The Dot Bong Bubble

“What are you people? On dope?!”
—Mr. Hand (Ray Walston), Fast Times at Ridgemont High

Should asset owners consider investing in cannabis?

Just to be clear, I mean in legal, cannabis-related investment opportunities. There is a lot of hype in this area (the weed and the value chain—or, in the parlance of the cannabis trade, plant-touching and ancillary services). Evangelists almost without exception point to the Peter Thiel-backed Founders Fund’s 2015 investment in Privateer Holdings—a private equity firm focused on legal cannabis—as the watershed event that legitimized cannabis investing.

Is this, in fact, evidence of the institutionalization of cannabis? No. My admittedly small sample set of asset owners and consultants confirmed this, as no asset owner or consultant could attest to having current exposure (or even a bona fide interest) in a cannabis-related investment. This makes perfect sense for two reasons.

First, the legal cannabis market is incredibly small by any institutional measure.

Advocates put annual revenues in the US from cannabis at $35 billion to $40 billion.

But the estimate is specious because it includes the assessed size of the illegal marijuana market. Projected retail sales of the legal recreational and medical marijuana market in the US in 2016 range from $3.5 billion to $4.3 billion.

(These estimates include ancillary businesses like security companies, insurance providers, consultants, logistic firms—e.g., “the Uber of pot,” which facilitates the delivery of medical marijuana to patients in 20 minutes or less—real estate companies, a marijuana dot-com finder for strains and dispensaries, and an odor elimination system for removing lingering stale marijuana smells. I could find no evidence the value chain includes Doritos or pizza sales.)

Regardless, industry insiders paint a consistently rosy growth scenario. The ArcView Group, an investor network providing funding for cannabis ventures, projects a $10.8-billion US legal sales market by 2019. Several specialty venture capital and private equity firms offer cannabis-focused funds, but assets under management are small. Details are sparse, but it seems that Privateer closed on a $75 million round in 2015, bringing its total raise to $82 million. ArcView claims to have raised $73 million for 116 companies. These figures are large in absolute terms—but to the world’s most serious allocators, they are relatively meaningless.

Size is not the only problem. Perhaps more importantly, the investment opportunities in current legal marijuana businesses—available through both public and private investments—rarely meet asset owners’ diligence requirements.

While size matters, so does institutional gravitas. Starting your sales pitch with the phrase, “these are the last days of prohibition…” indicates­ a certain dissonance.

There are plenty of cannabis-related common stocks, although the classification of such stocks is a bit smoky. The Marijuana Index Global Composite comprises about 168 securities—many of which any prudent investor would call penny stocks—and their combined market cap is less than that of PotashCorp (POT). (If you’re wondering, there is no marijuana company exchange-traded fund, yet.)

The term ‘penny stocks’ should make investors convulse. But if you need further deterrents, our benevolent US regulators feel it their duty to forewarn investors of the possible perils. The US Securities and Exchange Commission has a special webpage entitled, “Investor Alert: Marijuana-Related Investments.” Not to be outdone, FINRA (Financial Industry Regulatory Authority) has its own disturbingly labeled webpage, “Investor Alerts: Marijuana Stock Scams.”

The second reason to just say no to cannabis investments is that while 23 states and the District of Columbia currently have legalized medical cannabis, according to existing federal law marijuana is a Schedule I controlled substance (along with, for example, heroin and LSD) and “anyone involved in the possession, production, growing, or the sale of marijuana is subject to federal prosecution by the US government under the federal Controlled Substances Act (CSA). Consequently, state marijuana laws are preempted by the CSA,” according to a drug policy journal.

Cannabis investments (and those rosy growth projections) are based on a regulatory arbitrage that assumes no adverse federal action will be taken against the states that have legalized marijuana.

One ganjapreneur assessed this situation and concluded, “I go to sleep very easily knowing the DEA [Drug Enforcement Administration] is not going to kick down my door.” Well, that’s certainly reassuring for prospective investors.

Currently, the legal cannabis market is anathema to fiduciary duty: it’s incredibly small, consumer-focused, and fraught with substantial investment, business, and legal risks. Other than that, Mrs. Lincoln, how did you like the play?

My advice is that asset owners and consultants place cannabis in an investment tickler file, preferably one that is cool and dark with a relative humidity of about 60%.

Angelo Calvello, PhD, is CEO of Impact Investment Partners and co-founder of Rosetta Analytics.