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Put your life savings in pot stocks – but first, read this

Readers will by now be familiar with the pot stock craze sweeping the ASX. The faintest hint of marijuana is enough to send a share price rocketing – a stark difference from the real world, where it can be a cheap ticket to a date in court.

Companies like Zelda Therapeutics Ltd (ASX: ZLD), MMJ Phytotech Ltd (ASX: MMJ), Auscann Group Holdings Ltd (ASX: AC8), MGC Pharmaceuticals Ltd (ASX: MXC) and more have all shot higher in recent times:

Pot stocks over the past 3 months (source: Google Finance)

Frankly, I’m bearish on the medical marijuana industry. In my opinion there are too many competitors for them all to win. But I know that many readers like them, so before you get swept up in the craze and mortgage the house to buy pot stocks, please consider these 3 things:

  • Who holds the power in the industry?

Or to put it another way, who screws who? Can medicinal marijuana companies effectively raise or maintain prices that they receive from end users? Are medical marijuana users eligible for government rebates? Will health insurers pay for the use of these products? Believe me when I say health insurers and pharmaceutical companies, big players in the sector, have a lot of pricing power.

If not, sales are dependent on the consumer’s hip pocket, which means price is a key consideration. That means that bigger companies will be able to squeeze out smaller ones through economies of scale until the industry stabilises. It is important to consider the market power of pot company suppliers, as well as their customers and competitors.

  • How is management incentivised?

What does management get rewarded for doing? Are they paid appropriately given the size and financial position of the company (e.g. profitable/unprofitable) and does this compare favourably to other similarly-sized companies on the ASX? Are management founder-types, or are they relative newcomers to the medical marijuana industry (e.g. opportunists, or hired talent).

What you really want to find out is if management has long term incentives in place to grow revenues, achieve cash flow break-even, and then profitability.

  • Why will your chosen stock be the winner?

This is the big one. There are nearly 15 medical marijuana companies on the ASX and there are dozens more overseas. The industry is not big enough for all of them. So, it is important to look at company-specific factors including products, cost of production, possession of intellectual property, and other points of difference between companies. Two key things I would look for first are valuable patents, and a strong distribution network.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.