How to Find Hot OTC Stocks
Over-the-counter, or OTC stocks, are securities that trade on the OTC-BB or Pinksheets instead of a centralized exchange like the NYSE or AMEX. They are characterized by their low prices – typically below $1 per share – and the lack of news and financial information. However, investors willing to do a little digging can often find gems among the chaos. Here’s TheOTCInvestor’s four step process for identifying hot OTC stocks in any market!
Step #1: Seek Out Profits
The vast majority of OTC stocks are losing money regularly; and despite the promises, many will continue to lose money over the foreseeable future. Other companies show a profit, but it is not derived from operating activities, but instead the result of a lawsuit or other one-time influx. OTC investors are best off seeking out stocks that are making consistent profits from operating activities.
Investors can find these profitable OTC stocks by reading through their SEC filings. Since companies can claim one-time income as profits, it is important to read the company’s latest 10-K or 10-Q filing to make sure that the profit is coming from operating activities. The best way to do this is to look at the statement of cash flows, as it details exactly where hard cash is coming from and where it is being spent.
Step #2: Find Sustainable Growth
Some OTC stocks may have real profits, but not necessarily sustainable growth. For example, a pharmaceutical company may have licensing revenues coming in from its drugs, but those licenses may end up expiring in a year or two. As a result, it is important to seek out OTC stocks that have sustainable growth in the form of real products and services, instead of from short-term contracts or payments due from third parties.
Investors can find this information in SEC filings as well, by searching for the “Management’s Discussion and Analysis” section. Typically, this section will break down revenues and tell investors exactly where the money is coming from, as well as outline any contracts. However, companies may also report this information elsewhere in the SEC filings – this is when the search function on your web browser becomes useful!
Step #3: Find Low Multiples and PEG Ratios
The next step to identifying a hot OTC stock is to find companies with low multiples. Calculating price earnings multiples is simple: Just divide the current price per share by the earnings per share. Then, compare this earnings multiple to that of competing public companies. Typically, OTC stocks will trade at lower multiples to those on centralized exchanges, but they should still be within reason.
OTC stocks trading at less than 5x earnings are considered cheap if they are profitable with strong growth rates (as we discussed earlier). To find out just how cheap, investors can calculate the PEG ratio by dividing the PE ratio by the growth rate in percent (whole numbers). The growth rate typically used is the one for the next year. So, a company trading with a PE ratio of 5x earnings and a 20% growth rate next year has a PEG of 0.25. Normally, companies trading at a PEG of less than 1.0 are considered undervalued, but in the world of OTC stocks, companies just trade with a PEG under 0.50 to be considered truly undervalued.
Step #4: Check the Liquidity
There’s an old saying: “Something is only worth as much as a buyer is willing to pay.” This simple rule is often misunderstood in finance – just look at the subprime securities crisis where they were considered by financial professionals as being worth much more than anyone was going to pay, causing massive writedowns at banks.
It is important for investors to consider the liquidity in OTC stocks before purchasing them. If you are purchasing 100 shares, be sure that the trading volume is at least 100 shares per day. If you are purchasing 5,000 shares, be sure that the trading volume is at least 5,000 shares per day. Similarly, look at the bid and ask spreads to make sure that this liquidity is reasonable. OTC stocks with a large spread make it hard to buy or sell at a good price.
Conclusions
In the end, following these four steps can help investors identify hot OTC stocks that aren’t the subject of market manipulation.
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