Marijuana stocks come in two flavors. Companies using marijuana to derive compounds that can be turned into FDA-approved drugs to treat specific diseases -- GW Pharmaceuticals (GWPH) and Insys (INSY) for instance -- and companies looking to grow and sell marijuana directly to customers.
Source: GW Pharmaceuticals
If you're going to invest in the former, you'll need to understand the diseases they treat and the Food and Drug Administration approval process in general. Investing in those types of marijuana stocks is no different than investing in any other biotech and comes with the same potential risks and rewards.
If you're thinking about investing in companies growing or selling marijuana for consumers, you need to understand the potential pitfalls from investing in that type of marijuana stock.
1. Micro-cap stocks are risky
Most companies involved with medical and recreational marijuana are micro-cap stocks, so small that The Motley Fool rules preclude me from mentioning them by name so we don't move the stock price.
Others aren't as ethical, making marijuana stocks ripe for pump-and-dump schemes by stock manipulators. In May, the Securities and Exchange Commission suspended trading of five marijuana stocks and warned investors about the potential dangers in investing in micro-cap stocks: "Microcap stocks are particularly vulnerable to fraudulent investment schemes because there is often limited publicly available information about microcap companies."
You should also consider why the companies have such small valuations. Sure, some of it has to do with limited sales. But risk premiums are also pushing down their valuations. There's potential for the companies to go bankrupt and investors have taken that risk into account when valuing the company.
2. Not all stock markets are created equal
Many of the marijuana stocks are traded over the counter, so they're not required to be registered with the SEC like companies on the Nasdaq or New York Stock Exchange. Companies often issue quarterly and annual reports, but since they aren't filed with the SEC, they don't have to be audited. You'll just have to take the companies' word that the reports are accurate.
Another major problem with investing in stocks that trade over the counter is their volumes tend to be very low. The limited number of investors can make for wide bid and ask prices -- the price investors are willing to buy and sell at -- making it hard to get the price you want. The low volume also makes it hard to sell a large number of shares without affecting the share price.
Source: Chuck Coker, Flickr
3. Government regulation
While 23 states and the District of Columbia have legalized marijuana sales, including Colorado and Washington that allow recreational use, federal law still makes it illegal to produce and sell marijuana
For the most part, the current administration has made medical marijuana a low priority. In August 2013, Deputy Attorney General James Cole told U.S. attorneys working for the Department of Justice to focus on the big picture crimes -- for example, using marijuana sales to fund criminal activity and movement of marijuana from states where it's legal to where it's illegal -- but leave companies following state law alone, even if they're large-scale, for-profit commercial enterprises. According to Cole, "Both the existence of a strong and effective state regulatory system, and an operation's compliance with such a system, may allay the threat that an operation's size poses to federal enforcement interests."
But just because the current administration has decided that there are other federal crimes that should take priority, doesn't mean that future administrations will take the same stance.
Worth the risk?
The marijuana industry is growing quickly -- Marijuana Business Daily estimates that it could bring in as much as $4 billion in the U.S. in 2018 -- so it's understandable that investors might want to make it part of their portfolio.
Unfortunately, it'll need to get that big before companies are large enough to justify being on the major exchanges. At that point, marijuana stocks might be investable if the expected returns are worth the risk of a potential federal crackdown.
