Investing

The Blunt Truth About Marijuana Stocks — The Motley Fool

When it comes to investing, few, if any, industries have performed better over the trailing year than marijuana stocks. Over the trailing 12 months, the 13 marijuana stocks with a market cap in excess of $200 million have increased in value by an average — an average — of better than 300%!

Three reasons marijuana stocks are budding

Why are investors so gung-ho on pot stocks? To begin with, the public’s opinion on cannabis has shifted dramatically over the past two decades. Before California became the first state to legalize medical weed back in 1995, just a quarter of respondents in Gallup’s national survey wanted to see cannabis legalized nationwide. As of its 2016 poll, some 60% of survey-takers, an all-time high, wanted to see pot legalized for recreational purposes. Support for medical cannabis is even higher, often near 90%. If the public supports legalizing marijuana, the idea is that it could put pressure of state or federal legislators to allow its expansion.

Image source: Getty Images.

To some extent, certain states are also eager to legalize marijuana. California, for instance, pushed Proposition 64 through, with the help of voters, to generate upwards of $1 billion in additional tax revenue each year from the sale of recreational weed. California is known for its budget deficits, so this added tax and license revenue could help it fill some of its future budgetary needs.

And, of course, we can’t overlook the growth of the legal weed industry. According to cannabis research firm ArcView, North American legal pot sales jumped 34% to $6.9 billion in 2016, and they could approach $22 billion by 2021. This is coming from a mixture of organic growth in already legal states, expansion from soon-to-be-approved states and countries, and black market consumers shifting to legal channels. As a reminder, Mexico recently legalized medical cannabis throughout the country, while Canada’s parliament is debating a bill introduced by Prime Minister Justin Trudeau that would legalize recreational marijuana by July 1, 2018. 

Add this together, and we have a pretty clear recipe for success for marijuana stocks.

A blunt reality for pot stocks

But I have a news flash for pot stock investors: There’s actually very little correlation between rapidly growing legal weed sales and the publicly traded marijuana stocks you can buy right now.

There’s no denying that legal weed sales are growing rapidly. However, a vast majority of recreational and medical cannabis sales throughout North America are coming from smaller, privately owned businesses. Another way of saying this is that the marijuana industry is currently very fragmented. There are multiple smaller businesses competing with one another, which means there isn’t much in the way of larger businesses for investors to consider buying. Thus, as legal pot sales increase, the average marijuana stock investor isn’t necessarily going to see any benefits.

A tipped over bottle of cannabis buds lying atop a pile of cash.

Image source: Getty Images.

Additionally, it’s worth pointing out that most marijuana stocks have only been in existence for a few years. Sure, Canada approved medical marijuana all the way back in 2001, but companies like Canopy Growth Corp. (NASDAQOTH:TWMJF) and MedReleaf (NASDAQOTH:MEDFF), which are among the largest Canadian producers and retailers by market cap, were only founded in 2014 and 2013, respectively. Being so wet behind the ears implies that these companies could very well encounter growing pains. For Canopy Growth, these “growing pains” have manifested in the form of surprising quarterly losses due to capacity expansion and acquisition-related costs, despite strong revenue growth.

This brings us to the next point: most marijuana stocks are still losing money. Even with nearly $7 billion in legal North American sales last year, just two marijuana stocks were profitable in their most recently reported quarter. The deck is heavily stacked against their success.

On top of the industry being fragmented, marijuana stocks within the U.S. face two inherent disadvantages. First, businesses that sell a federally illicit substance, like marijuana, are disallowed from taking normal corporate income-tax deductions. This means paying far more in taxes than a “normal” business would. And second, marijuana businesses have little or no access to basic banking services since financial institutions report to the Federal Deposit Insurance Corporation, which is a federally created entity. Without access to a line of credit, loans, or even a checking account, pot stocks face an uphill climb. 

As things stand now, marijuana stocks are wholly avoidable until the industry matures.

A book on federal and state marijuana laws lying next to a judge's gavel.

Image source: Getty Images.

Here’s what could change the game for (some) marijuana stocks

There is, however, one factor that could genuinely change the perception of some pot stocks for the better: a countrywide legalization effort.

Within the U.S., the idea of legalizing recreational pot is a pipe dream — at least with President Trump and Attorney General Jeff Sessions in office. Trump’s now-former White House press secretary, Sean Spicer, had warned in February that the current administration would be more stringent with federal regulatory enforcement on cannabis, and Jeff Sessions is perhaps the most ardent opponent of marijuana’s expansion in Washington. There’s virtually no chance of major federal progress before 2020, in my opinion.

But for our neighbors to the north, there’s a real possibility that recreational weed could be legal by next year. The Canadian government has estimated that opening the door for recreational marijuana could generate $5 billion to $7 billion a year, which would be a boon for companies such as Canopy Growth and MedReleaf, both of which have been aggressively expanding their capacity. Canopy Growth has done so mostly through acquisitions, while MedReleaf’s recent IPO provided much needed funding to organically expand its Bradford, Ontario facility.

If, and only if, Canada’s parliament moves forward with a recreational legalization effort, Canadian pot stocks may finally be worth a serious look. However, the bulk of publicly traded marijuana stocks belong nowhere near investors’ portfolios.

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