3 Things That Could Extinguish The 'Reefer Rally'

Investors in the publicly-traded cannabis-related sector can do little wrong in 2014 so far, with stocks soaring and, for the most part, holding the gargantuan gains. The Marketfy 420 Investor Cannabis Stock Index, which rose 59% in 2013 and was based upon 8 stocks, has increased by 377% so far in 2014.  The index, which was rebalanced on 12/31 and expanded to include 20 stocks (equally weighted), will be rebalanced quarterly going forward, and there are several new names that will enter at the end of March.  Here is the action since 12/31/13:

It is evident that the sector is on fire, but will it persist?  Here are three things that could lead to a cooling off of the stock market's most exciting sector so far in 2014.

Federal Government Policy Changes

While most investors probably favor marijuana legalization at the national level, this might actually be problematic for cannabis stocks, as a green light would surely open the door for lots of competition both in the real world and certainly in the stock market.  On the other hand, it's always possible that the "hands-off" policy that enables expansion state-by-state, could suddenly end.  Colorado's implementation has been smooth, but what if Washington's doesn't go so well?  

Ambiguity and a measured pace create the best scenario for the cannabis sector, as the current companies will be allowed to execute on their plans without fear of new entrants with more financial resources or established brands.  The federal goverment shared some love on Valentine's Day, when the Department of Justice and the Department of Treasury jointly issued new rules related to banking.  Right now, the most likely scenario is this friendly status quo, but investors should be alert to any changes in the regulatory landscape.

FINRA/SEC Actions

The self-regulatory organization of Wall Street, FINRA, which is not as well known by its full name, the Financial Industry Regulatory Authority, has warned and warned again about "marijuana stock scams".  With the rapid ascent in the stocks of companies that just press release their intention to get into the space, it is clear that there is room for dishonesty.  One CEO in the space went as far as to suggest that a sweep has already commenced, though there has been no evidence yet to suggest that this is correct.  Creative Edge Nutrition (FITX) CEO Bill Chaaban posted to his company Facebook page:

I had an amazing call with the people at FINRA yesterday. They are investigating every company in the medical marihuana space to confirm if they are real. This is very exciting for FITX because I can assure you we are 110% real. We have revenue .. We have real deals .. And real projects. I look forward to giving them whatever they need to do their job. I look forward to them cleaning up this space. And yes it will happen very quickly  job well done to them !

A clean up of the space may be in order, but this would likely create a panic that could hurt all stocks, with investors and traders shooting first and asking questions later.  This is a very real risk.  The most at risk would appear to be the pink-sheet companies, but even SEC filers could come under scrutiny.  

New Companies Entering the Market

New listings are creating tremendous excitement, but, for the most part, most of these stocks are very low quality, attracting speculative interest only.  In the not-too-distant future, there are going to be better companies entering the public markets and with likely higher market capitalizations.  The entire universe of publicly traded cannabis-related stocks is about $10 billion, but the demand is likely much higher.  As newer and potentially better companies enter the space, investors may reassess what they are holding and dump their existing stocks for the shiny new toys.  Valuations appear to be unsustainably high in general, and new supply could push some of the stocks back to earth.  This is most likely not an overhang on the entire sector but rather a risk-factor for the lower quality names.

How to Play It

While these concerns are all worth noting, the likely scenario is that the overall sector is quite healthy.  Sure, there will be winners and losers, but it's not likely that there will be a massive correction like the market experienced for six months in 2013 after an early-in-the-year run-up.  The market was ahead of itself last year, but the underpinnings are much stronger now, with medicinal benefits much more greatly appreciated and a successful implementation thus far in Colorado with Washington progressing.  New investors are flooding into the market, driven by more knowledge, media fascination and a better understanding of the opportunities ahead in both medical and legal cannabis.

The best way to insulate oneself from the risks is to remember that the sector, which is dominated largely by penny stocks and certainly companies without substantial operating histories, is going to be volatile.  Focusing on good management teams and companies that have reasonable access to capital, like Growlife (PHOT) and Terra Tech (TRTC), with broad exposure to legal and medical cannabis and compliance with SEC filing requirements, won't protect from market-wide corrections, but one's portfolio is likely to hold up better in that event.

Another high quality and differentiated company is GW Pharma (GWPH).  The NASDAQ-listed UK biotech has strong marketing partners, a war chest built up following its recent successful secondary offering at $36, and multiple shots on goal.  This stock has experienced relatively low correlation with the rest of the sector too.

Finally, focusing on the Canadian opportunity could give investors a near-term catalyst that could help the stocks hold up in a sector-wide downturn, as the new rules begin in just a month.  Advanced Cannabis Solutions (CANN) just announced a consulting contract related to a Canadian project and should be considered as a beneficiary as well.  Investors appear to not fully understand that our neighbor to the North is implementing a de facto legalization.  Tweed, Inc., which has a license already, is likely to begin trading publicly soon, another potential catalyst for the entire group of companies leveraged to the Canadian opportunity. 

A rising tide lifts all boats, and that has been the case in 2014.  Investors in the sector should be aware of the risks of a correction, taking into consideration the factors described here as well as just understanding the ebbs and flows of cyclical moves within a postive secular trend.  The 'Green Rush' is very real, but the price action won't always be so friendly.

Disclosure:  I have no personal investments in any stocks mentioned, but 420 Investor has a trade-alert service called Flying High that currently holds positions in EDXC, FITX, FULL, MCIG, and PHOT.