Source: By Alain Soutenet and Todd Davis March 10 2015
In the nine months leading up to their peak in March 2014, marijuana stocks rose over 6 fold in value, fueled by the speculative frenzy that followed marijuana’s legalization in Colorado and Washington and the promises of high returns from a nascent industry that is predicted to grow by the most conservative estimates to a $10 billion plus market in the next 4 years and experience an astonishing compounded annual growth rate of 40%.
Micro-cap companies, undeterred by the ongoing federal ban on cannabis, hurried into the space to provide growers, processors and dispensaries with the services and technologies necessary to create a legitimate infrastructure and the controls necessary onto which the industry as a whole could be developed. By March 2014, the marijuana index had listed 45 publicly traded companies in the marijuana space that were reaching unprecedented valuations, soaring briefly beyond $6 billion.
Nine months later, prices had fallen over 80% and by the end of 2014, the dust was settling as the sector was struggling to find a solid bottom after the much anticipated bounce from the November elections results opening the doors to adult use in Alaska, Oregon and Washington, DC had failed to materialize. The year ended in a gloomy mood for investors in marijuana micro-caps who had poured an estimated $1 billion in investment capital.
This unfolding is in many ways reminiscent of the Dot.com bubble when the technology sector experienced a 78% drop in stocks’ valuation between March 2000 and the fall of 2002. Internet technology stocks kept reeling for years to come as investors stayed on the sidelines and avoided the sector altogether.
While cannabis stocks did experience a similar boom to bust curve, albeit in a more condensed time frame, it is important to recognize the common forces behind the two bubbles, but also to draw the line and identify how fundamentally different the cannabis industry is from the Internet economy, as seen from the perspective of their disruptive impact and adoption patterns.
The premise of Internet technologies was the creation of a new economy that assumed a “paradigm shift” in the way customers purchase goods and services. The adoption pattern turned out to be slow and profit margins so slim that today only a handful of highly capitalized companies that could afford to operate at a loss for years to come have survived and are now firmly in control of the e-commerce space.
In contrast, the premise of cannabis entrepreneurs is to legitimize under the umbrella of state-mandated programs, an existing thriving industry that has been operating in the grey and black markets for decades. The size of the marijuana market is not subject to speculation; it has been well researched and documented. And the industry operates, at least for the near term, at very healthy profit margins. In Colorado where the sale of marijuana has been legal for over a year now, an estimated 35 to 40% of transactions are still considered to originate from illegal sources, underscoring the latent market potential.
Most micro-cap companies are traded in the largely unregulated OTC Market, inevitably and unfortunately attracting unscrupulous groups and individuals. As early as August 2013, FINRA started issuing warnings about marijuana stock scams and in April 2014, reiterating its warnings of fraudulent activities and pump and dump scams, FINRA and the SEC ordered the suspension of trading on several marijuana companies suspected of accounting irregularities, the issuance of unregistered offerings and the dissemination of inadequate or potentially inaccurate information, triggering a wide spread retreat from investors and the unraveling of the short lived rush of capital into the sector, leaving behind a taste of distrust that has been ever since hard to erase.
Investors are questioning the soundness of investing in marijuana stocks in today’s environment and rightly so. On the surface, companies appear to be more fairly valued than they have ever been and we are starting to see well diversified companies who diligently dedicated their resources to develop industry specific solutions to bring compliance and standardization to the industry emerging from the shadows and move from a development stage to sustainable revenue generating models.
Concurrently, more companies are going through an audit process to become fully reporting and have their listing status upgraded. Through transparency proper capital can be raised more efficiently through full registration like Reg-A and S-1 filings, attracting accredited and institutional investors.
The Federal ban on marijuana is by design preventing public companies from realizing any revenue from the sale of cannabis and cannabis infused products. Consequently, only ancillary businesses that provide supporting technologies and services and are engaged in the supply chain are able to operate as public entities, leaving a large piece of the pie to private enterprises who control the products and realize revenues from direct sales.
The future of the cannabis industry is in the hands of voters who are increasingly supporting legalizing medical and adult use of marijuana, keeping them at odds with a federal government that for a variety of reasons, political or not, is reluctant to revisit the classification of marijuana as an illegal substance. Yet the momentum is squarely in favor of the legalization movement and the pendulum is likely to shift towards full legalization once California, Nevada, Arizona and most northeastern states legalize adult use by 2017, unleashing an industry with the potential to generate over $3 billion in tax revenues alone.
The financial windfall for states is hard to ignore and will certainly play a role in bridging the divide between state and federal policies. Between January and November 2014, the state of Colorado took in a total of $67.5 million in tax revenues from the sale of medical and recreational marijuana. NerdWallet, a personal finance site, estimates that legalization in California would generate for the state over $519 million per year while New York would take in $248 million.
Meanwhile, savvy investors like Peter Thiel, co-founder of Paypal and early Facebook investor, are quietly investing in marijuana enterprises, while funders of Tesla and Uber are taking minority interest in marijuana tracking and compliance software, a reflection of a series of positive signals from Washington: Congress last fall instructed the Department of Justice to refrain from interfering with states mandated marijuana programs, the first marijuana credit union is expected to open soon in Denver, more banks are opening their doors to marijuana businesses and the SEC is now allowing the registration of shares for companies whose activities are directly linked with and serving the cannabis industry.