Seeking Alpha

Why Marijuana Stocks Will Cost Their Investors

by: Peter Leeds
Peter Leeds
Small-cap, micro-cap, Penny Stocks, marijuana stocks

There is a current bubble in marijuana-related stocks, and like all bubbles since 1637, it will burst.

Investors getting involved are paying far too much for the shares, and have already missed the boat.

Many of the underlying pot businesses are financial train wrecks, although the typical investor does not seem aware of this fact.

Good ideas and good investments are two very different things.

Great ideas do not translate into great investments. Often, the businesses which seem like no-brainers are typically the ones which cost shareholders the most.

Yes, a cure for cancer is a great idea. No, while the masses don't always see it, a tiny company working on a cure for cancer is not a wise investment. Yes, a business which converts salt water to clean drinking water is a great idea. The small penny stock trying to build the technology - not so much.

This was true of dot com stocks before the bubble burst, it was true when the world seemed fixated on nanotech, and there was a time recently where it seemed everyone not throwing money into 3D printers would be left behind. Perhaps we can now relate with the Dutch in 1637 during the height of the tulip mania, where a single bulb often traded for the value of a house!

We can look back at many of these investor stampedes and see that the result is always the same, whether for shares or tulip bulbs - dramatically over-valued prices. Perhaps you laugh, perhaps you wince, perhaps you shed a tear for the optimistic victims, but unless you observe the warnings of previous stampede mentalities, you may be doomed to suffer a similar fate.

It is unfortunate, but just such a mania has grown in modern times right before our eyes. We will describe a fictitious company for example purposes, but sadly our scenario is by no means atypical of the current state of affairs. Yes, many would argue that legalized recreational marijuana has numerous benefits. No, some tiny company loosely involved with cannabis does not make for a good investment.

This becomes even more true when you consider that only half a year ago the company was a gold exploration penny stock, and now has $20 million in debt, produces no revenues, and lost tens of millions in the last few months. All this before we even discuss the low barriers to entry to new competition in the industry, their office in a one-room glorified closet, and the fact that their CEO bankrupted two companies before now.

"But hey, it's pot and it's hot right now." And investors borrow money from their grandma and pile in.

Consider what those investors fail to see - that when you buy a share of stock, you are buying a slice of a business. The purpose of a business is to make money, and it is only through the generation of those dollars that there will be any value to the shares beyond speculation. Early in the game, speculation is often enough to lift the stock into the stratosphere, but a tipping point eventually arrives. And it always does. There comes a day where shareholders realize that they basically own smoke in the wind, and it is then that reality does what reality does.

There are 50 States and the District of Columbia, but despite what the future holds, right now recreational marijuana is legal in only one of them. Even Washington State, which seemed like a lock to join Colorado in their closely-watched "experiment," has taken a step back to rework their regulations and laws.

Legalizing recreational marijuana is a movement which is still in it's infancy, and it does seem that many States will embrace Colorado's lead. There will certainly be significant money to be made once the concept is more widely embraced. In terms of tax revenues alone, the Associated Press has reported an expected increase of between $20 and $134 million dollars.

Add to this the potentially surprising drop in crime taking place in the State. According to the Colorado Department of Public Safety, in the first two months of legal recreational use (when compared to the same period in the previous year), homicide rates have dropped 67%, robberies by 7%, violent crimes by 2.4%, and property crimes by 14%.

Of course, when such an idea does become somewhat commonplace, less experienced investors often buy the first business they believe stands to gain. This typically means they buy penny stocks with the word hemp or cannabis in their name. Unfortunately, they really don't seem to look any deeper into the company than that.

The initial flood of money into these thinly traded penny stocks can spike the price of the shares to ridiculous levels. Even at these astronomical, absolutely unjustified, prices more buyers join the stampede. The shares climb even further. In the most alarming examples, some of the market capitalizations of these businesses operating out of their glorified closets approached one billion dollars.

The over-valued penny stocks will not be the businesses to generate the potential revenues, nor will they gobble up even a sliver of the possible market share. Actually, the lion's share of revenues always go to the well-funded, well-positioned, conglomerate corporations. Specifically companies legitimately worth billions, with a recognizable name, business alliances, and deep pockets.

It is much too early in the game to predict potential winners from legalization of marijuana, if in fact such a social trend does occur. However, consider the likes of massive vitamin companies, cigarette corporations, and even energy drink or alcohol purveyors. Not the penny stock with a market capitalization in the hundreds of millions, run by a husband and wife team looking to make toe rings out of hemp.

In other words, a great idea does not make for a great investment. This is especially true when your investment philosophy involves gobbling up any company with cannabis or marijuana in the name, and sitting back waiting for the riches to pour in. The wealth is actually going the other way - to those trading their tulip bulbs for your house.

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. I have no business relationship with any company whose stock is mentioned in this article.