Marijuana Stocks and the Risks of a '420 Friendly' Portfolio

NEW YORK (TheStreet) -- High on marijuana stocks? You'd better do your homework before investing. A "420 friendly" portfolio still carries plenty of risks, conflicting state and federal laws among them.

"When it comes to investing, the question is: A) Am I going to get a return on my investment, how safe is it? And B), do I have any potential criminal things I need to be concerned about?" said Dan Humiston, President of the International Cannabis Association, a sponsor of the Cannabis World Congress & Business Exposition, held in New York in mid-June.

The industry has exploded in recent years, with the Marijuana Medical Business Daily estimating its current value at $3.1 billion.

According to Cohen Grassroots Research, a California-based investment research company, there are about 280 publicly traded marijuana companies operating in the United States, 260 of which are listed for trading. Around 140 of those companies report to the SEC, 80 utilize alternative reporting methods, and the rest are non-reporting.

Just a handful of the public companies have a market value of more than $500 million, while the vast majority -- Cohen estimates more than 240 -- have a market cap of under $50 million.

"The most important thing to remember is that 90% of the companies out there are penny stocks, and most of them are scams -- there's a lot of garbage out there," said Adam Heimann, creative director and partner at MarijuanaStocks.com, a website that tracks cannabis investments and news. For potential investors, with the exception of a handful of companies that are long-term holds, the best strategy is to focus "on day trading, trying to ride momentum, taking a quick profit."

Conflicting laws create another risk. Medical marijuana is currently legal in 23 states and Washington, D.C., and laws allowing recreational marijuana use have been passed in Colorado, Washington, Oregon and Alaska.

Marijuana is, however, still federally outlawed and is listed by the Drug Enforcement Administration as a Schedule I controlled substance, putting it in the same category as heroin, LSD and ecstasy.

The takeaway for investors: it's a jungle out there.

Heimann pointed to GW Pharmaceuticals (GWPH) , a U.K. biotech company that develops cannabinoid medicines to treat multiple sclerosis spasms and cancer pain, as a potential long-term holding. Along with Insys Therapeutics (INSY) , another biotech company in the cannabis arena, GW Pharmaceuticals trades on the Nasdaq.

Heimann also mention Cannagrow Holdings (CGRW), which he described as "a penny stock backed by land."

Many believe that the industry is evolving and expect more good options for investors on the horizon.

"Initially, it was people looking for a quick hit, coming in on penny stocks, hoping for it to rise quickly and then dumping it," said Humiston. "But the quick-hit people are gone. The market has flushed them out."

Now marijuana-stock holder are developing a more long-term focus, and more sophisticated investors are entering the market, including funds. "It's an exciting time, because you're in on the ground floor," he said. "I think it will mature the way most industries do."

In the meantime, there are some important points to consider before investing.

"I think it really comes down to, number one, what your level of risk tolerance is, and number two, which parts of the industry," said Scott Greiper, president of Viridian Capital, an investment bank and advisory platform dedicated to the cannabis market.

Among the most important risk-assessment factors are legal issues. Simply put, do you want to invest in a company that actually touches the product? Such entities run a greater legal risk, meaning a greater investment risk as well.

"If you don't want to get involved with any company that touches the plant, because at the end of the day this is still a federally illegal drug, then there's lots of other ways to invest in ancillary products and technologies," Greiper said. Companies that provide security, lighting, consulting services, software and devices avoid direct contact with marijuana and, from a legal standpoint, pose less risk.

Another risk is inexperienced management teams. "You better be willing to do your homework in really understanding the background of the management teams that are running these public companies, because there is an overall gap in the business experience that these operators have -- not experience in the industry, but the business experience of growing businesses, of running a public company, of having real reporting standards so you're compliant with the SEC," he said.

Cash flow is also a factor to consider, though it may not tell much yet since many companies are too new to generate significant revenue.  Of the rest, none of the moneymakers are "touching the plant," Heimann said. "It's people that are selling the light bulbs, companies like CGRW, that has the land."

Even with Nasdaq biotechs, he said, "most are non-revenue producing for a very long time."

That's why it's imperative that investors do their research and read the filings of the companies in which they want to invest.

"No revenue doesn't always equal a scam down here, because a lot of these companies are starting from the ground up," he said. "For this thing to go from Class I drug to medically acceptable to recreational, and then all of a sudden, everyone's just making revenue with it in the public market, that would be great. But that's not real."

Paul Cohen of Grassroots Research suggested investors play the long game and avoid the temptations of day trading. "Take a look at those companies that are really going to be the foundation of this industry," he said. "Place your bets on those companies that you think will do well regardless of the flux, and regardless of the questions in this industry."

He highlighted Pazoo (PZOO) , "a national testing company building out a Starbucks kind of footprint," and Surna (SRNA) , a manufacturing company, as stocks he likes in the sector.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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