Marijuana Stocks And Legalization - The Complex Relationship

by: Individual Investment Strategist

I have been following much of the chatter on Seeking Alpha and elsewhere regarding the publicly traded companies of Medical Marijuana, Inc. (OTCPK:MJNA); Hemp, Inc. (OTCPK:HEMP); MediSwipe, Inc. (MWIP.OB); Tranzbyte Corp. (OTCPK:ERBB); Growlife Inc. (OTCPK:PHOT); Medbox, Inc. (MDBX.PK); AVT, Inc. (AVTCE.OB) - delinquent in reporting at the time of this article as noted by the appended E; Terra Tech Corp. (OTCQX:TRTC); Rapid Fire Marketing, Inc. (OTCPK:RFMK); GW Pharmaceuticals Plc. (OTCPK:GWPRF), and a few others for quite some time now. I am not going to analyze each of these stocks fundamentally or technically for you as there are authors here on Seeking Alpha who attempt to do this, instead I am going to briefly cover what most of the others have not - the topic of legalization and why at this stage it matters more than the quarterly statement of any publicly traded company in this budding industry.

When it comes to the legalization of any substance classified as a Schedule I drug, there are many considerations that must be taken into account. The road to rescheduling anything that is under this classification is difficult and complex to navigate for many reasons. It is for these reasons I believe many of the other authors here are concerned about the wrong, negative or positive aspects regarding the companies in question. Seeking Alpha, being a place where nearly anyone can publish information, has likely been the number one site publishing and distributing articles on the topic of marijuana stocks. In responses to these articles, many contributing commenters have questioned legalization, yet nobody has gone into what it will really take, why this is moving slowly on the federal level, or what this could mean for these stocks.

State and Federal Law - the First Consideration

Many people believe that the federal government is taking its sweet time to respond to the legalization in Colorado and Washington states. In a sense they are, but there are reasons for this.

In their response, the federal government on one hand could favor legalization. This would open doors that are currently closed to these companies in terms of capitalization, product assortment/selection, R&D, ability to conduct business freely, and the ability to provide (for reputable companies) more disclosure and increasing transparency to shareholders with regard to company operations. On the other hand, a response in favor of continuing the current quasi-legal medical status or continuing with the "war on marijuana" could leave each of these companies open to the repossession of all assets and criminal actions justified under federal racketeering (specifically see pages 22 and 46) and money laundering laws; these federal violations are in addition to numerous other state and federal laws regulating possession and usage of marijuana while it is considered a Schedule I drug. For these reasons, it is difficult for these companies to capitalize via traditional methods and why institutional investors will not be attracted to, or participate in, the trading of these stocks at the moment.

Those following marijuana reform have been waiting for Attorney General Eric Holder to say how the federal government is going to react to the legalization of marijuana in the states of Washington and Colorado. Personally I too have been waiting to see what he says, and in this Associated Press article, he made it clear that he is in no hurry to address the issue at hand. The overall tone conveyed by Holder in the interview hints that legalization is a very complex matter. I would not look for a decisive change in his tone anytime soon because, as he says, marijuana is still illegal and his department has to uphold the law. All of that and it truly is a very complex matter - more than most realize.

Why is this a complex matter when a recent poll shows the majority of citizens (51%) support legalization? The first definition we should make when determining this is in regards to the Supremacy Clause of the Constitution. Under this clause, the Constitution and federal laws take precedence over state law; this means that the Constitution our nation was founded on grants Congress the power to preempt any state law which counters federal laws. This is an inconvenience when it comes to the recent legalization by two states and ultimately the clause gives the federal government a fair amount of power to overturn or manipulate state laws legalizing marijuana for recreational purposes.

Why not reclassify marijuana and move it off of the Schedule I list? This sounds like an easy task, but it is not an easy or straightforward thing to do. The side of the government which we think can reclassify the drug cites many reasons against reclassification, including the fact that we do not understand all of the "chemical components" of marijuana (we do not understand the chemical components in my tap water either…), but that still does not even hint at the real dirt behind the complex process of reclassification. Proponents for rescheduling and legalization will cite a myriad of medical benefits outlined in this article and the links contained in it going to the National Institutes of Health. They will also cite the drug is virtually harmless when compared to alcohol, cocaine, or even prescription drugs. Opponents to rescheduling will cite equally valid scientific results and studies. The consequences to one's health is not the focus of this though, reclassification is, and while there are negative studies documented, domestic opponents to legalization will utilize these studies to their fullest.

Money - the Second Consideration

Since I was a teenager I have heard that marijuana is the largest cash crop in the United Sates. If true this means that if legalized and taxed it would bring a stream of revenue into the tax pool unlike almost any other single substance/product/industry has to date. The often overlooked perspective here considers how much money is being allocated and generated by fighting the "war on marijuana." According to a study by the Cato Institute, legalizing marijuana could save 8.7 billion dollars (2008 dollars) through reducing the expenditures involved in fighting marijuana. In the same study, it is mentioned that 82.5% of all arrests in 2007 were due to possession of drugs and 42.1% of those were specifically for marijuana offenses. The Cato Institute study is the single most complete and reliable source I have found for expenditures and potential revenues on both the state/local and federal levels. Of course all law enforcement agencies would not like to see their share of budget allocations shift away; in California alone, nearly 1 billion dollars were spent in 2008 attributable to enforcing marijuana prohibition. The 2013 budget from the Office of National Drug Control Policy is requesting 2 billion dollars in its budget to fight drugs internationally. Legalizing marijuana could allow us to reduce major expenditures at home and abroad. The main point, that our government on many levels is trying to figure out, is if legalization would be net positive without sacrificing what is viewed as necessary funding for law enforcement to be as expansive of a force as it is now. Money, believe it or not, is not the biggest factor in ending prohibition, but it is an irritant that will continuously create support for prohibition from various parts of the government.

