Just Say No to Pot Stocks

Not long ago, merely mentioning the idea of investing in marijuana stocks would likely have elicited a question about what you had been smoking. But now Colorado and Washington state have legalized marijuana for recreational use, and pot stocks are on fire. But that doesn’t mean you should join the party.

There are dozens of reasons why companies that hope to capitalize on the budding legality of marijuana are likely to face hurdles. The most significant is the complex legal landscape. The federal government considers cannabis a banned substance but says that states can decriminalize the drug as long as they set up a legal structure. That has prompted two states — Colorado and Washington — to allow recreational use of marijuana and 18 additional states and Washington, D.C., to allow medical use. However, each state has a different set of rules — and more than half consider all marijuana use a crime.

Banks, uncertain of how to deal with the legal ambiguities, have been unwilling to do business with the companies — neither lending to them nor allowing them to open checking accounts. U.S. Attorney General Eric Holder recently vowed to set up a legal framework that will allow banks to open accounts for legal marijuana operators. For now, the lack of banking access creates an operating challenge.

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Legalities aside, investing in industries in their infancy is almost always a dicey proposition. Consider personal computers. Although the industry soared at the outset, the top players from 30 years ago, Osborne and Commodore, are long defunct. And unlike computers, which require technical expertise and patents, the barriers to entry into the pot business are far lower. That could lead to a raft of new competitors when the legal issues are settled. Indeed, Morningstar analyst Thomas Mullarkey says that if marijuana were legalized nationwide, it would make sense for big tobacco companies to enter the market, vastly increasing the competition and likely driving down prices.

Already, even the top players in the cannabis industry are losing bushels of money. “These companies are financial train wrecks,” says Peter Leeds, an expert on the penny-stock market, where many pot stocks trade. “They have tens of millions in debt, and they have no way to repay it.”

Of the roughly 50 publicly traded companies with a pot connection, Leeds says, just two are worth considering: GW Pharmaceuticals (symbol GWPH) and GrowLife (PHOT). But because their shares shot into the stratosphere after the Colorado legalization bill passed last year, he wouldn’t buy either of them at their current prices. If the market were to cool down, they’d be stocks worth watching.

GW Pharmaceuticals, based in London, has received approval to sell cannabis-derived treatments overseas for both multiple sclerosis and epilepsy, and the company is seeking approval from the U.S. Food and Drug Administration to sell its drugs here. GW lost $7 million on $44 million in revenues in 2013. Its stock, which languished below $9 during most of 2013, now trades at $66. (Prices are as of February 28.)

GrowLife has focused on hydroponic growing systems and indoor lights, often used to cultivate medical marijuana. Shares of the Carson, Cal., company, which sold for 4 cents last year, now fetch 37 cents. GrowLife reported $2.9 million in revenues and a $4.6 million loss during the first nine months of 2013. Although the stock’s market value of $261 million is not inconsequential, a share price in pennies suggests an even greater level of risk in an already risky area.