12 Criteria for Picking The Right Pot Stock
I was born in 1958, when “Ike” was in the Oval Office, Fidel Castro was fighting Batista in Cuba, Desi was fighting Lucy on TV, and Ed Sullivan’s cameramen were only allowed to film Elvis Presley from the waist up.
Throughout most of my baby boomer existence, mainstream society viewed marijuana as “the devil’s weed.” For the counterculture of the 1960s, smoking pot was an illegal act of rebellion.
And today? In many cities throughout America and Canada, it’s as easy to get marijuana delivered to your front door as pizza. When I was a teenager, my elderly mother used to search my bedroom for marijuana contraband. Now, mom takes cannabidiol and other pot extracts for her joint pain.
The legalization of cannabis is one of the greatest investment opportunities in a generation. However, when the news is out about an industry’s good fortunes, the rest of the investment herd piles in. Risky and even fraudulent stocks proliferate. Some investors make a fortune; others lose their shirts.
Every portfolio should have exposure to the marijuana industry. But how can you pick the right pot stock? Below are 12 actionable criteria you should follow.
1) Market capitalization
Small-cap stocks are generally defined as having market valuations of between $300 million and $2 billion; a mid-cap hovers between $2 billion and $10 billion. Micro-cap is below $250 million.
At this stage of the marijuana industry’s development, the majority of marijuana stocks that you find will fall under the small- and micro-cap category. There are a few mid-cap marijuana stocks and an even smaller number of large-cap stocks. These sizes are usually the result of mergers and acquisitions.
So far this year, small- and mid-cap companies across a wide range of industries have been bringing both stability and growth to investors. Many of the top-performing stocks of the past decade were small caps and most were value stocks. These two asset classes also outperform large-cap growth stocks during inflation, which could be just around the corner.
Accordingly, small- and mid-cap marijuana stocks offer outsized growth potential as well as an inflation hedge. Large-cap marijuana stocks probably won’t grow as fast as the small fry, but they confer less risk.
And those enticing marijuana “micro-cap” penny stocks? Avoid them. Penny stocks are popping up in the marijuana industry like mushrooms in the rain. Some of these penny stocks are future growth companies and they’re worth a look by aggressive investors. But most of them, sad to say, are inherently weak investments poised to crash.
2) Official exchange
Make sure the marijuana stock is traded on an official exchange. Not all over-the-counter stocks are toxic, per se. There are plenty of solid OTC-traded stocks.
However, keep in mind, OTC equities are less regulated than their brethren on the NYSE and NASDAQ or the credible foreign exchanges such as Toronto’s TSX.
OTC stocks aren’t mandated to disclose crucial information to the public, making it difficult to perform a deep dive into the stock’s fundamentals.
3) Analyst following
It’s a good sign if the marijuana stock is followed by a sizeable number of analysts on Wall Street. There’s an army of pseudo-analysts opining about stocks out there, especially about marijuana stocks on social media and message boards. But look for coverage by serious number-crunchers at research firms such as Morningstar, Fidelity, etc.
Marijuana stocks tend to get whipsawed by the rumor mill. Tune out the white noise by the amateurs and look for seasoned advice from the pros, including our team at Investing Daily.
4) Provides a value add
I especially like the “pick-and-shovel” plays on the marijuana boom. These companies aren’t necessarily about growing marijuana. They’re infrastructure stocks that can be wildly profitable.
Marijuana investing remains risky, but you can seek greater safety (and profits) by focusing on the ancillary firms that provide infrastructure services for growing pot companies in either the recreational or medicinal segments.
Pick-and-shovel plays can be reliable money-makers, because they provide essential value-added services. What’s more, they usually enjoy a diversified roster of clients in several different industries, which buffers them from the inherent volatility of the marijuana business.
Pure plays can be risky. It’s worth remembering that marijuana itself is only a plant. It’s an agricultural commodity. Once the bad players are weeded out (pun intended), there will be a struggle over market share. We’re already seeing ruthless consolidation, as marijuana companies merge for vertical integration and economies of scale. Commoditized businesses eventually witness price wars, which weighs on earnings.
When looking for suitable marijuana investments, my strategy is to find companies that apply a unique value-add, whether in the recreational or medicinal sector.
I look for pot companies with patents, proprietary technology or special managerial know-how. I also prefer companies with solid balance sheets, branded products and extensive supply chains. These are the marijuana investments that will survive and thrive, whereas it’s no great feat to simply grow a plant or squeeze oil out of a leaf.
