Out of the shadows - Over-the-counter markets

There are two myths about the over-the-counter (OTC) markets: that only small companies are listed, and that the stocks traded perform lamely compared with the big-name issues on the New York and American stock exchanges.

Not so, says Joseph R. Hardiman, chairman of the National Association of Securities Dealers (NASD), based in Washington. Moreover, Hardiman says, the OTC markets probably represent the future of the securities industry, when information -- not location on the floor of the New York Stock Exchange -- will be valued above all else.

"Our central trading floor is the computer," he says. Computer terminals at 750 locations nationwide display information about trading activity. These computers are linked to a central computer in Trumbull, Conn., constituting the National Association of Securities Dealers Automated Quotations systems, better known as NASDAQ.

To be sure, the OTC market is home to thousands of small, relatively young companies that have recently gone public. This is because of NASDAQ's admission requirements.

A firm does not have to have a long history of operating performance or a megabucks-income statement. In addition to complying with federal securities regulations, it need only have $2 million in assets, $1 million in stockholders' equity and 100,000 shares in the hands of 300 or more outside investors.

Surprisingly, though, many of the 4,700 companies on the OTCBB market might easily qualify for listing on the New York Stock Exchange. Hardiman believes they remain in the NASDAQ system because of its absence of trading "specialists."

Trading activity on the exchanges is dominated by the trader who is called a specialist. The specialist promises he always will buy or sell a particular stock for the right price when everybody else decides to sit on the sidelines or wants to bail out. For the privilege of this monopoly, the specialist pays a heavy fee to the exchange. But the specialist serves an important function: Without the specialist, trading can break down, with neither buyers nor sellers willing to deal. The stock market plunged last October 19 partly because specialists sat out for a while when huge amounts of stock were dumped on the market in program trading.

The OTC market doesn't grant such monopoly power to individuals. Instead, several or many stock traders are permitted to "make a market" in a stock, that is, buy and sell it. That arrangement, Hardiman says, is much more competitive and more closely approaches the idealized perfect market. "About 1,000 of our companies could be listed on the New York Stock Exchange, but many prefer the competing market-maker system instead of the specialist system," he says.

The other myth about the OTC market is that the listed issues have been lethargic when compared with the blue chips. Wall Street sages in the aftermath of the stock-market crash were recommending that investors stash their money in highly capitalized heavy-weights. Hence the "flight to quality," as investors sought what were perceived as solid, secure stocks that supposedly could ride out any calamity.

Yet from mid-December -- generally regarded as the time that the market's meanderings ended -- to mid-March, OTC stocks as a whole have outperformed nearly every major stock index.

During that three-month period, the NASDAQ index was up 24.5 percent. The next-best performer was the American Stock Exchange, which was up 22 percent. The New York Stock Exchange rose 13 percent, while the Standard & Poor's 500 -- which contains stocks from all markets -- gained 12.1 percent. The 30 stocks that make up the Dow Jones Industrial Average were up 8.5 percent.

Hardiman concedes that the blue chips outperformed the OTC market during the long bull market before the crash. But that period, he contends, was somewhat a departure from the long-term trend. "We had a growing presence in the U.S. market of foreign investors who invested in blue chips," he says. During the past 30 years -- except for the 1983-87 period and in 1972-74, when the Nixon administration experimented with price controls and floating foreign-currency exchange rates -- the OTC stocks have come out on top of the blue chips.