The Marijuana Industry Is Going Through Puberty, Not a Crisis

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Source: http://www.flickr.com/photos/psycho-pics/

Source: http://www.flickr.com/photos/psycho-pics/

The marijuana industry is not going through a crisis. What the marijuana industry is going through is more like puberty — awkward and painful, sure, but there’s no reason to panic just because things got out of hand and mom and dad had to step in and ground some companies.

In case you missed it, this is pretty much what happened. In March and April of this year, the Securities and Exchange Commission (mom and dad) suspended trading for the securities of five marijuana companies. Here’s who got hit:

  • Aventura Equities, Inc. (OTC:AVNE) on March 5 “because of questions concerning the adequacy and accuracy of publicly available information about Aventura, including, among other things, its financial condition, the control of the company, its business operations, and trading in its securities.” Aventura Equities recently acquired 100 percent of Aventura Laboratories, which holds cannabis-related intellectual property.
  • Petrotech Oil and Gas Inc. (OTC:PTOG) on March 14 “because of questions that have been raised about the accuracy and adequacy of publicly disseminated information concerning, among other things, the company’s operations.” Petrotech is an oil and gas company that recently began expanding into the quasi-legal marijuana industries in Colorado and Washington.
  • Citadel EFT, Inc. (OTC:CDFT) on March 21, “because of questions that have been raised about the accuracy and adequacy of publicly disseminated information concerning, among other things, the company’s business operations and assets.” Citadel EFT provides credit terminal and merchant account services.
  • Advanced Cannabis Solutions, Inc. (OTC:CANN) on March 27 because it appears to the SEC “that there is a lack of current and accurate information concerning the securities” of the company, and “There are questions regarding whether certain undisclosed affiliates and shareholders of Advanced Cannabis common stock engaged in an unlawful distribution of securities.” Advanced Cannabis Solutions is a development-stage business serving the marijuana industry.
  • GrowLife Inc. (OTC:PHOT) on April 10 “because of questions that have been raised about the accuracy and adequacy of information in the marketplace and potentially manipulative transactions in PHOT’s common stock.” GrowLife is a picks-and-shovels company supplying equipment to companies in the marijuana industry.

The regulatory action comes after the Financial Industry Regulation Authority (FINRA) issued an alert to investors in August 2013 warning about potential scams associated with marijuana-related stocks. Specifically, FINRA warned about the well-known ‘pump-and-dump’ scheme, in which, “fraudsters lure investors with aggressive, optimistic — and potentially false and misleading — statements or information designed to create unwarranted demand for shares of a small, thinly traded company with little or no history of financial success (the pump). Once share prices and volumes reach a peak, the cons behind the scam sell off their shares at a profit, leaving investors with worthless stock (the dump).”

The warning was timely. As the national conversation surrounding marijuana barreled forward, cannabis-related stocks began to rise. The industry, sensitive to momentum and seeking to draw public investment dollars, turned up the volume on its marketing.

In a vacuum, self promotion is not a bad thing. Every business has to be its own advocate, especially those that trade equity over the counter. But effective self advocacy in the OTC markets is especially challenging because of dubious reporting standards and the sometimes well-earned bad reputation of other penny stocks and penny stock brokers. The OTC markets suffer asymmetric information and therefore breeds moral hazard and adverse selection. It’s kind of like a flea market for stock — the good merchants blend in with the bad, the honest blend in with the swindlers, and the mantra of the buyer is “beware.”

In this environment, there are really only two groups of people who prosper: the swindlers and exceptionally savvy consumers with a tolerance for risk. The rest, the honest merchant and the unassuming consumer, just lose out.

So who’s a swindler, and who’s an honest merchant? And what can consumers do to make sure they don’t become victims?

The SEC is tasked with answering those questions, and, unfortunately for the commission, they are enormously challenging to answer. The pump-and-dump scheme is about as old as equity trading is itself and, like all criminals, avaricious investors evolve with the times. The reason FINRA issues warnings and the SEC exercises its power to halt trading is because people still commit microcap stock fraud and there are new victims all the time.

Worse yet, investors are most unassuming in the presence of an opportunity for huge returns, and this is exactly what marijuana stocks appear to offer. With the legalization of recreational weed in Colorado and Washington, the emergence of marijuana businesses (investment opportunities) hasn’t escaped anyone. If you expect that marijuana will be legalized at a federal level at some point in the future, as many people do, then you are tempted by investing — not so much by the businesses themselves, but by the allure of the first-mover advantage. Investors want in early, and they’re sometimes willing to tolerate enormous risk to do so, and in the process can overlook fraud.

There’s a lot to be concerned about in the marijuana market. Regulators know this and investors should know this, but knowledge doesn’t necessarily translate into power here. Most of the viable investment candidates in the marijuana industry have been vetted enough to establish only one fact: No one really knows enough to take an informed position, except for possibly the companies themselves. That is, most investors are at a hopeless information disadvantage and simply have no way to know if the company they are investing in is truly financially sound, let alone fraudulent.

But still, investors invest. Marijuana stocks soared when recreational weed went on sale in Colorado. Here is a stock chart for GrowLife and Advanced Cannabis Solutions for the past year. You can see where each company had its stock frozen by the SEC by the horizontal line — and note the inevitable cliff at the edge of that plateau.

GROWLIFE INC Stock Chart   PHOT Interactive Chart   Yahoo  Finance

Even if these companies are generally on the up and up, they threw red flags, and those flags should be investigated. Moreover, it is fair and reasonable to distrust the companies in question, and it is especially reasonable for the vast majority of investors to simply sit on their hands. If it’s impossible to be confident in your investment, then don’t invest. The industry will evolve over time and the market will legitimize as the businesses do.

For now, the industry and most of the businesses in it is too young to be really valuable to most investors. The spoils should — and probably will — go to the companies that grow up the fastest. Investors want more mature companies with experienced management, reliable cash flows, and a transparent and stable capital structures that will capitalize on the marijuana market as it expands, not businesses that are built on a rickety foundation but that are poised to spring.

To be clear, these businesses are probably out there, just as there are honest merchants at the flea market, but it’s the buyer’s obligation to beware.

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