Why Investors Should Avoid Marijuana Stocks

Marijuana is popular. It's fully legal in two states and the majority of Americans believe that'll soon be the case nationwide. But this doesn't mean investors should jump head first into the industry.

In the middle of last year, the Financial Industry Regulatory Authority warned investors that "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."

Known as "pumping and dumping," this is an old trick on Wall Street. Most recently, it was even the subject matter of a best-selling book and Oscar-nominated movie starring Leonardo DiCaprio. The subject of both was Stratton Oakmont, a Long Island-based boiler room that manipulated the price of microcap stocks in order to turn a profit.

Whether this same type of activity, or one of equally dubious nature, is now affecting cannabis stocks is impossible to say with certainty. Yet there's enough evidence of speculative frenzy, if not intentional malevolence, that investors would be wise to steer clear of associated stocks.

In the first case, many of the companies are trading for ridiculous valuations despite having little to no actual businesses behind them. CannaVest serves as an apt example. As a commentator on Investorplace.com recently observed, while its annual revenue came to $2.2 million last year, its selling and general administrative expenses added up to $2.4 million. Despite this, the company claims to have a "gross profit" of $1.3 million.

Along these same lines, some of these companies found their way to the public markets via reverse mergers, which allows them to avoid the regulatory scrutiny of an initial public offering. It's a backdoor to the equity markets, and, as a general rule, companies that employ it should be avoided like the plague.

Finally, if there was any doubt about the propriety of these companies, the recent decision by the Securities and Exchange Commission to halt the trading of shares in Advanced Cannabis Solutions, which trades on the over-the-counter market under the symbol CANN, should put said questions to rest.

To be fair, the company and its executives, two of which I spoke to earlier this year during research on an in-depth series on the industry, deserve to be given latitude until the SEC looks into concerns that "undisclosed affiliates and shareholders" unlawfully distributed the company's stock. But I, for one, wouldn't be interested in sitting around and waiting to find out. Not with Advanced Cannabis Solutions, nor any other company in the industry.

In short, it's simply too early for these companies to go public. The perils and uncertainty are too high to hoist onto the public equity markets. And, as a result, the extreme risk, and for that matter extreme reward, should at least for the time being remain with private investors who have the knowledge, wherewithal, and on-the-ground access to the companies themselves.

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