- Cheap shares could be beneficial or damaging to a stock price.
- Early investors need to have a product to believe in, preventing them from immediately selling off as the stock profits.
The capital structure of a company and of an industry has major influence. Companies that are new to the world of public trading have a lot to learn, including the understanding of who owns shared and the price those shares are owned at, which hold more weight than just the forecast of where the business could go. News media website Grizzle recently posted an article to bread down the capital structure of stocks in the cannabis industry, which is still fairly new in many states.
Dilution, which occurs when a company increases the number of shares by issuing new shares, making the share worth less individually. However, there are a few factors that are necessary to consider for this market. For instance:
- The future sale of stocks could ultimately anchor stock prices for companies that offer many warrants, convertible debt, and other options that may contribute to dilution.
- After the shares are available for free trading, there could be pressure on stocks that are exceeding the option stock price.
- While the upside for stocks trading below the option strike price could have certain limits imposed, these stocks are not at risk of near-term insider trading pressure.
- Stocks with low dilutions, no options included, and fast revenue growth are a positive purchase.
- Avoid stocks that already have slow revenue growth, significant dilution, and options that are deep in the money.
Grizzle included several graphics to show where the top cannabis stocks are positioned, including how significant dilution is and their current stock price (as of August 27th). Specifically, their data included Aleafia Health, C21 Investments, Curaleaf, Dixie, Emerald, Green Growth Brands, Hexo, iAnthus, Kushco Holdings, Liberty Health Sciences, and others. See where each one stands in the graphics below, keeping in mind that the larger circles indicate more dilution.
While the Grizzle article shows other companies as well, the point is clear – cheap stock weighs heavily on stock prices. Cheap shares create two situations –
- If the stock price rises significantly above the original price that the investor paid, many insiders sell off their stock to profit, which ultimately drops the price back down.
- For any increase, the cheap stock at or above the current price anchors the stock. This leads insiders to sell their stock the moment that a return opportunity arises.
Early investors can be both good and bad for a stock, depending on the activity that happens after. These investors get companies off the ground, creating startup capital for the brand that eventually leads to the public markets. Companies that are lucky enough to find investors with the same priorities can make the shares more stable and will ultimately create a source of additional revenue as time progresses. However, early investors that just want to turn a profit quickly and leave could end up selling early, dropping the price, and leading to more losses.
Independently, cheap shares aren’t really an issue, and any company that already has financial issues has had to drop their shares well below the market price. Companies that have been in business for years are familiar with the changing share levels. However, as they state, having a cost basis that is close to the current stock prices will provide less of an incentive to sell, because potential gain is smaller.
In this chart, there are three main conclusions that can be drawn:
- Low-cost shares were available to early investors, but issuance of stocks after the IPO correlated to a higher cost.
- The original cost of the shares doesn’t play as high of a role as the gap since the IPO was initiated.
- Selling pressure is getting close to its peak if the current price of the stock is lower than the insider shares, as long as the stock isn’t actually in financial trouble.
The future stock price still appears to be heavily influenced by the early efforts that the company makes in fundraising, which the cannabis industry has learned. Everything from the creation of products to distribution to the growth of sales had to be ready almost immediately, but the speed of getting the funds for these efforts had to be just as fast. The depth of an option in the money is a determining factor in how likely it will be converted for cashing out, which can be seen in the chart below.
Cheap shares can be a problem when stock volume is too low to accommodate the diluted shares sales. In this case, the supply will be more than the demand, which means that the stock price will drop, but cheap shares don’t mean that the stock will be stuck where it is.
Companies need to make their shares valuable with the growth of revenue and earnings, which will allow the early investors to sell their shares and gain a profit. Companies that already have a foundation will bring in more interest from institutions to help increase trading volumes, which means that insider stock sales won’t likely have much of an impact on the price.
Grizzle makes several recommendations to anyone that is looking to invest, saying that the companies that they choose should:
- Offer few dilutive securities, leaning towards the fewer options.
- Be established for at least a year in stock trading, allowing investors to miss the early investor sell-off.
- Have a reliable business model and rapid revenue growth.
- Have a strike price for the conversion and warrants that is above the present stock price, promoting a push for higher stock, rather than lower.
The recent industry selloff in the cannabis industry appears to be driven by multiple factors. While cheap shares and insider selling clearly contributes to the selloff, it is hardly the only factor. However, while prices are low, this may be a good month to choose stocks that have promise to grow.