Let me tell you about a line I heard a few years ago: “The cannabis industry is so hot that even Warren Buffett is investing in it.”
That was the story penny stock promoters were telling back in 2014, when somebody realized that Cubic Designs, a subsidiary of Buffett’s Berkshire Hathaway, was selling its mezzanine structures to growers to allow them to maximize production space.
If a company doesn't file with the SEC, don't take it seriously.
It was, to say the least, a bit of a stretch.
In my last column I shared some tips on investing in cannabis stocks but pointed out the need to watch out for landmines you may encounter, like fake news about Warren Buffett’s investments.
I often share Buffett’s famous quote when describing the quandary novice investors can face when they first jump into cannabis stocks. “If you’ve been playing poker for half an hour and you still don’t know who the patsy is,” the Omaha Oracle once said, “you’re the patsy.”
With a goal of helping readers avoid being patsies for cannabis opportunists, I want to offer a few tips.
1. Read the Filings
When it comes to cannabis stocks, I have a very easy first rule: If the company doesn’t file with the U.S. Securities and Exchange Commission (SEC), don’t take it seriously.
Many cannabis stocks file at OTC Markets but not with the SEC, which requires more information.
If you rely only on press releases, you’ll only get positive spin from the companies that issue them.
It surprises many to learn that some of the most actively traded cannabis stocks have never filed with the SEC, including American Green (OTC: ERBB), Hemp, Inc. (OTC: HEMP) and Medical Marijuana, Inc. (MJNA).
If the company does file with the SEC, that doesn’t mean that it isn’t risky or isn’t a scam. Remember: Enron regularly filed with the SEC. But quarterly (10-Q) and annual (10-K) filings, as well as other types of filings are must-reads as part of any investor’s due diligence.
Other forms to know about: 8-Ks are important updates. Form 4s describe insider buying and selling. Proxies (DEF 14A) provide information about matters upon which shareholders vote, including changes in the authorized shares or stock splits or reverse splits, and detail insider ownership and compensation. The S-1 is used to register shares for sale by the company or by outside shareholders.
Too many cannabis stock investors skip this important step and miss out on the most helpful information. If you rely only on press releases, you’ll only get positive spin from the companies that issue them.
2. Verify Basic Facts
When I encounter a new cannabis stock, I visit the corporate website (after reading the filings!). Many of these pretend cannabis companies have terrible websites, which is an obvious red flag. If they look legitimate, I do a few things before continuing my research:
- Look up the address. A virtual office or UPS store is a red flag.
- Call the phone number. Does it go straight to voicemail? Not good.
- Check for stock photos used in place of employees or company operations. Right-click on the image and choose “Search Google for image.” If the images show up all over the internet on different websites, the company may be trying to pull a fast one.
In addition to vetting the website, I like to review historical press releases from the company. What were they saying a year ago? Were they talking about the opportunities in 3-D printing before suddenly shifting into cannabis? Don’t laugh! That’s a true story.
More often than not, opportunists have promised the moon and not delivered. It’s easy to check the record.
3. Research the Executives
Most cannabis stocks are relatively new companies without extensive histories. That makes it hard to judge the prospects of the company.
Dig into the track records of the people running the company.
To overcome this lack of company-specific information, I dig into the track records of the people running the company.
If the CEO has worked for other penny stock companies, that’s a red flag. I recommend taking a look at the person’s profile on LinkedIn as a starting point. Then do an internet search to see if he or she is someone to trust with your investment. Bonus tip: Try to research the financiers behind the company, too.
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4. Check for Stock Promotion
Stock promotion takes many forms, but the most pernicious is when companies (or company investors) pay for positive “news” or blast emails. StockPromoters.com—free but registration required—is a helpful tool to help you find out. But it’s not complete.
In the cannabis space, I recommend avoiding stocks promoted by MarijuanaStocks.com, which takes outrageous sums of money to say good things about bad companies.
5. Understand the Financials
This is the most important point. Unfortunately, it can also be the most difficult task for investors.
The number one reason penny stocks fail is their capital structure, as desperate executives take on convertible notes with terrible terms. This debt converts to equity based on a future price and can lead to what’s known as a “death spiral,” where a very small debt can result in the issuance of literally a billion shares, diluting or even wiping out existing shareholders.
Another trick of penny stock fraudsters is to create convertible preferred shares that mask the true equity of the company. Fortunately, savvy investors can read the filings to better understand these capital structure landmines.
The bottom line: Investing in cannabis can be a great opportunity, but a great many opportunists know this too.
Next up: Why cannabis investors need to think globally. Talk with you in two weeks.