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OVER THE COUNTER BULLETIN BOARD EXCHANGE
MARKET STRUCTURE, RISK AND RETURN

Abstract

This study was motivated by the lack of knowledge of the OTC-BB Exchange and seeks to fill this void by enlightening investors about the structure of the OTC-BB Exchange and by providing estimates of the market's risk and return for the period January 1, 1995, through December 31, 1998. This research is an initial attempt to provide some empirical insights and analysis about the Over the Counter Bulletin Board Market. We found that a portfolio of equally weighted OTC - BB securities would have yielded a lower return and higher risk (as measured by standard deviation) than obtained by investing in equally weighted portfolios found on the larger exchanges for the time period of January 1, 1995, through December 31, 1998. We also observed that the relationship of returns of OTC-BB securities to the securities traded on the American Stock Exchange, New York Stock Exchange, Nasdaq and the S&P 500 is relatively weak. We believe that the reason for these results is the lack of financial information and poor liquidity.

Introduction

Each day, thousands of investors buy and sell securities listed on the Over the Counter Bulletin Board Exchange ("OTC-BB" or "Exchange").  Shares in thousands of firms are traded in this market and it is generally believed that these securities are "risky."  However, there has been no comprehensive empirical research performed on the OTC-BB.  We found it surprising that these OTC-BB firms never have been examined from a risk and return perspective.  This study seeks to fill this informational void by enlightening investors about the structure of the OTC-BB Exchange and by providing estimates of the market's risk and return for the period January 1, 1995, through December 31, 1998.  We believe that this information will help investors make informed portfolio decisions regarding these OTC-BB firms.

 The remainder of the paper is organized as follows.  Section 1 reviews the history and discusses the market structure of the Over the Counter Bulletin Board Exchange.  Section 2 discusses the data and research methodology.  Section 3 presents the empirical results and conclusions, and the fourth section provides a summary and suggestions for future research.

Section 1 – The Over the Counter Bulletin Board Exchange

A. History

 In June of 1990, the OTC-BB began operation as part of The Penny Stock Reform Act of 1990 which mandated the United States Securities and Exchange Commission ("SEC") to establish an electronic system to facilitate the widespread publication of quotation and last trade information.  Since December 1993, firms have been required to report trades in all domestic OTC equity securities through the Automated Confirmation Transaction Service ("ACTSM") within 90 seconds of the transaction.  The benefit of these structural modifications was to permit greater price transparency to investors.
  On January 4, 1999, the SEC approved the OTC-BB Eligibility Rule.   This meant  that beginning in July of 1999, and phasing in through June 2000, firms whose shares were to trade on the Exchange were required to disclose current financial information to a regulatory body (typically the SEC).  Firms refusing to publicly disclose their financial information were delisted from the OTC-BB. Subsequently, these firms listed their shares on the National Quotation Bureau Exchange ("NQB", or "Pink Sheets"). Prior to this rule, no OTC-BB firms were required to disclose any financial information.  All disclosure was on a voluntary basis.

During the mid-1990's, there were about 6,000 firms trading on this exchange. As a result of the OTC-BB Eligibility Rule, the number of OTC – BB listing firms decreased considerably during the late 1990's.

Exhibit 1

Number of OTC-BB Securities

Interestingly, while the number of firms trading on the OTC – BB was shrinking, the dollar volume of activity on the Exchange was increasing, significantly.

Exhibit 2

OTC-BB Daily Average Dollar Volume

Virtually all of the securities traded in this Exchange are microcap stocks.  Generally, microcap companies are those firms that: have small asset bases and revenues, tend to be low priced, trade in low volumes, and have market capitalizations below $250 million.  Certainly by comparison to the other major United States exchanges, dollar volume of OTC – BB securities is a fraction of what occurs elsewhere.

A major difference between a microcap security and other stocks is the amount of reliable, publicly available information about the company.  There is a plethora of information about large firms that trade on the major United States exchanges; in contrast, it is difficult to find reliable information about microcap securities.  If information exists at all, its source is either the company itself or a promoter paid by the firm.  There is little institutional coverage for OTC securities.

B.  OTC – BB Market Structure

An OTC equity security generally is any equity that is not listed or traded on Nasdaq® ("Nasdaq") or other national securities exchanges such as the New York Stock Exchange or the American Stock Exchange. The OTC-BB is a regulated quotation service that collects and distributes real-time quotes, transaction prices, and volume data for OTC securities. The OTC - BB is a quotation medium for subscribing members (i.e., the Market Makers) and is not an issuer listing service.  This is a subtle but very significant difference.  The OTC-BB's relationship is with the firm making a market in the OTC security rather than with the issuer.  For the other major United States securities exchanges the relationship is between the exchange and the company, not a broker-dealer making a market in that firm's security.

OTC - BB securities are traded by Market Makers that enter quotes and execute trades through a closed computer network, which is accessed through a Nasdaq Workstation. Securities traded on the OTC-BB include national, regional, and foreign equity issues, warrants, units, American Depositary Receipts ("ADRs"), and Direct Participation Programs ("DPPs").

