What Every Investor Needs to Know About the CannTrust Affair

For a supposedly “controversial” sector, legal cannabis has been refreshingly transparent and light on (actual) scandal, especially compared to, say, finance.

But there’s always one…

CannTrust Holdings Inc. (NYSE: CTST) is a licensed cannabis producer in Canada; CTST is a popular stock that’s seen 2019 highs of CA$14.87 (US$11.24) a share.

Those shares have slid 56% over the past month because of a mounting scandal.

There are $40 million worth of CannTrust products involved, and countless millions more in capital in play here.

Investors are wondering, so I’m going to show you what’s happening here…

In Canada, CannTrust Pulls a Big No-No

Basically, CannTrust was growing cannabis in unlicensed rooms and shipping the product to customers. Of course, that’s a problem. Health Canada seized 5,200 kilograms of dried cannabis, and CannTrust “voluntarily” held back an additional 7,500 kilograms of cannabis.

Altogether, that’s nearly $40 million worth of product.

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Even after the seizures, the scandal continued to snowball. CannTrust stopped shipping cannabis altogether amid allegations that CEO Peter Aceto and Chair Eric Paul knew about the illegal growing.

The board of directors acted quickly, firing Aceto and demanding that Paul resign – which he did.

Those are decisive steps, obviously, but the trouble is, they may not be enough to save the company.

The board is now “considering strategic alternatives,” which is lawyer-speak for “CannTrust is trying to find a buyer that will preserve some equity value for the company.”

For all that, I don’t have an opinion on what CannTrust might be worth to an investor after this scandal; there are just too many variables right now.

The value here is in what this can tell us about the future.

Here’s What CannTrust Can Do for Us Now

As I said, cannabis hasn’t yet been rocked by the kinds of scandals we’ve seen in finance, for instance, or biotech. But it’s a new sector after all, and it’s important to keep our eyes open to the risk.

To do my best to protect my subscribers from these shenanigans, I do extensive due diligence on the executives of the companies that go into any of our model portfolios. In fact, we just published a report running down the ideal qualities to look for in the individuals running a cannabis firm. (Learn how to get the report here.)

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But due diligence is no guarantee against a potential scandal down the road. CannTrust is the perfect example.

CannTrust is a small cap, to be sure, but it’s no fly-by-night penny stock operator. Outgoing CEO Peter Aceto had a sterling history, co-founding and running ING Direct Canada, which was ultimately acquired by Bank of Nova Scotia (NYSE: BNS), operating as ScotiaBank.

CannTrust earned listings on the Toronto Stock Exchange and the New York Stock Exchange. It earned a “Buy” rating from some of the biggest brokerage companies covering the cannabis industry. Health Canada had even just approved the company for outdoor growing operations.

None of that is easy to pull off. When it all comes together like that, you’d think you’ve got a company playing by the rules.

But that wasn’t the case this time.

We Need to See Everything Come to Light

The second lesson to be learned from all of this is… there is never just one cockroach. If you ever see one cockroach, you can be confident that there are more – many more – hiding behind the walls.

The same thing is true of executive scandals.

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You can be sure that illegally growing marijuana was not CannTrust’s only regulatory violation. That’s the main reason I’m so hesitant to put a valuation on CannTrust.

Put another way, I want to see the rest of the cockroaches before I can estimate what the cleanup job will cost – but the bad news is still piling up.

The company exported some of the illegal product to Denmark, which moves the affair from a mere regulatory debacle to a felony. And a big Canadian newspaper alleges that two executives at CannTrust sold stock after they learned about the illegal growing, but before it became public knowledge.

What does all of this mean?

Well, it doesn’t mean you should sell at the first whiff of scandal. As was saw with Aphria Inc. (NYSE: APHA) earlier this year, there are unscrupulous shorts out there who try to create scandals to induce people to sell their shares, driving the price down and profiting from their bet against the stock.

Instead, you should sell at the first indication that a scandal is true. In the case of CannTrust, that would have been at the initial disclosure of the illegal cannabis growing operation Health Canada found.

When unethical behavior has been proven, you need to get out.

However, doing that is more difficult than it sounds, particularly in the cannabis industry.

That’s because cannabis is changing from an outlaw status to a highly regulated industry, and some of the laws are still vague. With some of the regulations unclear, we can expect executives at the companies we own to push the envelope from time to time. We may even demand it – it’s how brilliant innovation turns into standard operating procedure.

Of course, that’s still very different from behaving unethically. But sometimes it’s difficult to determine the difference.

I find it helpful to think of football penalties. No one is going get labelled a dirty player if they receive a penalty for being offside or get flagged for holding. But if someone is caught taking steroids, say, they can expect a lengthy suspension and a cloud of suspicion to follow them for the rest of their career.

This is tough to get right every time, but it’s important to try.

But you can increase your odds of success in determining which transgressions are tough business, which are misunderstandings of an evolving regulatory environment, and which cross the line.

My advice is to apply your own set of ethical standards when you see a credible allegation of wrongdoing against an executive with a company you own.

Do you think the allegation amounts to a penalty for being offside?

If you do, then hold your stock for a while and see if you’re proven right. Best case, you’ll get the chance to add to your position at favorable prices.

But if you see someone credibly accused of something that outrages you personally, don’t wait around to see what the company will do, because you can be sure that something equally or more outrageous will be reported in the near future.

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