Weed Stocks 101: What You Need to Know
February 26th, 2016
The cannabis industry is often considered to be the Wild Wild West of the equity markets. Since the industry is so new, most companies fall under the “development stage” designation with little in the way of revenue and profit. The majority of these companies also trade over-the-counter with little liquidity. These are dangerous waters for most individual investors that are oft-advised to stick with low-cost and diversified mutual funds or ETFs.
On the other hand, Canada has already legalized medical cannabis and has official plans to legalize the drug for recreational use. This could help set a precedent for the United States and other countries considering the same. In the U.S., ArcView Research estimates that the industry hit $3.5 billion last year and GreenWave Advisors reckons that it could hit $35 billion in size if all 50 states legalize the drug and the federal government ends prohibition.
These tremendous growth rates make the industry difficult to ignore for investors willing to take on some risk in their portfolio. After all, a $35 billion cannabis industry could rival the $37.6 billion domestic wine industry. The question is: How do investors find real opportunities and avoid potentially disingenuous companies in the space?
Sharks in the Water
The cannabis industry has exploded from just a handful of publicly traded companies in 2013 to more than 350 companies in the space today. While some of these companies are billion dollar enterprises, such as GW Pharmaceuticals plc (NASDAQ: GWPH), the majority are micro-cap stocks trading with market capitalizations of less than $100 million. These stocks are considered to be high-risk by many financial advisors given their low liquidity and lack of information.
“The sector is littered with companies, a total now in excess of 350, most of which are not productive enterprises, to put it nicely,” says Alan Brochstein, CFA, of 420 Investor and New Cannabis Ventures. “I think better companies entering the space would be a reason to invest. For now, I have shifted my own focus over the past year or so to Canada, where there are better companies with reasonable valuations and good liquidity for their stocks.”
Many Canadian companies are dual-listed on U.S. over-the-counter exchanges and Canadian exchanges where there is greater liquidity. For instance, Canopy Growth Corp. (TSX-V: CGC) (OTC: TWMJF) trades over 21,000 shares per day on the U.S. OTC Markets Exchange and 558,540 shares per day in Canada on the TSX Venture Exchange. The company also generates tangible revenue as a licensed producer under the country’s MMPR program.
Matt Karnes of GreenWave Advisors suggests that individual investors should avoid reverse mergers altogether, saying, “Understand the investment risks that are unique to this industry, including legal, operational, and financial risks, and avoid buying a stock that stems from a reverse merger since the requirements to go public are far less restrictive with a reverse merger and there are inherently added risks to the investor as a result.”
Popular cannabis stocks that did not go through reverse mergers include MassRoots Inc. (OTC: MSRT), Indoor Harvest Corp. (OTC: INQD), and Medicine Man Technologies Inc. (OTC: MDCL), among several others. For many private companies looking to go public, the traditional initial public offering route may be more appealing to avoid the negative stigma attached to RTOs.
Investors interested in the cannabis industry should be prepared to take on much more due diligence than they would in blue-chip stocks. For instance, looking at valuation metrics like price-earnings ratios and debt levels may be a good start for blue-chip stocks, but trying to value a company that’s pre-revenue is much more challenging. It’s also necessary to take a much closer look at the management team and capitalization structure to avoid problems.
Alan Brochstein recommends that investors ask themselves a number of important questions before committing any capital, including:
- Does the company have a good business model that is differentiated from others?
- Is management capable? Do they have success stories, whether in the cannabis industry or not?
- Does the management team have cannabis-centric experience, or are they approaching this solely from the proverbial ivory tower?
- Does the company have a good financial foundation?
- Is the valuation, incorporating not only the shares issued but other shares that could be issued due to the conversion of preferred stock or debt, make sense?
- If public, is the trading volume reasonable high relative to the amount an investor would want to buy or sell?
