Investing

5 Essential Rules for Investing in Marijuana Stocks — The Motley Fool

“Green rush” is a phrase that’s been used quite a bit lately. People use the expression to refer to the explosive growth in the legal marijuana industry. Some of that growth has stemmed from a wave of legalization of medical marijuana, while some of it has also come from a smaller number of U.S. states that have legalized recreational use of the drug.

Anytime there’s a rush in any industry, it presents opportunities for investors to profit. Unfortunately, these rushes also present just as many opportunities for investors to lose money. Profiting from the green rush is possible, though. Here are five essential rules for investing in marijuana stocks that should increase your likelihood of making money.

Image source: Getty Images.

1. Forget the hype

Above all else, forget the hype about marijuana stocks. You’re probably not going to become the next “marijuana millionaire,” no matter what some marketers on the internet might tell you. There’s nothing magical about marijuana stocks that automatically makes them better investment candidates than other stocks.

When you buy a marijuana stock, you’re investing in part of a company. The purpose of that company is the same as others that are publicly traded — to provide products and services to customers and to create shareholder value. If you focus less on the allure of the product and more on the potential for the business and the industry in which it operates, you’ll be much better off.

2. Understand the risks

Every company, every stock, and every industry comes with its own set of risks. It’s critical that you understand the risks for marijuana stocks and the marijuana industry in general before investing.

What are those risks? U.S. marijuana growers face the possibility of a crackdown by the U.S. government. After all, federal laws still prohibit the sale and use of marijuana, regardless of legalization by individual states. Canadian marijuana suppliers don’t have to worry about that particular threat. However, the potential exists that something could derail efforts to legalize recreational use of marijuana in the country.

Also, many marijuana stocks have tiny market caps and are traded over the counter, rather than on public stock exchanges. There are significant risks with such stocks, including lack of liquidity and limited information, which can impact your ability to make wise investing choices. 

3. Identify the leaders

It’s smart to pick stocks of companies that are leaders in a given industry. That’s especially true for the marijuana industry, which could be ripe for commoditization. 

For example, in the Canadian market, Canopy Growth Corporation (NASDAQOTH:TWMJF) and MedReleaf (NASDAQOTH:MEDFF) claim the highest revenue currently. The size of a company’s sales isn’t everything, but it certainly could be important if consolidation begins to occur in the Canadian marijuana industry. Larger suppliers like Canopy Growth and MedReleaf are more likely to survive a wave of mergers and acquisitions. 

Sometimes, leaders might be hard to find. The U.S. doesn’t have one or two dominant, publicly-traded marijuana growers. Instead, the market is spread across many smaller players. It could be helpful to take a broader perspective and look to stocks like Scotts Miracle-Gro (NYSE:SMG). Although Scotts isn’t technically a marijuana stock, the company is definitely a leader in providing hydroponics and lighting supplies to the marijuana industry.

4. Evaluate prospects realistically

Canopy Growth stock trades at 35 times sales. MedReleaf shares trade at 19 times sales. Those multiples reflect expectations of enormous growth baked into the stock prices. Some marijuana stocks are priced even more expensively. You need to evaluate the future prospects for marijuana stocks realistically, making sure you follow rule No. 1 and forget the hype.

Man using calculator and reviewing business documents

Image source: Getty Images.

How can you evaluate a stock’s prospects? First, look for reputable data about potential growth for the industry. For example, accounting and consulting firm Deloitte projects that the Canadian recreational marijuana market could generate between $4.9 billion and $8.7 billion. Deloitte is a respected company, and its estimate is based on survey data about how many Canadians are likely to use recreational marijuana, combined with publicly available data on sales volume from jurisdictions where recreational marijuana is already legal (for example, Colorado) and current market prices in Canada. 

Second, determine how likely a given stock will be to capture a significant market share. This requires some guesswork. For example, if you think Canopy Growth can capture 10% of the Canadian marijuana market and use the lower end of Deloitte’s range, the company could achieve roughly $500,000 in annual sales. Is there room for Canopy Growth stock to move higher from its current market cap of $1.4 billion under this scenario? Probably so. But if you think the company won’t get nearly that significant of a market share or if you question Deloitte’s projections, the stock might not be a good pick.

5. Invest with a long-term perspective

Finally, think long-term. Warren Buffett was right when he said, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

The reality is that some marijuana stocks could turn out to be flashes in the pan. Some, on the other hand, are stocks of well-run businesses with experienced management teams that have a solid plan for growth and the ability to execute well. If you invest in the stock of a company that can establish a long-term competitive advantage, you’ll be much more likely to win. That’s true for marijuana stocks, as well stocks in any other industry.

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