Finding Bargains in the Market's Dark Corners

Of the countless things I've learned from  Berkshire Hathaway (BRK.A) (BRK.B) chairman Warren Buffett, one of the most influential came from an interview he gave to BusinessWeek in 1999. In that interview, Buffett said, "If I was running $1 million today, or $10 million for that matter, I'd be fully invested. ... It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee it.”

While having billions of dollars to invest is a rather wonderful problem, Buffett is clearly handicapped by Berkshire's colossal size. His message to smaller investors is direct: If you want to achieve truly market-crushing returns, concentrate your research on the universe of small-capitalization stocks. Furthermore, as my colleague Curt Morrison pointed out in a recent article, illiquid stocks have outperformed liquid stocks by 2.1% annually over the past 40 years. These results, of course, make perfect sense. For various reasons, large investors cannot invest in small, illiquid stocks, and with fewer smart people looking at a stock there's a greater chance for mispricings. In my experience, the smallest and most illiquid stocks tend to trade on the pink sheets.

The 101-year-old pink sheets market, so named for the pink newsprint on which quotations used to be published, typically deals in the over-the-counter stocks of very small companies, and is the back alley of the stock market. Because companies trading on pink sheets are not required to file financial statements with the SEC or meet other regulatory obligations, the market is littered with all sorts of debris, including penny-stock frauds and the empty shells of bankrupt companies. Any recommendation of a pink-sheets stock, like the ones that may clutter your e-mail inbox, should immediately raise a red flag.

It may surprise you, then, that Warren Buffett has been known to shop in the pink sheets. In fact, any investor willing to look hard enough will find many fine businesses among the weeds, and when small capitalizations, illiquidity, and the stigma associated with the pink sheets intersect, they form a trinity of market inefficiency. The resulting mispricings can sometimes be glorious. If you think Google (GOOG) has done well, I know of a sleepy 112-year-old California citrus grower whose shares closed on the pink sheets at $73.50 on the date of Google's IPO (Aug. 19, 2004). Most recently the shares changed hands at $217, or a 195% return versus Google's 128% gain since its IPO. If that return figure piques your interest, here are a few tips to find potential bargains in the overlooked corners of the market.

Starting Your Search
Although it may sound quaint, the best way I've found to screen for pink sheets stocks is by flipping through the pages of a stock manual. Published annually, Walker's Manual of Unlisted Stocks contains financial summaries on 500 of the leading pink sheets stocks. The manual is an excellent resource because it filters out the stock scams and other rubbish. In addition, because financial information for these stocks is scarce, having condensed financial statements in one location greatly speeds up the research process. After finding a stock worthy of further research, your next challenge is obtaining full and audited financial statements. Some companies will publicly release their financials, but many will only share results with shareholders. In the latter case, your only shot at getting a look at the books may be to purchase a nominal number of shares.

The Value of Scuttlebutt
"Scuttlebutt" is legendary investor Phil Fisher's term for the proprietary insights you can gain about a business by doing your research legwork. Obtaining scuttlebutt is much easier with small companies, and your insights will often be a great deal more valuable. For example, digging up useful scuttlebutt about  General Electric (GE) is almost impossible. Unless you are a major investor, GE's management isn't likely to grant you access to the company. And if you do uncover something that thousands of other investors have strangely missed, it would have to be one amazing insight to move the needle at a company with $150 billion of sales and multiple unrelated business divisions. On the other hand, the heads of many small companies are happy to answer questions, even from small investors (you may be one of a handful of people to ever ask about their businesses). Moreover, your insights do not have to be particularly blinding to make you a lot of money. The stock of the California citrus grower I mentioned earlier likely did not rise because the economics of oranges have improved; it's probably because growing oranges is no longer the highest and best use of the company’s land. (Orange County, Calif.--home to some valuable real estate--is so named because it used to be covered with orange groves).

Purchasing Shares
When you're ready to make a purchase, it pays to be extremely patient. The bid/ask spreads on the pink sheets are often jaw-dropping, so a market order is almost always a mistake. Unless you believe time is of the essence, you will be better served by putting up a limit order at the bid price and waiting for willing sellers. It may take you many weeks or months to accumulate a position, but you'll avoid paying bid/ask spreads that can amount to a significant percentage of the stock’s price. As always, you should only make a purchase if prices offer a margin of safety to your intrinsic value estimate.

Have an Owner Mentality
Warren Buffett has often said that he would be happy to hold his stocks even if the market were to close for the next 10 years. You should adopt the same mentality not only because it makes sense, but also because with pink sheets stocks the market may actually close for the next 10 years. Many stocks on the pink sheets lack an active market, so trading in and out is not possible. I own a stock that has not traded in over a year, but that hardly concerns me. The company’s results show me that intrinsic value continues to grow at a steady clip and the dividends clear just fine. I don't have the excitement of a daily quote, but I do own a piece of a valuable business obtained at a bargain price. Although it may take a few years, the return on my investment will take care of itself.

Illiquid Stocks on Major Exchanges
Investing in the pink sheets is not for every investor. Unless you have the time and inclination to thoroughly research your investments, it's best to stick to companies trading on major exchanges with regulatory oversight. Fortunately, even stocks that trade on the NYSE or NASDAQ can suffer the same pricing inefficiency due to small size and illiquid shares. For example, the opening paragraph of our Analyst Report on  Student Loan  should be music to the ears of many investors: "Although it's lightly traded and lacks a Wall Street following, Student Loan is a great business and has strong prospects." It is not surprising, then, that shares of Student Loan have appreciated significantly since it had a 5-star Morningstar Rating last fall. If you'd like to find the next stock that's been overlooked by the market, Morningstar's list of  5-star stocks is a good place to start.

(Note, the Morningstar Rating for stocks is a benefit of Premium Membership. If you're not a Premium Member, sign up for a 14-day free trial.)