Up in Smoke

We are witnesses to the advent of a new age: a medical and recreational one. Of course, I’m talking about marijuana. And unless you’ve been behind a cloud of smoke, we’ve recently witnessed more than 20 states approve marijuana use for medicinal purposes. In November 2013, voters in Colorado and Washington passed legislation approving the plant for recreational use.

This once illicit industry is now fast becoming a legitimate one, spawning new companies and publicly traded stocks in the marijuana industry that are worth over 50 million dollars, including hydroponic companies, vaporizer producers, and research houses for medicinal purposes. Naturally, this activity has peaked investors’ interest. Marijuana companies’ prices rose more than 50 percent in 2013 and opened 2014 with a bang, climbing almost 150 percent in just three weeks! While those returns sound great, I’m here to tell you that there is no such thing as a free lunch in the world of investments. So, let’s take a deep breath or two, be mindful, and diagnose these astronomical returns.

To raise capital, many small young companies have an Initial Public Offering (IPO) of their stock. First, employees and management are given shares of the stock before it goes public at a heavily discounted price. Then, the new stock issue is sold to the public. Often, IPO’s initially shoot up in value because people are so excited about buying into a new company in an up and coming industry. Again, it sounds great, but buyer beware because you are about to enter the Wolf of Wall Street’s lair. Not to kill your buzz, but would you make a bet in which you had an 80% chance of losing?

Many of the pot industries’ companies are tiny, and many of the stocks are penny stocks. In fact, some are so small (my industry calls them “Pink Sheet” stocks) that they aren’t even listed on a stock market exchange. And as any professor of finance will tell you, the reason a stock is priced at five cents a share is because it’s only worth five cents a share! A common thought is that if the stock goes up to 10 cents a share, you’ve doubled your money. True, but if it goes down to one cent a share, you’ve lost most of your money.

For certain, it’s an ugly reality after the IPO buzz wears off. The companies soon go down in value. Way down. Indeed, their value often falls below their initial offering price. (The smart money usually waits a year or so and then buys some stock in the new company).

A better way to invest in this particular industry is to buy a little bit of all the companies in this industry. In theory, a few winners could negate the effect on the many losers. Who the winners will be, however, is anyone’s guess. In my humble opinion, a better way to tackle this issue is to buy an index of small companies which is spread across all industries. Over time, small companies have outperformed large ones, but they are more risky and volatile. Like I said earlier, there is no free lunch in the investment world.