Why Be Unlisted?
An OTC stock is one that is unlisted and doesn't trade on an exchange. For some, being unlisted indicates a company that is extraordinarily risky with high potential for fraud. In other words, uninvestable. But for others (like me) unlisted stocks are merely a different category of stocks with their own advantages and disadvantages. Still, those of us who consider unlisted stocks part of our investing universe should ask ourselves just why a publically-owned company would choose to remain unlisted. After all, the norm for companies with a significant number of shareholders is to list on a national exchange. Listing on the NYSE or NASDAQ is costly, but the cost is surely more than covered by the benefits of increased liquidity and the higher valuation afforded listed companies.
Allow me to present a brief list of common reasons why companies remain unlisted and trade OTC, from the most benign to the most sinister. I have seen each of these reasons time and time again across thousands of unlisted stocks, both in the US and abroad.
No Need for Capital
This is perhaps the best reason for a company to remain unlisted. Recall that listing on a national exchange typically boosts a company's valuation to a higher multiple of revenues or cash flows. This indicates a decreased cost of capital, which is extremely beneficial for companies that rely on a flow of fresh capital from investors, especially equity capital. At higher valuations, equity raises result in a smaller percentage of the company being sold in secondary offerings, which benefits existing shareholders.
However, for investors in a company that produces excess capital, a higher valuation can reduce long-term returns. A responsible company will return excess capital to shareholders either through cash dividends or through share repurchases. In either case, a lower valuation is beneficial to long-term holders as they reinvest dividends or as their ownership increases proportionally via buybacks.
A good example of this process in action is Computer Services, Inc. Investors in Computer Services have enjoyed a 12.7% compounded annual return over the last decade, seriously outpacing stock indexes. Computer Services generates substantial excess capital and routinely repurchases stock and increases its dividend. Since 2005, the company has repurchased 16.2% of its shares outstanding. This large decrease would have been muted if the company's shares had traded at a higher average valuation during the period. Reinvested dividends and share repurchase programs would have netted far fewer shares.
Sadly, these types of companies are all too rare. I can think of only a handful of unlisted companies that regularly generate excess capital and return it to shareholders. Most companies that enjoy these characteristics are either privately owned or have long since by bought by larger competitors.
Some companies are simply too small for an exchange listing to be viable. I have seen various figures thrown around for the cost of maintaining an exchange listing, but most estimates indicate that an NYSE listing costs close to $1 million annually when the reporting and compliance costs are included. A NASDAQ listing is cheaper, but both are prohibitive for companies earning only a few million in operating income. Some of my best investments have been in companies earning only $2-10 million per year, and the cost of an exchange listing would have been a material drag on earnings.
Companies too small to support exchange listings are a fruitful market segment for value investors. Because they are both tiny and unlisted, many of these companies receive little press and go under-researched, leading to frequent mis-pricings. Some of these companies possess a valuable option that can result in big returns: uplisting. Many of these tiny companies grow rapidly, and will eventually seek to list. Investors who bought in prior to the listing often do very, very well. I'm almost always thrilled when one of my small holdings announces an uplisting, because I know the increased exposure will result in a higher valuation.
Can't Meet Listing Standards
The NYSE and NASDAQ require a level of disclosure that some businesses either can't or won't meet. Sometimes businesses in the midst of restructuring or restating are unable to file timely financial reports, eventually disqualifying them from listing. And sometimes companies simply do not want to provide the detailed reporting that standard filings require.
This lack of disclosure is a mixed bag. Sometimes important details are left out, but often the incomplete filings provide opportunities for value investors willing to do additional legwork. In the absence of standard filings, some investors conclude the elevated risk of fraud is enough to disqualify a company for investment. That's fair enough. But I don't automatically exclude a company from consideration for not disclosing every detail down to its receivables aging schedule. I know of many companies that choose not to release fully-detailed filings simply because of the expense and effort involved. (Others, of course, provide incomplete disclosure in order to obfuscate and distract from untoward actions. But that's the next topic.)
In cases where business details are easily verified, incomplete disclosure may be sufficient. I know of a few real estate companies trading OTC that reveal little about the details behind their operations. Yet the holdings are easily verified through public tax records and the assessments and reassessments listed there are invaluable in estimating the real estate's value.
Sometimes companies choose to remain unlisted because the behavior of insiders would never stand up to the increased scrutiny that comes with listing. Excess compensation, empire-building, entrenched management and rampant self-dealing are common in companies of any listing status, but are much easier for unethical management teams to accomplish off-exchange.
There are numerous companies that walk the line between ethical and unethical treatment of shareholders, and some that engage in outright abuses. For example, some years ago I became a shareholder (one share only) in a company that refused (and still refuses) to provide any financial information to shareholders unless they would sign a non-disclosure agreement indicating the shareholder would not share the information with anyone else, including other shareholders. Seeing no alternative, I agreed to this demand and signed the agreement. Sure enough, management's rapacious actions were obvious soon as I saw the financial statements. Though the company did over $100 million in revenues per year in an industry with reasonable operating margins, operating profits were positive in only one of the previous five years. The reason? Management saw fit to pay themselves over $8 million annually. The board was clearly there only to approve management's demands, and were paid handsomely for providing effectively no responsible oversight. There is nearly no hope that this company will ever change its ways, and management likes it that way.
Companies like these are probably best avoided by smaller investors, even if the financial metrics look promising. In these cases, management represents a huge intangible liability that offsets any potential under-valuation.
Ramifications for Investors
When evaluating an unlisted stocks, investors should consider the company's motivations for remaining unlisted and incorporate their conclusions into their subjective opinions of company and management quality. Sometimes remaining unlisted indicates a high quality company with a shareholder-oriented management team. After all, why list if you don't need capital and you want to maximize returns for shareholders in the long run? Listing might produce a short-term gain at the expense of long-term returns. And in cases where a company's economics can't support the expense of a listing, doing so would only be a vanity move meant to bolster management's prestige at the expense of shareholders.
On the other hand, there are plenty of instances where a company remains unlisted for bad reasons, and investors should approach these companies with caution. When management is a liability, investors should incorporate the liability into their estimate of intrinsic value.
Alluvial Capital Management, LLC holds shares of Computer Services, Inc. for client accounts. Alluvial may buy or sell shares of Computer Services, Inc. at any time.
OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.
Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at email@example.com.