The cannabis industry is the bane of my existence as an investment analyst. It is a wretched hive of scum, villainy and penny stock fraud, and yet the “legalization story” is so compelling that retail investors are drawn to the space like moths to a flame. This is lottery ticket investing at its finest only many clients don’t seem to realize that the lottery is rigged.

Fortunately it is pretty straightforward to pick these things off from an analytical point of view. As a public service I will share some tips that may be helpful in avoiding obviously fraudulent stocks. Most of these can be generalized to other investment opportunities.

Stock Fraud Red Flags

#1: The stock is a microcap/penny stock (trades on the OTC bulletin board or pink sheets). Penny stocks are riddled with fraud. There are a lot of them and the SEC doesn’t have the time and resources to run around investigating every shady operator in existence. Trading volumes are usually thin which means the prices are easy for insiders and assorted other scumbags to manipulate through a variety of schemes (the most common being the pump and dump). Not all microcaps are frauds but they are much riskier fare for unsophisticated investors.

#2: Thin trading volumes and/or a price history showing huge spikes and crashes. This can be indicative of market manipulation.

#3: Screwy financials. Shady penny stocks tend to share some common attributes in their financials. Here are some (in no particular order):

• Seemingly large mismatches in revenues and expenses (e.g. revenues of a couple hundred thousand dollars and operating expenses of several million dollars) that don’t seem aligned with investment programs, R&D or product ramps.

• Inadequate capitalization, such as a few hundred or a few thousands of dollars in cash in a bank account and no other assets, but grand ambitions of market penetration and dominance.

• Large accumulated shareholder deficits in place of shareholder equity.

• Substantial liabilities associated with conversion options on convertible debt. This type of financing is variously referred to as “toxic debt” and “death spiral financing.” It can also be used to perpetrate a pump and dump scheme.

• Going concern flags from auditors.

• Material weaknesses in internal controls flags from auditors.

• Business summaries that discuss a past history of operating as different companies or in entirely different industries. One way these frauds perpetuate themselves is by repeatedly merging and reverse merging shell companies to operate in “hot” industries like cannabis.

• Large volumes of related party transactions. It is particularly egregious if cash is flowing from a public entity to a private entity controlled by insiders.

• Limited independent oversight of the executive. Some of these stocks will have a CEO who is also the CFO and the sole board member (or variations on that theme). This could be a sign of a lean startup operation but it is also indicative of limited risk control–especially with regard to cash controls.

• Patterns of late SEC filings or requests for clarification on filing data from SEC staff.

#4: Executives have past association with crashed penny stocks. This is maybe the most significant red flag you can find. Most shady operators in this space are professional or semi-professional scumbags and so they move from scam to scam to scam. Google is your friend here (Googling NAME + SEC can be remarkably fruitful).

READING NEWS STORIES IS NOT A SUBSTITUTE FOR REAL DUE DILIGENCE

In a past life I did a little freelance journalism. I have friends with years of experience in journalism, including business journalism. Believe me when I tell you that journalists are not paid to do proper due diligence.

In most cases the journalist is assigned a story by an editor. The editor says “go talk to this weed guy, weed is hot right now.” The journalist dutifully goes and interviews the weed guy and reports on what the weed guy has to say. Most journalists are not looking into the weed guy’s background and they are certainly not digging into the weed guy’s company’s financials. They may not even be comfortable interpreting financial statement data. In fact, they may never even set foot on the business premises (budgets are tight in media these days). So the journalist will see what the weed guy wants him to see. This is all well and good if you are in the entertainment business but not so much if you are an investor.

John Hempton summarizes the issue neatly in an old post dissecting the Sino Forest fraud (Sino Forest was a Chinese timber company that fabricated acreage). He writes:

Where I am less sympathetic is to Paulson’s statements that staff went to see the operations (and hence they judged they were real) and also to the line that they did a thorough review of the financial statements.

If you go see Sino Forest’s operations you will see what Sino Forest wants to show you. They will show you trees. You can’t tell whether that is 5 thousand hectares or 500 thousand hectares. Seeing trees does not answer the question. There is no point looking at things that are not going to tell you anything anyway – and so Paulson’s staff member wasted his time looking. That is an amateur-hour mistake.

If you are going to look at the operations (and it is often worthwhile) then do the work properly and look through the eyes of a competitor or a customer or a supplier. And find them yourself rather than talk to sympathetic ones supplied by the management.

When management say good things about themselves that provides no actionable investment information. When management say good things about a competitor that is golden. When suppliers you have found yourself say good things about a company that is useful. When management say bad things about their business that is useful.

Speaking to management and hearing good things about them said by them does not help in investment and hence does not constitute actionable analysis.

Not all penny stocks are frauds. Nor are all marijuana businesses. However, in my experience retail investors often struggle to distinguish between compelling narratives and attractive investment opportunities.

The reason for this boils down to availability bias. Retail investors assume that the information that is readily available to them is also the most useful. In reality it is just the opposite. The rosier the outlook, and the easier it is to find information confirming that view, the more skeptical you need to be with your due diligence. It is in the fraudster’s interest to make sure positive information is widely and readily available.