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Marijuana Stock Guidelines

Picking Winners from a Young and Risky Field

Written by Briton Ryle
Posted May 1, 2014

California and Alaska had their gold rushes. Texas has its oil rush. Now Colorado has its weed rush. The legalization of recreational marijuana in the state of Colorado has sown the seeds of the first legitimate non-medicinal marijuana operations in the U.S., with grow ops sprouting all across the state.marijuana money

In January alone, $14.02 million worth of recreational pot was sold by 59 businesses in Colorado, generating some $2.01 million in state tax revenue. It’s turning out to be quite the lucrative industry – for the state, anyway.

For many pot growing businesses, however, it’s quite the struggle. Though marijuana is one of the easiest crops to grow, entrepreneurs are finding out that growing a marijuana company is not nearly as simple, and that burning their cash does not produce as sweet an aroma as the burning of the pot itself.

Yet marijuana stocks keep getting bought up with enthusiasm, their price multiples drifting higher and higher into bubble territory. Not only are their valuations too high, but their investors must be too. Looking a little more closely at some financials, we find that experimenting with marijuana stocks could be causing hallucinations.

Weeding Out the Weeds

It is doubtless that the marijuana growing and vending industry will flourish in the not too distant future. But as with any new industry, the beginning is always rocky. The majority of the publicly traded marijuana companies and those that cater to them are experiencing growing pains, and are likely to do so for quite some time.

In the table I've assembled below, you can see how revenues from pot sales are dreadfully low and operating expenses are prohibitively high to justify their ridiculous valuations against other Micro Caps.

Micro Cap Marijuana Stock Comparison%2C May 2014Several metrics noted above point to unsustainably high stock prices in the marijuana field:

• While micro-cap stocks from the hospitality, financial and energy sectors are generating the typical revenue-to-market-cap ratios you’d expect from a micro-cap – generally in the 50-150% range - marijuana-related stocks are posting revenues that are less than 1% of their market caps.

• Where a typical micro-cap stock trades at 1-3 times price-to-sales and price-to-book-value, pot stocks range from the low 20s to well over 1,000 times their sales, while price-to-book of 23 and 33 means their stocks are trading that many times more than their companies are actually worth.

• Where the average micro-cap has manageable operating expenses with positive or near-positive operating margins, pot companies’ operating margins reach thousands of percent in the negative! Such operating losses can only cause their capital to wither away, and fast.

As ugly as those figures are, the picture was even worse at the beginning of the year when Colorado legalized the sale of pot for recreational use, as noted in the graph below. We can see why investors have been drawn to the mostly penny stocks, since all it take is a little pop in price to multiply your investment 5 times over.

HEMP daily index%2C May 2014

Source: BigCharts.com

But since then, marijuana stocks have been wilting under the heat of unfavorable light.

Heavy Reliance on Equity Capital Cultivates Fraud

The main problem with marijuana producers and vendors is their being stuck between two codes of law – state law which deems them legal, and federal law which still prohibits many of their activities.

Trapped in such legal limbo leaves them with very few fundraising options. Most banks will not lend them capital, while credit card company refuse to extend their services. Debt figures illustrate this quite well. Where mainstream mirco-caps SOHO, VYFC and XWES have debts equalling 260%, 159% and 20% of their market caps respectively, the six marijuana companies listed in the table above have debts averaging just 1.4% of their capitalizations.

So if they can’t borrow, from where do they get their money to run their companies? They have to rely on selling company stock to raise the capital they need. And the way their operations are burning through cash as noted in the table above, pot companies need to continually sell more and more shares – and of course, keep their stock prices high.

It’s that latter part that foments fraud… the need to keep their stock prices high. Many marijuana companies have resorted to the decades-old trick of releasing upbeat and encouraging news and reports to drive their stocks up, selling company stock at the higher prices, releasing some bad news to drive the price back down, buying shares back at the lower price, and repeating the process over and over again.

The old “pump-and-dump” scam is especially profitable with penny stocks, where a single press release can move a thinly traded stock by hundreds of percentage points overnight, as the graph above shows.

The practice is widespread enough to prompt the Financial Industry Regulatory Authority (FINRA) to issue a caution to investors last year:

“The con artists behind marijuana stock scams may try to entice investors with optimistic and potentially false and misleading information that in turn creates unwarranted demand for shares of small, thinly traded companies that often have little or no history of financial success.”

More than one marijuana stock has had the trading of its shares suspended during investigations of fraudulent reporting. GrowLife stock was suspended last month by the Securities and Exchange Commission over concerns of “the accuracy and adequacy of information in the marketplace and potentially manipulative transactions in PHOT’s common stock.”

A Crash Follows Every High

As with any new industry, it will take some time to weed out the companies infested with fraud. Sometimes it’s as simple as just letting the scammers run themselves into the ground, as no scam is long lasting. What remains afterward will be the sounder companies that have cultivated their seedling businesses well.

Until the marijuana sector is thus weeded out, investors have plenty of other, fully matured and fruitful companies to choose from without needing to seed cannibas in their portfolios.

Joseph Cafariello

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