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Marijuana Stocks: Guilty Until Proven Innocent

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Marijuana stocks have been all systems go since the calendar changed over to 2019, and it's certainly not hard to understand why. Following the legalization of recreational cannabis in Canada this past October, sales are expected to soar from a few hundred million dollars annually to perhaps as much as $6 billion by 2022. That's a lot of growth in a short period of time, and investors clearly believe it'll translate into "green" for pot stocks.

Short-sellers are coming out of the woodwork

But as marijuana stock valuations have climbed into the stratosphere, pessimists have also come out of the woodwork. Think about it this way: These are companies with little in the way of sales at the moment and pretty hefty operating losses that are, in some cases, being valued in the billions of dollars. On paper, many are a fundamental nightmare, with the industry drawing comparisons as the next "mania" to hit Wall Street. And where there are manias, there are bound to be short-sellers betting on a drop.

A businessman in a suit giving the thumbs-down sign.
A businessman in a suit giving the thumbs-down sign.

Image source: Getty Images.

Over the past couple of months, a handful of short-side reports have been published questioning the legitimacy of actions taken by the management teams of select pot stocks. Mind you, short-side reports are issued across all industries and sectors. They can be published by well-known Wall Street investment firms or activist research firms such as Citron Research, which focus on identifying corporate fraud and almost always have a short position in the companies they issue reports on. It's this latter group of short-sellers, the activists that often hold a short position, that can be dangerous for publicly traded companies.

Generally speaking, when accusations arise from short-sellers, investors take the approach that a company is innocent until proven guilty, just as a defendant would be presumed innocent in a court of law until proven guilty. But when it comes to marijuana stocks, short-side reports have demonstrated legitimacy in the early going, such that pot stocks might have to be considered guilty until proven innocent going forward.

Cases in point: Namaste Technologies (NASDAQOTH: NXTTF) and Aphria (NYSE: APHA).

Pot stocks: Guilty until proven innocent

Back in October, Namaste Technologies was accused of "complete fraud" by Citron Research. In particular, Citron's report alleged that Namaste had made fake claims of a potential uplisting to the Nasdaq in order to get investors to buy its stock. Andrew Left, the head of Citron, also claimed that then-CEO Sean Dollinger had sold company assets to an inside party, despite this record not appearing anywhere in the company's filings or earnings reports.

An accountant chewing on a pencil while closely examining figures from his printing calculator.
An accountant chewing on a pencil while closely examining figures from his printing calculator.

Image source: Getty Images.

On Monday, Feb. 4, following an internal review, Namaste Technologies found no evidence of misleading claims of its uplisting to the Nasdaq, but it did find that Sean Dollinger had sold assets to Namaste executive David Hughes. As a result of this nondisclosure, Dollinger was terminated with cause, and the company is now in the process of exploring its strategic options, which may include a sale. Whereas putting itself up for sale would normally be construed as a positive, Namaste's internal review findings could compromise its bargaining power were a suitor to emerge.

Then there's Aphria, which was hit with a co-authored short-side report from Quintessential Capital Management and forensic analysis company Hindenburg Research in early December. The duo alleged that Aphria had grossly overpaid for three Latin American assets that were purchased from SOL Global Investments and that SOL Global had purchased these assets from shell companies for a fraction of the price. SOL Global chairman Andy DeFrancesco is also an advisor to Aphria, so the possibility of all parties having a vested interest was raised.

Last week, Aphria announced the findings from its special committee review process. The good news is that the independent committee found that a reasonable price was paid for the company's Latin American assets and that their development remains on track, in accordance with Aphria's overseas expansion strategy.

However, the committee also uncovered that "certain of the non-independent directors of the Company had conflicting interests in the Acquisition that were not fully disclosed to the Board." Or, put in another context, there were potential fiduciary violations very similar to what was uncovered at Namaste. Vic Neufeld, who has helmed Aphria for nearly five years, announced last month that he was stepping down, with three board directors in total (including Neufeld) leaving.

Two rows of dried cannabis covering neatly arranged hundred-dollar bills.
Two rows of dried cannabis covering neatly arranged hundred-dollar bills.

Image source: Getty Images.

Investors may also recall that this wasn't the first Aphria acquisition to be called into question in 2018. The buyout of Nuuvera was met with criticism after Aphria insiders disclosed vested stakes in Nuuvera just a day prior to the deal closing. Though it's not unheard of for insiders of one company to own a stake in a company that they're acquiring, investors would want to know about it well in advance to ensure that a fair price was being paid.

Even though these short-side reports haven't proven completely accurate, independent reviews have also demonstrated that part of their research was correct. That makes short-side firms two for two in uncovering wrongdoing in the pot industry.

While it pains me to say this, short-side reports need to be given credence by marijuana stock investors until further notice.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool recommends Namaste Technologies and Nasdaq. The Motley Fool has a disclosure policy.