5) Manageable debt
Study the marijuana company’s balance sheet. Determine whether it has sufficient cash to satisfy creditors. If a company is imploding, its cash cushion will wane. Soon it won’t be able to pay its bills.
A handy indicator is the “cash ratio,” which helps you calculate a company’s ability to pay short-term debt obligations. The ratio is determined by dividing current assets by current liabilities. A ratio higher than one means that a firm has a solid chance of paying off its debt; below one means the firm probably can’t.
Some indebted companies beat the odds and clean up their balance sheets. But poor debt metrics usually spell doom. U.S.-based marijuana companies are especially vulnerable to cash flow and debt problems, because they lack access to mainstream banking services, due to marijuana’s prohibition on the federal level.
6) Smooth auditing process
Public companies are required to get their books audited by an outside accounting firm. It’s not unusual for a company to switch accounting firms. However, the dismissal of an auditor for no clear reason should make you suspicious. It typically indicates internal dissension over how to handle numbers. Those numbers could be fishy.
Examine the auditor’s letter. As part of the proxy statement, auditors must write a letter confirming that the financial data was presented fairly and accurately, to the best of their knowledge. Does an auditor letter raise doubts as to the company’s viability? Get worried. Auditing irregularities are rife in the marijuana sector.
7) Stability among top management
High executive turnover means that the firm is suffering internal turmoil. When top managers quit their cushy jobs on their own volition, it usually means one thing: the firm is in trouble.
In covering the marijuana industry since its infancy, one dynamic I’ve noticed is that a lot of cannabis start-ups are run by young pot enthusiasts with little or no corporate experience. As the firm grows, they tend to spin through the C-Suite revolving door. That’s a red flag.
8) Reasonable valuation
Seems like a no-brainer, right? Well, this rule is often ignored. Investors can get excited about a hyped stock that seems too compelling to avoid. Even if it’s absurdly overvalued.
This truism bears repeating: If a stock is considerably more expensive that its industry or direct peers, or its estimated growth is greatly out of whack with its valuation, stay away.
Before the marijuana market correction of 2019, many marijuana stocks were trading at nosebleed valuations that weren’t justified by projected earnings growth. Most of those stocks crashed and burned.
9) Financial transparency
If a company’s books are murky, management is hiding something. It’s one reason many investors shy away from investing in foreign-based stocks.
Anti-corruption watchdogs have decried the opaque accounting practices of equities based in many non-U.S. countries. But companies in the developed world can be guilty of the same thing.
If, for instance, a marijuana stock has been kicked off a major exchange and now trades on the “pink sheets,” remain wary. A lot of marijuana companies are little more than a web site and a lot of hyperbolic press releases.
10) Low short interest ratio
Short interest is the total number of shares that have been sold short by investors but have not yet been covered or closed out. When expressed as a percentage, short interest is the number of shorted shares divided by the number of shares outstanding.
For example, a stock with 1.5 million shares sold short and 10 million shares outstanding sports a short interest of 15%. Most stock exchanges track the short interest in each stock and issue reports at the end of the month.
If short interest is spiking, it’s a signal that investors are souring on the stock and it bears closer scrutiny. I often see a high degree of rising short interest among overly hyped marijuana stocks, as the sharks circle in for the kill.
11) Absence of excessive insider selling
If corporate insiders are dumping a stock, they know something that the rest of us don’t. It’s a tip-off that the people running the company realize that the stock is about to underperform the market. But there’s a caveat: sometimes insiders sell for personal reasons that aren’t related to the health of the company.
If only one corporate insider is selling, or if the stock has run-up quite a bit, it may simply indicate an individual’s desire to pocket profits. But if several corporate insiders are all selling within a short period of time…watch out.
12) Safety of core assets
If a company is dumping flagship assets at fire sale prices just to keep the lights on, the end is near.
Let’s look at it in personal terms. I’m an avid baseball fan; my team is the Boston Red Sox. If I owned, say, a baseball autographed by Ted Williams, I wouldn’t sell it unless I were going broke. Same principle applies to companies.
As I’ve just made clear, you need to conduct especially careful due diligence when it comes to picking a pot stock. The good news is, we’ve done the homework for you! For our latest report on the best investment opportunities in cannabis, click here.
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