“At New Cannabis Ventures, which is free and doesn’t require registration, we recently wrote about a new offering under the Reg A+ format, warning potential investors about the implied valuation,” said Brochstein. “We also try to highlight companies that are succeeding in terms of attracting funding and making progress in addressing important challenges or identifying opportunities in the legal cannabis market.”
Investors should also exercise caution when it comes to referring sources of information covering the cannabis industry.
In a 2014 statement, FINRA issued some guidance to investors in this regard:
Ask: “Why me?”. Why would a total stranger tell you about a really great investment opportunity? The answer is there likely is no true opportunity. In many scams, those who promote the stock are corporate insiders, paid promoters or substantial shareholders who profit handsomely if the company’s stock price goes up.
Consider the source. It’s easy for companies or their promoters to make exaggerated claims about lucrative contracts, the company’s revenue, profits or future stock price. Be skeptical about companies that issue a barrage of press releases and promotions in a short period of time. The objective may be to pump up the stock price. Likewise, be wary of information that only focuses on a stock’s upside with no mention of risk.
Do your research. Search the names of key corporate officials and major stakeholders, as well as the company itself. Proceed with caution if you turn up recent indictments or convictions, investigative articles, corporate name changes or any other information that raises red flags. For example, the CEO of one thinly traded, yet heavily touted, company that purports to be in the medical marijuana business spent nine years in prison for operating one of the largest drug smuggling operations in U.S. history. The former CEO of a similar company was recently indicted for his role in a multi-million dollar mortgage-based Ponzi scheme. Check the Federal Bureau of Prisons Inmate Locator to determine if a solicitation is coming from someone who has served time in a federal prison. Many states also have similar prisoner locator systems.
Know where the stock trades. Most unsolicited spam recommendations involve stocks that do not trade on The NASDAQ Stock Market (NASDAQ OMX), the New York Stock Exchange (NYSE Euronext) or other registered national securities exchanges. Instead, these stocks may be quoted on an over-the-counter (OTC) quotation platform like the FINRA-operated Over-the-Counter Bulletin Board (OTCBB) and the platform operated by OTC Markets Group, Inc. Generally, there are no minimum quantitative standards that a company must meet to have its securities quoted in the OTC market. Many of the securities quoted in the OTC market don’t have a liquid market. They’re infrequently traded and can move up or down in price substantially from one trade to the next. This may make it difficult to sell your security at a later date.
Read a company’s SEC filings, if available. Most public companies file reports with the Securities and Exchange Commission (SEC). Check the SEC’s EDGAR database to find out whether the company files with the SEC. Read the reports and verify any information you have heard about the company. Remember that just because a company has registered its securities or has filed reports with the SEC does not mean it will be a good investment—or the right fit for you. Also, be aware that not all financial information filed with the SEC, or published elsewhere, is independently audited. Unaudited financials are just that—not reviewed by an independent third party.
Be wary of frequent changes to a company’s name or business focus. Name changes and the potential for manipulation often go hand in hand. One low-priced stock now claiming to be in the medical marijuana business has had four name changes in the past 10 years. Another company switched from the coffee business to focus “on the rapidly emerging medical marijuana industries.” Name changes can turn up in company press releases, internet searches and, if the company files periodic reports, in the SEC’s EDGAR database.
Check out the person selling the stock or investment. A legitimate investment salesperson must be properly licensed, and his or her firm must be registered with FINRA, the SEC and a state securities regulator—depending on the type of business the firm conducts. To check the background of a broker or investment adviser, use FINRA’s BrokerCheck. You can also call your state securities regulator. When using BrokerCheck, research the name of the person who contacted you, as well as the name of the firm they claim to work for. Verify the caller’s identity using the phone number on the firm’s website or in a publicly available telephone directory.
There’s little doubt that the cannabis industry is a risky investment for individual investors due to the legal status of the industry itself and the nature of the publicly-traded companies involved. In general, Canada presents the most legally mature market that has attracted some of the largest companies. But, ignoring the United States could mean passing up on opportunities that could yield significant returns over the long-run.
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