Intro To Pot Stocks: Plenty Of Risks Mixed With Large Potential Rewards

by: Mike the PhD

I don't write much about pot stocks, not because I find them distasteful or because pot is illegal - I'm in favor of the small investor making money anywhere he can and using every edge he can get. Instead what concerns me about pot stocks are two things: potential regulatory risks and the agency costs problem. This article outlines these two problems and suggests a possible way around the second one.

Once pot stocks get passed these hurdles, they could have a bright future ahead of them and the industry could grow at a pace similar to that experienced by 3D printing companies. (Of course that kind of growth profile and the associated price swings could scare some investors given the volatility in stocks like DDD, SSYS and XONE - see my article here for more details.)

First and foremost, it is important to realize that ALL pure play pot stocks currently trade off the exchanges on the pink sheets and OTCBB. This means the stocks are widely more speculative than even the riskiest plays on the NYSE and NASDAQ. Stocks that trade off exchanges are effectively unregulated and the vast majority file little or nothing in the way of financial statements. Even when a company does file a financial statement, the statements don't have to be audited by an accounting firm. As a result, one potential way to look for profits on pot is simply to buy stocks like (NYSE:GE) or Phillips (NYSE:PHG) that supply lighting and other supplies to pot growers. Of course, since these firms are so big, pot legalization won't help them much, and pot crackdowns won't hurt them much. As a result, if investors want to pursue pot stocks, you have to get risky and go off-exchange.

Stocks like OTCPK:MJNA, OTCPK:HEMP, OTCPK:CBIS, XCHC.PK, and (CANV.OB) all are involved in the nascent medical marijuana industry principally in California, Washington state, and Colorado. Small suppliers to the pot growing industry include companies like OTCPK:PHOT, MDBX.PK, MWIP.OB, OTCQX:TRTC, OTCPK:GRNH, and OTC:FSPM. Again, all of these stocks are extremely small, their stock prices are generally well below $1, and they are very volatile. As a result, any money invested in these firms should effectively be considered a gamble.

Even beyond the risk of these firms being prosecuted by the federal government, there is a significant risk surrounding regulations on these firms going forward. Since the federal government still considers marijuana to be illegal, the FDA and other regulatory agencies haven't written any regulations on this industry. That leaves the individual states to regulate the product, and given the scrutiny and publicity each state faces on the issue, none of them want to allow legal sales to customers without having extremely strict regulations in place. With both Colorado and Washington set to begin issuing sales licenses in the next 12 months, these regulations should begin to be published soon.

Microbial testing, pesticide testing, health inspections, product consistency inspections, and all of the standard paperwork necessary to run a legal business will substantially raise costs for most pot producers. And given past severe illnesses reported in medical studies from consuming moldy pot, or pot tainted with E coli or Salmonella, there is certainly a strong chance that a corner-cutting distributor could give much of the legal industry a bad name if future illnesses gain widespread attention. Further, given the simplicity of the retail business, even if pot regulations aren't too costly, and severe illnesses don't capture headlines after pot goes mainstream, there is likely to be a surge of competition that will drive most pot retailer's profits way down. After all, none of the pot shops out there are likely to have a strong brand-name right away - this is a whole new market for consumers.

These regulation hurdles aren't even the biggest business threat that investors in pot stocks face, however (at least in my view). Equally hazardous to investors' health is the much trickier agency problem. Basically the agency problem is an economic concept that just means that if the manager of a company doesn't own 100% of that company (i.e. he has shareholders) then he has an incentive to look for ways to use shareholders' profits for his own benefit.

The classic example of this is a CEO using a company's profits to buy a corporate jet/fancy office/limo for himself. This is the justification for the SEC and other bodies strictly regulating corporations and for the existence of boards. However, most boards for small companies do very little in the way of monitoring and controlling managers, and as I have already explained, regulations on pink sheet firms are next to nothing.

As a result, assuming pot companies take off and start making a lot of money, there is very little to stop a CEO of a pot company from spending all of the money the company makes in ways that benefit himself rather than returning it to shareholders. There are no analysts watching him, press coverage of these firms is next to nothing, regulations are nonexistent, the board is a rubber stamp, and even if shareholders wanted to vote the CEO out, he could easily compel the board to put a poison pill of some sort in place.

This is an enormous risk for investors in pot stocks. Let's face it, CEOs of pot companies clearly are not afraid to stretch (break?) the law, why would they be afraid of cheating shareholders?

One could make the same statement about CEOs of bigger companies, but at least in those cases, there are a lot of checks on the CEO's power.

So what is an investor to do? Well currently nothing - BUT, within the next month or two there may be an alternative. The SEC is currently working on finalizing the rules governing what's called crowd funding. This is intended to be a new mechanism for small investors to allow them to invest in small high risk companies in order to allow them to grow. The rules aren't finalized yet, but under the JOBS Act which passed last year (see bill here), investors will be able to go online to many different websites and directly invest money into small firms. Up to 500 investors will be able to invest anywhere from $1 million to $50 million in small firms with the exact investment amount being based on a variety of technical factors that haven't been determined yet.

Investors interested in taking a gamble and investing in pot stocks would probably be wise to look at investing via crowd funding, rather than the pink sheets. Doing crowd funding investment will enable the investor and the company's management to have a much closer relationship which should help to mitigate the agency problem. For example, if you are one of 50 or 100 owners in a company, you have a lot better chance of being able to call up the CEO and get an honest appraisal of what is going on in the business than if you are one of 1 million shareholders. Further, a lot of crowd-funding activity is expected to be local in nature, and it's obviously much easier for a local investor to get in his car and drive ten minutes to meet with the CEO who lives in the same town than to try and meet with a busy CEO of a public firm.

In summary, given these risks and hurdles, most investors should be extremely wary of investing in pot stocks. For those who are willing to take the risks, off-exchange companies are currently the only option, but new innovations in crowd-funding should soon offer other alternatives.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.