Book Reviews, Trading

Book Review of The Darvas System for Over the Counter Profits by Nicolas Darvas

This is a book written by Nicolas Darvas, after he became famous with his box trading system. As this book is quite dated, and the OTC market has developed quite a bit since then, many of the things written may no longer be relevant. Nonetheless, there are still some good tidbits to pick out.

Unlike his first book, there is no trading system that he has developed for OTC stocks. Rather the book mainly highlights the pitfalls of playing in the OTC markets, due to the limited liquidity, small issues, lack of dealers, etc. The book also goes into some discussion about OTC bonds and mutual funds, for example cautioning that a fund manager who can make good returns on a small sum of money may have a lot of trouble doing so with a much larger sum.

If you are a Darvas fan, this might be worth a quick skim through. If not, it may be more worthwhile to read more updated books if you are interested in trading pink sheet or other OTCBB stocks.

Syndicates Form to Distribute Stock

  • A broker-dealer acting as a broker is restricted to a maximum of 5% profit. There is no profit limit if it acts as a dealer, i.e. buys and sells securities for its own account.
  • Investment bankers, dealers, and brokers form syndicates to market huge quantities of new securities after they have been registered with the SEC, and also to distribute blocks of seasoned stocks for large sellers in order not to disrupt normal trading markets.
  • Dealers who were members of one syndicate usually remained associated with that syndicate on the next distributions. Defections meant being ousted from future syndicates.

Characteristics of OTC Stocks Successful Within First Year of IPO

  • Stocks were in a “hot” or “emerging” industry.
  • Small number of outstanding shares (< 300,000)
  • Management held a hefty slice of the pie.
  • Issue price between $5 and $10 a share.

Characteristics of Successful OTC Rebound Stocks

  • Market made by 5 – 15 dealers, many of them member firms of the NYSE.
  • Can be in prosaic industries: bookbinding, flour and feed milling, film editing, lawn mower business, etc.

What to Look For in an OTC Stock

  • Look up who the investment banker leading the specific syndicate is, and what his record has been.
  • Look for an issue with earnings growth goal of at least 25% per year after taxes.
  • Seek a small company.
  • Find well-managed companies whose officers have a substantial amount of outstanding common stock.
  • Look for institutional ownership.

What Not to Buy

  • Never buy any stock that had been peddled to the public via a best-efforts underwriting (i.e. underwriter charges commission for the shares he manages to sell).
    • Only consider stocks that were underwritten on a firm commitment basis (i.e. underwriter buys all the stock and then unloads).
  • Never buy a stock that have gone through more than 2 cooling-off periods.
    • A cooling-off period of 20 days starts after a prospectus or offering circular is filed with the SEC. The cooling-off period is extended for another 20 days if the SEC has objections to the registration.
  • Never buy big blocks of any OTC stock unless you have made provision for the right firm to sell the shares when the time comes for selling.
    • The right firm must be able to hit the wholesalers simultaneously to sell off your stake without dropping the price.
  • Never buy a penny stock in the mining and oil business.
    • The rebound chances of such issues are as remote as a lame horse winning the next Kentucky Derby.
  • Never buy a stock in bankruptcy or reorganization.
  • Never buy any OTC issue unless at least 5 dealers make a market in it — and those dealers have a substantial amount of capital to take in any shares to be sold in the future.
  • Never buy a OTC stock that did not rebound in good markets.

Shell Companies Are a Hidden Opportunity

  • Dormant companies sleeping in the pink sheets can become possible profit vehicles whenever they are awakened through the sale of control.
  • A profitable company may buy over a dormant listed in order to avoid the hassle and costs of filing for a public offering.
  • Chances are that the companies called shells will readily be found in those beleaguered stocks called “penny stocks”.

Penny Stocks Are Made, Not Born

  • Penny stocks of industrial or service companies which lurk undiscovered in the pink sheets were at one time “dollar stocks.”
  • Most penny stocks were born dollar stocks. As they grew in popularity after birth, they generally rose higher than their offering prices — and collapsed below $1, when, for operating or other reasons, a disillusioned public dumped the shares back on the dealers making the market.

Risk Management

  • Having made a penny stock purchase, unload half the purchase as soon as the stock doubles in price.
  • Never hold any OTC dollar stocks long enough for them to become penny ones. Cut losses quickly — and run.