The OTC - BB operates as a dealer system.  As a result, all securities being quoted on the OTC - BB must be sponsored by a participating Market Maker that registers the security with the NASD OTC Compliance Unit along with the required issuer information.  Once approved by the Compliance Unit, the Market Maker will be notified that it has been registered in the security and may enter a quote and commence trading. Only Market Makers can apply to quote securities on this service.  Issuers contact an authorized OTC - BB Market Maker for sponsorship of a security on the OTC - BB.

The OTC - BB is different than the Nasdaq market and the other major United States exchanges in that it: does not impose minimum quantitative financial listing standards (i.e., a minimum net worth or market capitalization requirement); does not provide automated trade executions; does not maintain relationships with quoted issuers; and does not have the same obligations for its Market Makers. However, upon delisting from the Nasdaq or other national exchange, a security may move to the OTC – BB Exchange.

The OTC - BB Eligibility Rule Phase-in began on July 1, 1999, and was completed as of June 2000.  The objective of the Eligibility Rule was to protect investors by ensuring that they have access to OTC companies' current financial information when considering OTC investments.  During the latter half of 1999 and first half of 2000, every company whose securities were quoted on the OTC - BB was reviewed for compliance with the filing requirements for publicly disseminated financial statements.  As a result, in excess of 3,000 firms were delisted and removed from the OTC – BB.  In general, these firms' securities were then traded on the NQB exchange.

Nasdaq is in charge of monitoring the filing status of all OTC - BB issuers.  In the event of a filing delinquency, Nasdaq will disclose that the financial statements on file are not current.  After 30 days, if Nasdaq has not been notified that the appropriate filing has been made with the issuer's regulatory authority, the issuer's security will be removed from the OTC - BB.

C. A Comparison of the Nasdaq to the OTC - BB

There are very significant differences between firms listing their securities on the OTC - BB and Nasdaq.  It is relatively easy to obtain a listing on the OTC – BB. On the other hand, Nasdaq, as well as the other major United States exchanges, has rigorous listing standards to ensure a minimum quality of its issuers. Beginning in 1999, the only requirement of significance for inclusion in the OTC - BB is that an issuer be current in required periodic filings with the SEC or other appropriate federal regulatory authority; prior to 1999, even disclosing financial statements was optional.

The major United States stock exchanges have specific quantitative and qualitative listing and maintenance standards that are stringently monitored and enforced.  Companies listed on one of those exchanges have reporting requirements to the exchange and a direct relationship exists between both parties. In contrast, the OTC – BB does not impose a minimum level of financial standards, and there is no business relationship between the quotation service and the issuers.  Because the OTC – BB is a quotation service for its Market Makers and not an issuer listing service or securities exchange, there are no quantitative listing requirements that must be met by an OTC – BB issuer other than to issue financial statements.  To be delisted from the OTC – BB exchange, a firm either fails to file its financial statements in a timely manner with the required regulatory body, or all of its Market Makers withdraw from the stock.  Since there is no business relationship between the OTC – BB and the issuer, it is the Market Maker that chooses to quote a security on the system, files the application, and is obligated to comply with the regulatory requirements. The NASD Regulation governs the quotation activity and trade practices of OTC – BB Market Makers, but OTC – BB issuers are not regulated by Nasdaq.

D. A Comparison of the OTC – BB to the Pink Sheets

Just as the OTC-BB is distinct from Nasdaq, it is also distinct from the NQB.  The NQB transmits pricing information via paper (i.e., pink paper) and more recently via the internet.  The Pink Sheets are not owned or operated by Nasdaq or the OTC – BB; they are owned by an independent firm. It is important to note that firms listing on the NQB are not required to disclose their financial statements to any regulatory body, and the SEC does not require firms listing their shares on the NQB to disclose their financial statements.  The NQB is the only securities exchange in the United States that permits firms to trade their securities without disclosing their financial statements.

Prior to the enactment the Eligibility Rule, NQB and OTC-BB traded companies were the only publicly traded companies that were not required to disclose their financial statements.  Now that the Eligibility Rule is completely implemented, the NQB is the last remaining haven in the United States for public trading of non-disclosing companies.

Section 2 – Data and Research Methodology

We studied the financial performance of OTC – BB firms from January 1, 1995, through December 31, 1998, when approximately 6,000 stocks were traded on this Exchange. The typical company traded on the OTC - BB is small (whether considered in terms of market capitalization, revenue, net income or float) and infrequently traded.  Although these stocks are traded infrequently, there is an observable share price.  Thus,  pricing information did exist for these securities.

We obtained OTC - BB daily price and volume data for the calendar years 1995 through 1998.  Unfortunately, the raw data had to be edited, corrected and completed for each company.  The data on the tapes were not consistent with regard to company name and ticker symbol.  Furthermore, we did not have any information concerning the number of shares outstanding.  Thus, company name and ticker symbol had to be verified and made consistent from month to month and year to year.  Then, information regarding each firm's outstanding common shares was gathered manually from corporate disclosure statements.  If firms did not file any statements, then they had to be dropped from the data set. This resulted in a sample of approximately 2,000 firms with reliable data for the 1995 through 1998 calendar years.

