High Risk, but High Reward: FINRA Warns About Investing in Marijuana Companies

source: http://www.flickr.com/photos/31246066@N04/

source: http://www.flickr.com/photos/31246066@N04/

“With medical marijuana legal in almost 20 states and recreational use of the drug recently legalized in two states, the cannabis business has been getting a lot of attention — including the attention of scammers.” On August 20, the Financial Industry Regulatory Authority — or, FINRA — issued an alert to investors warning them about potential scams associated with marijuana-related stocks.

Specifically, FINRA warned about the well-known ‘pump-and-dump’ scheme, in which, “fraudsters lure investors with aggressive, optimistic — and potentially false and misleading — statements or information designed to create unwarranted demand for shares of a small, thinly traded company with little or no history of financial success (the pump). Once share prices and volumes reach a peak, the cons behind the scam sell off their shares at a profit, leaving investors with worthless stock (the dump).”

The warning was timely. The conversation surrounding the legalization of medical marijuana in the United States was thrust into prime time recently primarily due to two events — one was the reversal of opinion on the matter by Dr. Sanjay Gupta, CNN’s chief medical correspondent, and the other was New Jersey Governor Chris Christie’s approval of medical marijuana for children.

As it stands, 20 states plus the District of Columbia recognize some legitimate medical use for marijuana. Cannabidiol (‘CBD’), a less psychoactive chemical found in the marijuana plant, has a wide range of demonstrated medical applications for conditions such as epilepsy, multiple sclerosis, anxiety, schizophrenia, nausea, and seizures, and has even been used to inhibit the growth of cancer cells. Tetrahydrocannabinol (‘THC’), CBD’s psychoactive big brother, has also been used to address medical conditions such as neuropathic and chronic pain.

Marijuana as medicine is at the heart of the pro-legalization argument. ProCon.org — an independent, nonpartisan, nonprofit organization — estimates that there are at least 2.4 million medical marijuana patients in the United States.

This estimate, extrapolated based off of the number of patients currently in the system, likely understates the true number of people who could use cannabis for a legitimate medical reason. Under federal law (the Controlled Substances Act), cannabis and cannabis resin are Schedule I drugs, putting them in league with LSD, MDMA (or ecstasy), heroin, and psilocybin.

This fact has made it enormously difficult for researchers in the United States and abroad (cannabis is illegal in most of Europe, despite pockets of use like Amsterdam) to increase their understanding of the plant’s medicinal qualities.

Serious medical research is only being conducted at a handful of facilities — but the data they are producing is compelling. It has been demonstrated that marijuana has the capacity to improve the quality of living of those suffering debilitating illness, often with extremely minor side effects. In some cases, marijuana has been proven to be an effective treatment for conditions that prescription medication — often saddled with damaging side effects — can not address.

Because of marijuana’s demonstrated and potential medical applications — as well as the recreational market, which many think is not far off — the plant is expected to become a cash crop like nothing else before it. Since cannabis is still illegal at a federal level, major pharmaceutical corporations such as Pfizer (NYSE:PFE) or Eli Lilly (NYSE:LLY) have yet to claim market share, and big tobacco – Altria Group (NYSE:MO), Philip Morris (NYSE:PM), among others — already fighting an uphill legal battle, has stayed away.

This trend has left small companies, most of which are privately held or trade penny-stock equity on the OTC markets, to fight for the title of ‘first mover.’ The ambiguous regulatory environment that surrounds the budding marijuana industry has cast a pall over businesses that operate directly within or even at the edge of the industry.

Investors seem to agree that at some yet-to-be-determined point in the future the floodgates will open and legal marijuana will be a multi-billion dollar industry. But the road there is still uncertain. The industry as it exists today is plagued with dubious actors, net losses, and micro caps — all red flags to anyone but the most risk-hungry investors.

That said, as the floodgates open, savvy businesses and their investors stand to make a tremendous amount of money. While the size of the market is opaque, the following indicates some speculation.

“The medical marijuana industry has grown at a rate of 13.8 percent per year over the last five years to about $1.7 billion in 2013,” said Nima Samadi, a senior analyst at IBISWorld, in an interview with The Huffington Post. “Over the next five years, we’re going to see even stronger growth. It’s expected to grow 24.3 percent per year and approach about $5 billion [by 2018]. The majority of that revenue growth has come from the non-profit medical marijuana collectives.”

Samadi’s forecast includes just the medical marijuana industry. Specifically, it does not include growth up or downstream, or the recreational market. Recreational legalization at a large scale is farther down the regulatory road, but also promises a much larger market.

Jamen Shivley, a founder of Diego Pellicer, is one of the few people willing to throw out estimates on the current size of the black-and-gray marijuana market that, ostensibly, equates to the size of the hypothetical legal market. His pitch to investors values the marijuana industry at $100 billion, which he suggests will grow as large as $500 billion worldwide.

Here’s a quick overview of some existing marijuana-industry players:

Company Market Cap Trailing twelve-months revenue TTM Price-to-sales ratio
Growlife, Inc.(OTC:PHOT) $19.22 million $2.78 million 7.15
Terra Tech Corp.(TRTC.OB) $6.86 million $406.81 thousand 14.95
Hemp, Inc. (HEMP.PK) $10.79 million $28.14 thousand 414.02
Cannabis Science, Inc.(CBIS.OB) $31.14 million $36.58 thousand 898.04
Medical Marijuana, Inc.(MJNA.PK) $128.23 million n/a n/a

At a glance — low market caps, low revenue, and in most cases, high price-to-sales. These are penny stocks traded on the pink sheets or over-the-counter markets. Simply put, the risks are too high for most investors, but that’s a pretty vapid statement without some context.

One risk already identified is the ambiguous regulatory environment. Active enforcement of the current federal regulatory position threatens to shutter some businesses and leave equity holders with nothing. At the very least, the specter of federal enforcement dissuades would-be customers. FINRA didn’t name names in its warning and as a result, most stocks in the marijuana category took a beating — even those with nothing to hide.

While it is absolutely true that investors should always have their guard up and be particularly rigorous in their approach to penny stocks and marijuana stocks, not every company in the space is a pump-and-dump scheme. Investors should be able to tell the difference between a viable investment candidate and a scam by examining company fundamentals, reporting history, transparency, and management. Who is in charge? What type of company have they built? Are they square with the SEC? Are they audited? And are they trying to hide anything?

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