Pink Sheets Basics: How to Profit Without Getting Fleeced

Most investors have heard the term "pink sheets" as a reference to stocks. But how many know what they are?

Pink sheets are companies that are traded over-the-counter and that aren't part of any major stock exchange. But that doesn't mean they are any less valuable than traditional stocks, exchange-traded funds (ETFs) or mutual funds.

In fact, expanding your portfolio with pink sheets can be extremely lucrative, but you have to make the right moves to rake in the big profits.

Let me explain. . .

Pink Sheets Basics

Pink sheets began as listings on an electronic database provided by Pink Sheets LLC, and have their name because the quotes were originally printed on pink sheets of paper.

Companies that are involved in this kind of over-the-counter trading fall just outside of the many regulations that restrict the activities of the major stock exchanges. That means they don't adhere to many of the time-consuming accounting and finance regulations of the U.S. Securities and Exchange Commission or the National Association of Securities Dealers (NASD), which helps the companies run more efficiently.

Also, some companies begin trading on the pink sheets as a first step to getting listed on a bigger exchange. And that alone can result in some price appreciation, as buyers who were previously wary jump into the stock.

And once those stocks do hit larger markets, even higher profits could be in store for investors who stay the course. For details about one small-cap stock with big-time potential, click here.

However, a lack of transparency can leave investors in the dark. These companies do not have to disclose as much about their business, and no one is knocking on their doors asking to see their books.

Of course, that does not mean they are something to be completely avoided. The fact that major institutions do not regulate pink sheet companies can be nerve-racking to some, but it is overly cautious to think of this kind of trading as the "Wild Wild West" of the financial world. Keep in mind that fraudulent misrepresentation of financials is a Federal offense no matter where a company's shares are listed.

To make traders more comfortable, Pink Sheets LLC recently created a new classification system to help investors assess the legitimacy of the companies in their roster. These classifications range from the highest, "PremierOX"—which are priced at least $1 per share and meet the requirements of the major exchanges—to the lowest, "Caveat Emptor" (literally "let the buyer beware" in Latin). The complete hierarchy can be found at the Pink Sheets Web site.

The problem with these stocks is simply that they are not badgered by any institutions to provide financial data on a regular basis. As a result, wise investors approach them like they would shallow water—they never dive in headfirst.

Some Pink Sheet-listed companies still offer limited information on the Pink Sheets website, despite their option not to. And investors should take advantage of this information before buying shares.

After reviewing the company profile on Pink Sheets and the company's own website, it's time to request information directly from the company you're interested in. Whether by phone or e-mail, get in touch with a representative of the business and request any information they can send you—whether it be about their finances, their products or, since many Pink Sheets companies are overseas—the political, economic and social situations in their countries. Risk assessments and future opportunities—anything you need to know to be sure of a company's potential—are also important.

A few of the companies listed on the Pink Sheets may not be very forthcoming with their information, and some have even been reported to be hostile with researchers. Be wary of companies that will not consider treating the interests of their minority shareholders as their own.

If the company you are researching is outside the U.S., you should also research the business laws inside the company's home country.

Often, foreign companies on the Pink Sheets are listed on a regulated bourse in their home countries. If that's the case, it will serve you well to research the securities regulations—or lack thereof—in those countries. For instance, a company listed in Frankfurt or London will have near or even more stringent laws to comply with than a regular listing in the U.S. But a Shanghai-listed company is operating under a very unfamiliar and sometimes informal set of rules.

That doesn't mean the Shanghai-listed company won't be exactly what it says it is and make you money. But it is a factor to take into account when buying shares.

Buy and Hold

Once you have thoroughly researched your stock of choice and purchased it through your broker or online, be prepared to treat it as a long-term investment.

These stocks are smaller companies that are not constantly watched by analysts and regulators. They can sometimes go days without even a single share changing hands.

This will no doubt make some of the nail-biters out there anxious, because they won't be able to check their favorite stock at every smoke break. But most intelligent investors find it liberating to be able to forego the short-term roller-coaster ride and focus on growth potential over the course of a company's natural life.

Don't ignore your Pink Sheet investments altogether. Make sure you keep up with the information coming from the company and any third-party news stories—just like you would with an investment on a traditional exchange. But don't sell just because you don't see a change over a few hours or days.

Now that we've given you the know-how to get started with pink sheet stocks, take the time to explore and research them carefully before you buy. And make sure you're prepared before you decide on a purchase.

If you'd like information about a Money Morning-approved small-cap stock—one with incredible growth potential that's already been spotted by industry giants—go here for our latest special presentation.