A Cannabis Stock Risk Management Tool

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 |  Includes: AVNE, CANV, CBDS, CBIS, EDXC, FSPM, GRNH, GWPH, HEMP, MCIG, MJNA, NGBL, PHOT, PLPL, PMCB, PUGE, REFG, TRTC, VAPE
by: Abdalla Al-ayrot

Summary

Presenting an indicator that has predicted weekly stock prices with +72.22% accuracy.

This indicator can be used to understand short term and long-term developments in demand factors for stocks in the Cannabis Industry.

Another tool that quantifies the supply factors will be presented later this week.

Indicator indicates that the SEC halts are the primary reason behind a nearly 50% downtrend in cannabis stocks.

The Indicator could have warned investors of the downtrend and thereby functioned as an excellent risk management tool.

This is the fourth article in my article series on Cannabis Stocks. I intend to dig through all of the listed investment opportunities in the cannabis industry.

Background

We have seen a big disconnect between private market valuations and public market valuations of companies in the cannabis industry over the recent 6 months. A disconnect in the sense that public market valuations are multiples of private market valuations.

My thesis is that this disconnect is primarily driven by hype from relatively inexperienced retail investors. The thesis is based on the rationale that institutional investors in many cases are restricted in their investment opportunities, with regard to minimum stock prie, stock exchange and federal laws. As marijuana is still illegal on a federal level in the US, it's too big a risk for institutional investors to invest in those stocks. Two other factors that restrict institutional investors' interest in these stocks are the career risk for portfolio managers and relatively high valuation of the stocks. If an institutional investor were to invest in the industry, they would be likely to invest in some of the private market companies, as they are valued at significantly lower multiples than the publicly traded companies.

One of the factors that indicate that retail investors are dominantly active in this market, is the story behind the origin of the twitter community #wolfpack, which is run by traders with a few months of market experience. Empirical evidence that further confirms the thesis is the results of a survey by Alan Brochstein, in which he asked the subscribers of 420 Investor, about their trading/investing experience.

A majority of those investors don't consider valuation as a crucial part of their due diligence process, which is due to their inexperience and lack of knowledge. The experience they might have is a few months of trading in marijuana stocks, which has soared +1000%. Everybody and their mother could have made money in cannabis stocks in the past months. Such conditions are far from the norm in the stock market.

What these investors' biggest weakness is what they don't know that they don't know.

These investors' experience and their perceived knowledge about the stock market is derived from a black swan period in the stock market. They think that the only way to make money from theses stocks is to buy the stocks, as that's what they have done in the past and it has worked. So they have kept doing it, this is what is called positive feedback loop. Brokers, stock promoters (they prefer to call themselves "investor relations consultants/firms/experts") and management have all confirmed them in their choice. But, what theses investors fail to recognize is that all these people have a vested interest.

Brokers want you to trade as often as possible, as that will make you pay them more.

Stock promoters want you to buy the stock, so that they can sell their stock to you (which they often get at 1% of the price that you paid).

Management wants you to invest, because without your money, they can't get paid. They often promise you all kind of stuffs, in order to convince you that the next contract/deal/sale/joint venture is just around the corner. But, they always do this under the standard "Forward-looking disclaimer," which removes their accountability for what they have forecasted. So, they often exaggerate and a lot of their forecasts are wrong...

A positive feedback loop can go on for years. A catalyst is needed to reverse the trend. A catalyst is usually hard to detect at first sight in most positive feedback loops. But, with promoted/hyped up stocks the catalysts are fortunately usually close to the same, which makes it somewhat easier to project the feedback loop's end. The two catalysts are often:

  1. Promoters and toxic financiers intensify their selling of shares, which increases the supply of shares.
  2. The promotion fades out, which decreases the demand.

In the past, promoters and toxic financiers sold their shares (which they usually obtain at a huge discount to the market price. Think minimum 30%) when they wanted to, without filing a registration statement. That is illegal, as they have to file a registration filling first. The SEC has cracked down on numerous toxic financiers for selling their shares without filing a registration statement first. This has made these people comply with the law, which means they now warn you before they dump their shares, by filling a registration statement.

One thing that makes you wonder (…or at least should make you wonder) is how on earth they can acquire shares at a huge discount to the market price LEGALLY. You see, it's fairly simple. These companies are to a large extent not real businesses, in the sense they don't have significant operating assets. Some of them are real businesses, but are bleeding money. These corporations are often sold as public shell for under $100,000 (Yes, you can find them online.). Some of these companies' only real goal is to enrich the financier behind the shell. Years ago this fraud was often very easy to spot, as the people behind those frauds often were majority shareholders and it was the same circle of people. But, as people have busted them, the toxic financiers' methods have evolved. Now, they seldom own shares, but instead they hold securities that are convertible into shares. It's usually not a plain vanilla convertible note, warrant or option. But, instead it's a custom convertible note, warrant or option, whose terms are written in a non-standard form, which makes it hard for a layman to understand the real terms of the security. The reason it's written in a non-standard form is for it to act as a smoke mirror, because they know that the investors that invest in the companies aren't sophisticated enough to understand such securities. Often these securities make the toxic financiers able to acquire shares at a +50% discount to the market value.