Once the raw data had been compiled and verified, each firm's market capitalization had to be determined.  Share prices were adjusted for splits, dividends, and capital infusions using the same procedure employed by the Center for Research in Security Prices, ("CRSP").  After adjusting each firm's price, monthly market capitalization values were determined.  These market capitalization values were used to generate monthly percentage changes in each firm's market value, or monthly returns.

The annual mean returns and standard deviations were computed via equations 1 through 4 which are employed by Ibbotson and presented in "Stocks, Bonds, Bills and Inflation 1998 Yearbook."

Each year, average monthly return relatives from equally weighted portfolios were compounded over the twelve monthly periods, then 1 was subtracted from the resulting value to obtain the average annualized return for the portfolio. The annualized monthly standard deviations were computed by applying equation 4, the formula which appears in Ibbotson's 1998 Yearbook, but was derived by Haim Levy and Deborah Gunthorpe [1993]

The Levy-Gunthorpe standard deviation is superior to calculating the annualized standard deviation of returns as the product of the standard deviation of the monthly returns multiplied by the square root of 12.  This second method treats the annual return as if it was the sum of the twelve monthly returns.  The Levy-Gunthorpe method is consistent with calculating the annual return as the result of compounding twelve monthly returns and thus provides more accurate and reliable results than the approximation.

OTC-BB performance was judged using the Sharpe Ratio, equation 5, correlation analysis, and Sharpe's Single Index Market Model, equation 6.

Annual Sharpe Ratios and correlation coefficients were generated for equally weighted American Stock Exchange, New York Stock Exchange, Nasdaq, S&P 500, and OTC-BB portfolios.  The Sharpe Ratios were used to judge the relative performance of the portfolios on a risk-adjusted basis, while the correlation coefficients documented the relationship between the returns generated by the portfolios.

Sharpe's Single Index Model, i.e. the Market Model, was estimated twice. Each time, the monthly Bulletin Board portfolio returns were regressed on the monthly returns for one of the other four portfolios. The first set of Market Model regressions encompassed the entire forty-eight month sample period and was used to determine the magnitude of the sensitivities, betas, between the Bulletin Board portfolio and the major indices.  The second set of regressions focused on the betas' temporal stability by estimating the Market Model over thirty-four month subperiods.

Section 3 Empirical Results

The data presented in Exhibit 3 show the return, risk, and risk-adjusted reward parameters of the major U.S. equity markets and the OTC-BB market for each calendar year between 1995 and 1998. The most striking results are contained in the Sharpe Ratio column.  These data clearly show that on a risk-adjusted basis, an equally weighted  portfolio composed of  over the counter bulletin board securities yielded a lower return than found from investing in equally weighted portfolios consisting of securities found on the larger exchanges. In other words, in general and on a risk-adjusted basis, OTC – BB returns were lesser than the returns found on the other major exchanges.

Exhibit 4 (A-E)

Correlation of Returns for Equally Weighted Portfolios by Exchange

Exhibit 4 identifies the correlation coefficients among equally weighted portfolios consisting of stocks traded on: the OTC - BB, the American Stock Exchange, the New York Stock Exchange, Nasdaq, and a portfolio comprised of S&P 500 firms.  Panel 4A  identifies the correlations for the monthly portfolio returns obtained for the entire forty- eight month sample period.  Panels 4 B through 4 E provide correlation coefficients for individual years. In general the relationship of returns of the OTC – BB to the American Stock Exchange, New York Stock Exchange, Nasdaq and the S&P 500 is relatively weak and unstable.  The correlation coefficients between the OTC - BB and the four other portfolios fluctuate from year to year and generally are less than .50.  However, the relationship of returns of the American Stock Exchange, New York Stock Exchange, Nasdaq and the S&P 500 to each other is relatively strong and more stable than the OTC - BB relationship.

 When we tested the null hypothesis of a zero correlation between each of the portfolios over the entire four year sample period, we found significant positive relationships between the Bulletin Board and American Stock Exchange, New York  Stock Exchange and Nasdaq.  No significant relationship between the OTC – BB and the S&P 500 portfolio was found during this four year period.  The positive and significant relationships between the OTC - BB and the Nasdaq and American Stock Exchange portfolios also were evident in the individual subperiods:1995, 1996 and 1998. The 1997 results indicated that the OTC – BB moved independently of the other four portfolios. Finally, we found no evidence of a significant relationship between the OTC - BB and either the New York Stock Exchange or the S&P 500 portfolios in any of the individual years. Thus, although significant relationships did exist between the OTC – BB and the major indices, these relationships cannot be considered strong or stable over time.

Exhibit 5:  Regression Results
Panel 5A: Model Results for 48 Month Period:
January 1, 1995 through December 31, 1998

Panel 5 B: Significant 34 Month Market Model Regression Results