How to Analyze Life Insurance Dollar Stocks

  • Investigate performance via balance sheet and income statement for the past 5 years.
  • Premium income must increase by more than 50% during the 5-year period under survey.
  • Company must write at least 10% in new insurance, over the previous years for at least 5 years — making an increase of 50% in new insurance during the investigative period.
  • Ordinary or straight-life insurance should consist of more than 60% of all policies in force. Avoid issues with the bulk of outstanding coverage in term insurance.
  • Company should enjoy a good, ready market — with at least 5 dealers.

Pink, Green, and Yellow Sheets

  • Pink sheets refer to the “eastern” section of the American OTC market, which also includes foreign certificates.
  • Green sheets provide lots of issues whose efforts and operations are located in western United States.
  • Yellow sheets represent OTC bonds and senior capital instruments.

Many Famous Companies Traded on the OTC Markets Initially

  • Many famous companies actually traded on the OTC markets initially. The National Quotation Board (NQB) Industrial Stock Index contained companies like American Express, Anheuser-Busch, Berkshire Hathaway, Dun & Bradstreet, Hoover, Eli Lilly, etc.

Price of a Stock Can Have Little to do with the Company’s Ability to Make Money

  • The price of a stock has nothing at all to do with the company’s ability to make or lose money. Alphanumeric ran up 126x over 3 years despite consistently racking up operating losses each and every year.

People Will Always Find Ways to Circumvent Regulations

  • People went around the Government’s margin requirements by selling a put option to a dealer, and the dealer sells a call option back to the put seller. This is equivalent to a long position in the stock with only 30% margin (25% for the put, and 5% for the call).

Open-end Funds Can Average Out Mistakes and Prop Up Prices

  • As long as fresh money comes into the hands of the fund managers, they can “average out” market mistakes. But, as is so often the case in closed-end funds which represent a limited capitalization, the managers cannot readily correct market errors.
  • Just as long as the mutual funds continue to receive an excess of investing funds over the funds they have to part with when people want out, they will continue to accumulate shares of issues that elevate the asset value of the fund itself (i.e. buy more shares on their existing stock to push the price up, which makes the fund show a huge gain on its entire position, even though if the fund were to unload its entire position, it will not be able to fetch the current “market price”)

How to Accumulate or Sell Large Blocks in the OTC Market

  • The supply of stock in the unlisted markets is generally much smaller than in listed ones. Moreover, OTC dealers are very shrewd. As soon as buying comes into the stock they specialize in, that stock becomes diamonds.
  • The best approach for large block buyers is to make a deal with the leading dealer in the issue, the man who makes the “primary market” and reveal what you are trying to attain on the buy-side. The potential buyer gives the dealer the leeway to round up a block at a probably less-expensive basis than if the buyer attempted to enter the market and make his purchase on his own through one or more sources.
  • On the sell-side, the same thing holds true. It is extremely difficult to unload a sizable position in any OTC stock without making some sort of “secondary” deal with the main market maker in the issue. He alone usually knows who is waiting to buy up the issue in hand at a discount – and how much that discount is.
  • Very often the dealer who is acting for the seller will go into the OTC market and buy enough shares for window-dressing purposes so that his competitors will be lulled into security until he is ready to hit them with a bundle of stock.

Darvas System Don’t Work for OTC Trading

  • … I employed a series of stop-loss orders to implement my trading techniques and to save my sin when trouble brewed. Such strategy, however, cannot be successfully employed when it comes to OTC trading.
  • Here, the trader must have at his disposal a source of service that watches his holdings carefully and lets him know what is happening whenever something happens…. one way…. is to get friendly with the person, or persons, you choose to conduct your transactions with.

People Gravitate to Speculative Issues

  • In 1969 a professor at a large eastern university handed his class in Security Analysis a term project. Briefly, the professor proposed that each student select and watch for three months a single OTC issue located in Long Island which he would want to put his own money into.
  • During that time the students would also familiarize themselves with the history and the statistical past of the companies they were interested in and prepare a comprehensive research report that included balance-sheet and income-statement analyses in addition to earnings and price projections.
  • Of the 18 students, only one selected a mature, solid company — in this case a bank. The others all picked speculations, some untried, many with disappointing statistics but with plenty of hope if not promise.



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