So anytime you read about a company, which has entered into a financing agreement or "Securities Purchase Agreement," whose terms are nearly impossible to understand, without consulting a lawyer and/or using 3 hours reading legal pages, be aware. It's usually a huge red flag. The easy way to know if the financing is not legit, is to open the legal pages and scroll down to the point where you can see who has signed the papers. Then Google the names, some of those toxic financiers have operated for decades in different kinds of frauds, which have made them make quite a few people angry, who express their frustrations on the Internet.

In order to get investors to buy the stocks, toxic financiers usually hire stock promoting newsletters. You can check whether a stock is being promoted on stockpromoters.com. In the case of cannabis stocks, the buying is to a large extent driven by renewed retail interest. So, in this case an indicator that can measure the development in the retail interest would be of great value.

Presenting the indicator

When an inexperienced retail investor is looking to invest in this industry, he is likely to search a number of keywords/sentences on Google for guidance. Due to Google Trends, investors are able to measure the development in the number of searches for all sentences and keywords. I have collected data on a number of keywords and sentences that I think newbie investors are likely to Google, before investing in the industry. This can be used as an indicator of retail interest, as the higher amount of Google searchers, the higher interest. In addition to that we have bought data from a variety of sources and weighted it so that it measures the retail interest as precise as possible (we got help from Ph.D's specilizing in this area). Let's call this indicator Ayrot Cannabis Retail Interest Index ("ACRI Index").

But, in order to know if the ACRI index is useful, I have backtested the performance of ACRI index relative to an index of cannabis stocks. I have created an equally weighted index consisting of the following stocks CannaVest Corporation (OTCQB:CANV), Cannabis Sativa, Inc. (OTCQB:CBDS), Cannabis Science, Inc. (OTCPK:CBIS), ENDEXX Corporation (OTCPK:EDXC), Fusion Pharm, Inc. (OTC:FSPM), GreenGro Technologies, Inc. (OTCPK:GRNH), GW Pharmaceuticals (NASDAQ:GWPH), Hemp, Inc. (OTCPK:HEMP), mCig, Inc. (OTCQB:MCIG), Medbox, Inc. (MDBX), Medical Marijuana, Inc. (OTCPK:MJNA), Nuvilex, Inc. (NVLX), Growlife Inc. (OTC:PHOT), Vape Holdings, Inc. (OTCQB:VAPE), Plandai Biotechnology, Inc. (OTCPK:PLPL), Puget Technologies Inc (OTCQB:PUGE), Medical Cannabis Payment Solutions (OTCPK:REFG), Terra Tech Corp. (OTCQX:TRTC) and Aventura Equities, Inc. (OTC:AVNE).

I have named the index Ayrot Cannabis Index ("AC Index").

A somewhat logical assumption is that an increase in the ACRI index in one week, should lead to an increase in the AC Index in the following week and the reverse with a decrease. As the time from first searching about the subject, to actually opening a brokerage account and decide which issue to invest in could take about a week for new investors.

So, I have tested predictive power of the ACRI index and have derived some interesting results. In the period September 7, 2013 to April 11, 2014 an increase/decrease in the ACRI index in one week, was followed by increase/decrease in the AC Index in the next week in 68.97% of the weeks. But, in the beginning of the above-mentioned period the search data was very low and we didn't see any real momentum in the AC index. Thus, if we adjust the data points to the period November 30, 2013 to April 11, 2014 the predictive power of the ACRI Index jumps to 72.22%. The following chart shows the development in the two indices.

Click to enlarge

As the ACRI index shows the retail interest has more than halved from its peak in January, which is partly due to the SEC halts. What remains crucial for traders and investors in the cannabis stocks is to monitor the supply (new stocks issuance) and demand (retail interest) factors affecting the market. In order for cannabis stocks to continue to climb higher, on already very high valuations, we will have to see a rebound in the retail interest, as that is where the new money in the industry will come from. If we don't see a rebound in the retail interest, in order for us to see continued higher stock prices, we will have to see a big contraction in the amount of shares being offered at the market and timing of those. As of today there aren't comprehensible index measuring the development in the supply of cannabis stocks. I will therefore present a comprehensible index that fulfills this need later this week.

Using the ACRI index to measure the SEC's halts' effect on retail interest

I gave my take on the halt of the trading in Growlife shares meant for the industry in a previous article. But, what I missed in the article is quantitative data that could confirm what I claimed. With the ACRI Index it's now possible to measure each SEC halt's effect on the retail interest and the subsequent impact on cannabis stock prices. The following chart includes the ACI index and the ACRI Index and I have placed a red arrow for every time the SEC has halted a cannabis stock.
Click to enlarge

The chart clearly shows that for every time the SEC has halted a cannabis stock, the ACRI Index has fallen afterwards, which in turn have led to a fall in the ACI Index in the following week. An interesting factor is that the ACI index has fallen by nearly 50% as a result of the SEC's halts.

Conclusion and final remarks

I have in this article presented a new tool that can be used for investors to measure the retail interest and thereby the likely future demand for shares. This can help investors make more informed investment decisions and be used as a risk management tool.

The tool can also be used to analyze different factors' effect on the industry, as it quantifies the development in the demand factors, namely the retail interest. The tool can also be used to measure the effect that the SEC halts had on the overall retail interest and the subsequent effect on cannabis stock prices. The results show that the SEC halts have cut the ACI Index in half.

Stay tuned for another tool that I will present through Seeking Alpha later this week along with a detailed discussion of the likely development in the cannabis stocks based on demand and supply factors.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.