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Why Investors Should Fear the “Sexy” Play

In the late 1990s, the internet was sexy. In the mid 2000s, oil and commodities and real estate became sexy. Now, marijuana companies have taken a hold of the trophy for “sexiest asset class.”

Stock prices are climbing, and investors are making a bunch of money. Capital investment is being spurred by large rounds of private placements, companies are doing reverse mergers to get listed on exchanges, and the array of stock promoters peddling the next stock that will make your portfolio see triple-digit returns are now peddling cannabis stocks.

Canadian marijuana companies such as Canopy Growth Corp.  (TSX:WEED)Aphria Inc.  (TSX:APH), and Aurora Cannabis Inc.  (TSXV:ACB) each find themselves within the newest “get rich quick” category of stocks.

Such companies have generally subscribed to the following formula for greatness:

  1. Find space, people with “operational know-how,” and investors to fund growing a few plants.
  2. Buy some seeds. Grow a few plants.
  3. Using legal accounting methods and mark up the value of the plants as they mature, leading to accounting gains and increased earnings.
  4. Show impressive sales growth numbers — numbers which may or may not be sustainable.
  5. Acquire other producers with money raised at higher valuations from more equity placements.
  6. Watch stock price soar.

I have written on the inefficiency of the market to correctly price future growth expectations, citing the mass market hysteria of the late 1990s related to internet issues with three specific examples for reference. These are interesting times, and as more sophisticated investors begin to take harder looks at the fundamentals of many of these businesses, the likelihood of an industry-wide tempering of growth expectations becomes more and more likely.

The ability for pro-marijuana or pro-legalization retail investors to “put their money where their mouth is” and plop a few thousand down on a marijuana name as a sort of political vote in favour of legalization can be dangerous. The worry I have is that the investors driving up the prices of these marijuana companies from small-cap or micro-cap status toward the billion-dollar level have low levels of sophistication and are lured in by the massive potential returns these former penny stocks have given investors who got in early.

A price bubble in any asset class is more of a mentality than anything else, and right now, it appears to me that the mentality many marijuana investors have is one which is detached from reality — based less on the fundamentals of the businesses and more on anticipating “how high the stock can go,” relying on the fact that other investors will continue to pile their money into these businesses for the simple reason that stock prices continue to increase at breakneck speed.

Stay Foolish, my friend.

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Fool contributor Chris MacDonald has no position in any stocks mentioned.

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