Investing in public marijuana company stocks is hot, but the risks might leave many out in the cold.
Last year the sector experienced double-digit gains, indicating that marijuana is emerging as a legitimate investment opportunity. The Viridian Cannabis Stock Index of 75 publicly traded companies reported a 38.4 percent gain in 2014.
The trend prompted Founders Fund, the San Francisco-based venture capital firm run by PayPal co-founder Peter Thiel, to enter the fray in January. The company agreed to invest millions in Privateer Holdings, a private equity firm in Seattle that's backing several private marijuana start-ups, including Tilray, a Canadian medicinal pot company, and Marley Natural, a weed purveyor launched by heirs of the late reggae star and ganja devotee.
Founders' infusion prompted several other mainstream private investors to finally take stakes in that rapidly growing yet complex and still risky multibillion-dollar marketplace. The ArcView Group, a cannabis industry investment and research firm based in Oakland, California, predicts a 33 percent rise in marijuana sales this year, to $3.5 billion from $2.7 billion in 2014. And that's just for legal weed alone.
While private funders are gradually getting into the game, retail investors have been in it for a few years, taking high risks on dozens of small over-the-counter penny stocks and micro-cap start-ups. Many are based in Canada, where medicinal marijuana has been federally legalized.
"There's going to be a shakeout in the public companies," predicted Scott Greiper, president of Viridian Capital and Research, a New York firm that services the marijuana sector, including its stock index. "It comes down to who's investing my money and running the company. The most important challenge for this industry is the emergence of professional, seasoned executives, operators and board members running both public and private companies."
Investors worried about putting their money into public companies that legally grow and sell pot might feel safer dealing with the industry's many ancillary businesses, including consulting, biotech, real estate and software companies. These include CannaGrow Holdings (CGRW), in Centennial, Colorado, which provides services to licensed pot growers in the state; and Totally Hemp Crazy (THCZ), a Dallas-based maker of hemp-infused beverages that recently signed a distribution agreement with a Dr Pepper bottler in Oklahoma.
That's the strategy guiding Cheryl Shuman, a high-profile proponent of medicinal marijuana, which she consumed in her own cancer treatment, and founder of the Beverly Hills Cannabis Club that bills itself as "the definitive authority on connoisseurship for discerning cannabis consumers."
Shuman got burned in a pump-and-dump penny stock scheme—several of which have been uncovered by the SEC—and doesn't invest in publicly traded cannabis companies anymore, instead putting her money into private licensing, media and real estate companies.
"My pride and joy is working with Native American properties," she said, alluding to last year's announcement by the U.S. Justice Department that Native Americans can legally grow and sell marijuana on their sovereign lands. "We have 78,000 acres now in the ground."
Shuman attends city council meetings and Congressional hearings to learn about what properties are zoned for marijuana retailers and cultivation. "It gives me legal, inside information," she said, "and anyone can go to those meetings. If you are going to invest in the stock market, go to industry expos and events, like Weedstock and CannaCon, and get to know the people behind the companies."
Despite studies supporting its efficacy, medical marijuana remains controversial and the plant's legal status precludes FDA authorization of products sold in dispensaries. Among the biotech companies in the industry seeking such status is London-based GW Pharmaceuticals (GWPH). The public company is also one of the only pure plays in the space, trading on both the NASDAQ and London exchanges.
"We are working directly with the FDA and the DEA to move our products through their [approval] processes," said Steve Schultz, vice president of investor relations at GW. "The only way to get there is through placebo-controlled clinical trials, and that's our pathway."
Outside the U.S., the company already has approval for two cannabinoid prescription drugs: Sativex, for the treatment of multiple sclerosis spasticity and cancer pain; and Epidiolex, for the treatment of childhood epilepsy. Both are in clinical trials in this country. Although the latest results of Phase 3 trials of Sativex as a cancer pain reliever failed, "we have two more trials coming up and feel confident that those could provide positive data," Schultz explained.
While retail investors go about their due diligence of dicey penny stocks, and exuberance in the market grows, investing in groups like Privateer Holdings appears less risky. "Prior to Founders Fund, our investors were ultrahigh-net-worth individuals and family offices around the world," said Privateer CEO Brendan Kennedy. "Founders has changed the environment, and we're starting to see many more institutional investors contact us."
Of course, full legalization of marijuana in the U.S. would open the floodgates for all types of investors, not to mention a slew of new stocks for them to target. Currently, 23 states have legalized medical marijuana, and four states plus Washington, D.C., have passed laws that allow recreational pot smoking and edibles ingesting. Nonetheless, cannabis remains an outlawed Schedule 1 drug per the federal Controlled Substances Act. Polls indicate that a majority of Americans favor some form of legalization or decriminalization of pot, and President Obama recently voiced support for medical marijuana.
"Big tobacco, big pharma, even big agriculture companies are starting to kick the tires to see where the opportunities are," said Chris Walsh, managing editor of Marijuana Business Daily. "If full legalization happens, you'll see a surge of companies from other industries get involved. That will shake up the sector."
If and when that happens, expect big investment bucks to follow.
—By Bob Woods, special to CNBC.com