

Those warnings aren't from the SEC -- they're from the Pink Sheets website!

Cloak and dagger
Because of these dangers, Pink Sheets has taken the admirable proactive step of publishing "warning labels" next to each quoted security. The labels come in four varieties:

• PS means the company's information is current.
• A yield sign means information is limited within a six-month time frame.
• A stop sign means no financial information has been reported for at least six months.
• A skull and bones is the worst category. Pink Sheets sums it up quite simply: "Buyer beware. There is a public interest concern associated with the company, which may include a spam campaign, stock promotion, or known investigation of fraudulent activity committed by the company or insiders."

The system is not unlike the way Yahoo! Finance shows a highlighted exclamation mark for companies such as The Children's Place Retail Stores (Nasdaq: PLCE), LAM Research (Nasdaq: LRCX), and Finisar (Nasdaq: FNSR), which are delinquent in their regulatory filings.

The moral
Look: Of the 5,000 or so securities quoted on OTC exchanges, there are of course more than a handful of legitimate, solid, well-run businesses. That's why Philip Fisher urged investors not to throw the baby out with the bathwater.

It's just that finding needles in that haystack is time-consuming and more than a little dangerous for retail investors. Even worse, if you find a needle and want to buy shares, the illiquidity of OTC stocks can make your hunt moot.

That's why, for average individual investors picking investments in their spare time, it's best to simply stay away from these stocks.

Why you shouldn't worry
It turns out that there are also roughly 5,000 stocks capitalized at less than $2 billion (how we define small caps in Motley Fool Hidden Gems) trading on the three major exchanges. Unlike Pink Sheets and OTCBB stocks, these companies are far more likely to file regular financial statements, have conference calls investors can listen in on, and meet a whole set of other (higher) listing standards. Thanks to these confidence-inspiring measures, they also tend to be more liquid.

If it's stocks with big potential that you're after, good: Small- and micro-cap stocks have historically been the best to own, and (in more recent history) they're the 10 best stocks of the past decade.

That's why Hidden Gems is devoted to hunting for these stocks, and the punch they pack is why we were recently named the No. 1 performing newsletter of the past year by Hulbert's Financial Digest.

We've uncovered more than a few big winners. You can see them all, including our team's top five stocks for new money, with a free 30-day guest pass. Click here to get the whole scoop.

This article was originally published Aug. 6, 2007. It has been updated.

Brian Richards does not own shares of any companies mentioned. Heeding Coach Finstock's advice, Brian also avoids playing cards with guys who have the same first name as a city. The Motley Fool has a disclosure policy that is cream cheese.