Politics - the Third Consideration

Then there is the politics of it - and those politics carry more weight than any of the previously mentioned components to this puzzle. The current leaders of our country are not likely to change their mind and broadly support legalization in the current climate. To do this would open doors that they could never shut again and nobody can quite paint a complete picture of what it would look like in all regards if those doors were open. Nor are future newly elected officials in D.C. likely to outright support legalization near the beginning of their terms since this could be career suicide in addition to a large expenditure of political capital. There is a very large shift in the current political climate that would have to happen in order for the movement to receive broad support in our nation's capital. We are currently experiencing what I believe is the beginning of this paradigm shift, but it will not mature overnight.

The international community (IC) does have something to say in all of this too. There are a couple of reasons for this. One is of course international aid (2 billion dollars worth) and the enforcement/military training we provide internationally under global drug enforcement policy. Even more important though is the UN. Recently the UN went on record condemning our legalization effort and legalization efforts in other countries. Like many here, I enjoy thinking that other countries should have no say in our state and federal laws. Political science for years has debated if the IC influences nations in the formation of their legislation or if nations influence the IC in international legislation and agreements. Prepare for the catch-22 as this debate is only the visible liquid moisture on the tip of the iceberg. As it stands, the UN has a right to condemn our legalization due to three international treaties that we as a nation signed. These treaties have a profound influence on federal laws due to the same Supremacy Clause of our Constitution that allows the preemption of state law. Under the Supremacy Clause, also known as Article VI of the Constitution, these treaties along with the Constitution and laws of the United States are "the supreme law of the land." So while the 1961 Single Convention, the 1971 Convention of Psychotropic Substances, and the 1988 United Nations Convention Against Illicit Traffic in Narcotic Drugs and Psychotropic Substances might not mean anything to most Americans, these treaties have had a great influence on our federal drug policy and laws. Our domestic scheduling of drugs is, amazingly enough, almost an exact duplicate of the schedule set forth by the treaties; this is not a coincidence. The single most insightful study available on the specific topic of international influence and domestic ability in legalization of marijuana is a paper published by the New York City Bar Association [NYCB] located here. I am no legal expert, yet I am assuming that the Bar Association writes with expert knowledge regarding law. In regards to Eric Holder's ability to make a change through the power granted by his position, this is what the NYCB had to say:

The Attorney General, who is in charge of scheduling under the CSA (and who has delegated this authority to the Administrator of the Drug Enforcement Administration), is not free to reschedule a substance such as marijuana to a less restrictive schedule absent a decision from the Commission on Narcotic Drugs, and ultimately a recommendation from the World Health Organization. (NYCB, 2012)

The UN Council responsible for these treaties also said, according to the same paper, that global drug policies have been a complete and utter failure. To act against these treaties which is outside the realm of probability, though not possibility, would be to backtrack on a firm anti-drug stance our nation has enforced globally and would probably make us the red headed step child of the UN Commission on Narcotic Drugs - especially given what Bolivia (another party to the treaties) went through to allow its citizens to chew on cocoa leaves (detailed information in NYCB study). Increasingly, we are seeing reports by other member countries regarding interest in marijuana legalization within their own borders. When you combine the treaties as they exist now and Article VI of the Constitution, the matter of legalization becomes a Constitutional matter since the treaties are granted power equivalent to that of our domestic federal laws.

What All of This Means for Our Stocks

Since the Legislative, Executive, and Judicial branches cannot lightly change the scheduling of marijuana, legalization will not likely happen in the next few months or maybe even years. It would not come as a surprise to me if the federal government preempted the laws of Oregon and Washington states simply because there is not enough time before 01/2014 to work out all of the domestic and international complexities involved in legalization. Our government is also unsure what effects legalization will have on society which is why there are federal grants such as this one available seeking to commission studies into the social, behavioral, and public health impacts. The international community is increasingly calling for reform on many levels when it comes to the global guidelines and failed global drug policies. Our nation as a whole though is not making baby steps any more in our attempt to end prohibition; we are running into this head on. For those investors or speculators out there, the one single thing you should consider when investing in these stocks is that at the end of the day marijuana is still illegal and exists in a legal gray area - both medicinally and recreationally.

For those of us who were hoping that some of these small caps would yield exponential returns, well they still might - do not lose hope yet. Until marijuana is rescheduled and legislation changes you risk all of your investment and will have no recourse, so my advice is to do your own diligence and follow practical investing guidelines. There is one point that is continuously brought up that is valid though - the lack of transparency for these companies. I would expect this lack of transparency and given the current environment in which these companies are operating, I would not expect many of them to come out and tell you exactly what they are doing on a daily basis simply as a matter of self-protection. Then again neither you nor I are trading these stocks based on standard principles, we are trading them based either on hopes of capitalizing from volatility or with the long-term hope that prohibition ends and the companies are valuable. When prohibition ends, there will be a flood of other heavily funded companies that will enter the market creating tough competition for any existing company that is not on their game. In my book though that day is when the real trading fun begins.

Disclosure: I am long OTCPK:MJNA, OTCPK:ERBB, MWIP.OB, OTCPK:HEMP, OTCPK:PHOT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.