Should you act on a friend’s stock tip?

Every so often, on a group text chat I have with a couple of friends, one friend will throw out a stock tip to the other. I mostly chuckle silently and wait until they ask me what I think, to which I usually say I have no idea, I invest in ETFs. This week’s WhatsApp version of Mad Money, though, got me thinking – what should people do when their friend says they bought a stock they think is going to go way up? And what if my friend’s idea is a good one?

His big buy this week was Aurora Cannabis, the Vancouver-based pot producer that’s considered one of the two biggest players, along with Canopy Growth, in the budding marijuana sector. His logic for buying goes like this: “It’s trading at $8 right now, but it’s going to get listed on the U.S. stock exchange in the next year or so and when it does Americans will start buying it up and it’ll go up in value.” My other friend responded: “Based on the performance and a couple articles I read I just put a buy order up.”

Clearly, my friends are not the kind of people who care much about valuations or other metrics, but they are typical do-it-yourself investors – they hear about an interesting company, they understand the business opportunity (investing in cannabis, as many DIY investors have done, appears, at least on the surface, like a no brainer) and they buy in.

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In fact, it’s not a bad way to approach investing, says Scott Willis, head of research Grizzle, a New York-based investment research company that studies cannabis companies, among other things. When you hear a stock idea around the water cooler, or in a chat group, the first thing the recipient of that tip should do is see if the idea makes sense. Reading articles is a good place to start. “Go to Google and find out information about the company,” he says.

You’ll then want to dig a little deeper by reviewing a company’s investor presentation, says Willis. They usually include forecasts on where the company is headed, the kind of growth it expects, information on its market and more. Look at analyst reports, too. If you can, dig even deeper by perusing the company’s financials. Find the company’s revenue and see how quickly it’s growing. Also, check if the business is profitable by looking at net income and cash flow growth.

Most financial filings discuss what the business is about and its prospects for the future. While finding these details may seem overwhelming for investors, a simple document search for “description of business” or “revenues,” should get you to what you’re looking for. “It’s always worth it to go deeper and look at the numbers,” he says. “You need to understand.”

As for Aurora itself, Willis says my friend is right about the company likely seeing its shares rise when it eventually lists on a U.S. stock exchange. Because pot companies are still generally small, don’t have many shares outstanding and are not easily accessible to the average American investor – unless they buy it on the TSX – demand for these stocks should rise, which would push up the price.

But, says Willis, there are better buys than Aurora. He’s bullish on Aphria, which is trading at 18 times enterprise value-to-EBITDA, versus 35 times for Aurora. It’s about half the size from a greenhouse-space and production perspective, but it plans on ramping up production over the coming months. As well, it produces cannabis cheaply, says Willis. By his calculations, it costs Aphria $2 to produce a gram of cannabis, while it costs Aurora $5. “That’s a huge difference,” he says.

No matter what company you buy, DIY investing is risky, so the more you can know about an operation’s growth prospects the better. The pot industry itself is clearly an up and coming sector, but it’s still early to know how things will shake out. Buying a basket of the top eight performing stocks might be a better way to go than picking just one, says Willis.

Unfortunately, my friends have learned the hard way that pitching each other stock ideas on WhatsApp is, at best, an unpredictable investment strategy. “Aurora is all over the place,” wrote the friend who pitched the idea the day after my other friend bought in. “I’m worried it will go down and (my friend) will hate me. I’ve lost $130 already.”

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What if your stock tip comes from a company insider?

Stock suggestions don’t always come from friends in chat groups. Many of us pal around with people who work at public companies. So, what if your friend tells you that business is going great? Should you buy into their company’s stock? It can be tricky, says Willis, as you don’t want to be trading on insider information.

A good rule of thumb is to avoid acting on any forward-looking statements. If the friend says that the quarter has been great or that some big deal is about to happen, don’t buy in. (And the person shouldn’t be saying that anyway.)

If they say, “business is going great, I love working here, and I own the stock,” then that’s good advice. “If they own the stock then that’s probably worth more than water cooler gossip from a friend,” says Willis. “That means something because they’re seeing it from the inside.”