A new study co-authored by a DePaul University professor calculates for the first time the risk and returns of investing in low-priced stocks traded on the Over the Counter Bulletin Board (OTC-BB) exchange. The research confirms empirically what many investors have long suspected—investing in OTC-BB securities is risky—but, surprisingly, found that the higher risk did not bring higher returns.

The study measured the financial performance OTC-BB-listed firms from Jan. 1, 1995 through Dec. 31, 1998, when 6,000 small company stocks were traded on the exchange. It found that a portfolio of equally weighted OTC-BB securities yielded higher risk and lower returns than obtained by investing in an equally weighted portfolio of larger company stocks traded on the American Stock Exchange, Nasdaq, New York Stock Exchange and the S&P 500 Index.

During the four years studied, the return volatility of the OTC-BB firms ranged from 13 percent to 38 percent. This exceeded the volatility range for the major exchanges and the S&P 500. Over the same time period, the New York Stock Exchange’s return volatility ranged from seven to 26 percent; the American Stock Exchange volatility ranged from 10 to 19 percent; the Nasdaq return volatility ranged from 13 to 30 percent; and the S&P 500 experienced volatility from 9 to 26 percent.

“The term ‘caveat emptor’—let the buyer beware—clearly applies when investing in OTC securities,” the study’s authors concluded. The research is the work of Carl Luft, associate professor of finance at DePaul; Lawrence M. Levine, director of corporate finance services for American Express Tax and Business Services; and Scott Larson, intermediate research analyst for Allstate Insurance.

“Thousands of investors trade on the OTC-BB every day, and yet the structure and operation of this market is a mystery to much of the investment community,” Luft said. “Unlike the larger exchanges, OTC-BB firms were not required to begin publicly disclosing their financial statements until last year, and data on the risk and returns of this market didn’t exist. This study provides that data and shows that you get what you pay for when you buy these low-priced, small cap securities.”

“A major goal of our research is to shed light on the structure of this market and help investors make informed decisions on their investment strategy,” Levine said.

The study, which took two years to complete, involved a comprehensive examination of OTC-BB data tape that recorded daily price and volume trading data during the four years studied. The research team edited and corrected the data and combined it in a database with information on the outstanding common shares of each OTC-BB company, which was gathered by DePaul finance graduate student Mary Jo Granahan through hundreds of phone calls to firms listed on the exchange. With this information, the research team identified a sample set of 2,000 firms with reliable data from which they calculated each firm’s annual returns and the market’s risk.

The researchers also looked for a correlation between the returns of OTC-BB securities and those of the American Stock Exchange, Nasdaq, New York Stock Exchange and the S&P 500. They found only a weak relationship between the returns of the smaller and larger exchanges.

The study’s authors believe their work opens the door to further research of the low-cost, small company stock market. One research project could involve the creation of a small cap stock index of OTC-BB, Nasdaq and American Stock Exchange firms, which would provide a more reliable risk and return estimates of the OTC-BB market. The authors also suggest more research on the role of OTC-BB stocks in a diversified portfolio of investments, the reasons for the OTC-BB market’s high risk and low returns, the effects of the OTC-BB’s new financial disclosure regulations, and the behavior of retail investors who have little information about a market.

Note to editors: For media interviews, Luft can be reached at 312/362-8428, Levine can be reached at 312/207-6167 and Larson can be reached at 847/402-4092.