7 Good Reasons Not to Buy Marijuana Stocks – The Fool Motley

The wait is almost over. In 17 days (October 17), recreational marijuana will be legalized at our northern neighbor, opening the door for sale in licensed clinics. With this legalization, the annual turnover could increase by $ 5 billion, once the industry is fully operational. It's this anticipation of rapid sales growth, associated with profits, that has pushed marijuana stocks up since the beginning of 2016.

But as the stock market has taught investors time and time again, nothing goes up in a straight line. If you're thinking of buying in the green rush or are already investing and wondering what you should do with your assets, here are seven good reasons not to buy marijuana stocks or sell what you own.

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1. The black market could undermine demand

The presence of the black market, even after legalization, is perhaps the biggest concern, even if it goes unnoticed. Cannabis research company Arcview found that the black market controlled more than 85 percent of all North American weed sales at the end of 2016. Although this number is likely to make its way into market marijuana will give up all its market share. The reason? Price.

In Canada, the federal government imposes an excise tax of about 10% on marijuana sales for recreational purposes. This low tax rate (comparatively, alcohol taxes ranging from 50% to 80%) should allow herbs for adult use to be competitive with black market. Unfortunately, this will probably not be the case. The legal channels must pay income taxes, license and license fees, rent, electricity, and so on. The black market has virtually no overhead, and it certainly does not have to pay taxes or fees. The black market should easily be able to reduce the price of legal channels, making it an attractive alternative for some consumers.

California offered an even more striking example of the power of the black market. Excise, state and local taxes in some areas of California can reach up to 45%, making the legal pot significantly more expensive than unlawful sources. In a recent survey conducted by Marketview Research in California, 18% of cannabis users surveyed admitted to having purchased unlicensed source pot within the last three months. This is one of the main reasons why the recreational marijuana market in California underperformed its expectations early on.

In short, ambitious sales targets could be disappointed because of the black market.

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2. Overproduction problems are likely

In addition to tax problems, the threat of overproduction is a real concern. While there is little precedent for the legalization of recreation around the world, a handful of US states offer worrying examples of what the future might be.

As of 2014, Colorado and Washington officially opened their doors to recreational weed sales, followed by Oregon and California. In each of these four states, producers have produced cannabis at a fast pace. And in each case we witnessed, or began to witness in the case of California, a sharp drop in the price of gram of cannabis.

Why do producers produce too much, you ask? Part of the answer might be that they do not know what kind of demand to expect. Another possibility is that they want to flood the marijuana market, lower the price per gram and chase the smaller players who can not survive with a smaller margin. This way, big players with deeper pockets can take over. In addition, producers may simply want to take advantage of high prices per gram at the beginning. Whatever the answer, and even taking into account economies of scale (that is, producers increase their production, their cost per gram to grow cannabis should decrease), this is a recipe for reduce operating margins.

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3. There is too much competition and not enough differentiation

A third good reason to avoid marijuana stocks is that there is simply too much competition in the industry and not enough differentiation to allow investors to determine which companies will win.

One of the most popular pot stocks in recent months has been Aurora Cannabis (NASDAQOTH: ACBFF). Aurora has used organic construction projects, strategic partnerships and numerous acquisitions to expand its production portfolio. Following its acquisition of ICC LaboratoriesAurora Cannabis could be on track for an annual yield of between 600,000 and 700,000 kilograms, once at full capacity. Being the best dog in production could certainly have its benefits, including being a must-have partner for branded beverage and tobacco manufacturers.

But to succeed in the cannabis industry, companies will have to do much more than simply outsell their peers, especially if oversupply issues drive down the price of a gram of marijuana. Aurora Cannabis focuses on patients with a higher medical marijuana margin, but it still has a long way to go to create its brands and create an identity that truly stands out in space. As such, it is a marijuana stock that I have suggested to investors to avoid.

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4. Dilution in equities is a long-term problem

Although it has been discussed for almost a year now, equity-based dilution deserves the attention of investors in marijuana stocks, as it is a permanent problem.

Before the adoption of the Cannabis Act on June 19, access to traditional forms of financing through a bank, such as a line of credit or a loan, does not exist. Was not available. Indeed, banks feared the possibility of criminal and / or criminal penalties for violating federal law in Canada. In the United States, there are even fewer interactions between financial institutions and cannabis companies.

Prior to the promulgation of the cannabis law, the only way to mobilize capital on a large scale was through bids. A repurchase offer involves the sale of common shares, convertible debentures, stock options and / or warrants to an investor or group of investors. ; investors. These offers have almost always succeeded in raising the funds needed for marijuana stocks to be able to make an acquisition or increase their capacity.

However, these offers have one disadvantage: dilution. All of these fundraising methods have increased the number of outstanding securities, which can weigh on stock prices and make marijuana stocks much more difficult to generate. Even worse, with the convertible debentures, options and warrants still in place for many marijuana shares, dilution will be an ongoing problem for years to come. Aurora Cannabis, discussed above, saw its turnover jump from 16 million at the end of fiscal 2014 to about 1 billion today.

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5. Tangible benefits are still far

Given the above, marijuana stocks are unlikely to be profitable on a recurring basis even though Canada is about to attack the green flag.

The first problem, as noted, is that dilution will weigh on earnings per share. With more shares outstanding to divide the bottom line, it is likely that earnings per share will be disappointing. In addition, with convertible notes, warrants, options and stock-based compensation, the number of shares outstanding is likely to continue to increase, putting pressure on earnings per share.

Intermediate profits are also accompanied by an asterisk. Adjusting the value of biological assets was the only real way to generate quarterly profits for pot stocks. Examine only on an operational basis, excluding adjustments to the value of biological assets, virtually all marijuana stocks lose money. With many capacity expansion projects still underway, costs are expected to exceed sales in the near future.

There is also a good chance that the excess supply will begin to lower the price of the weed gram in the not-too-distant future, which would be bad news for the operating margins. The economies of scale will help a little, but there is no guarantee that marijuana stocks will generate near the profits expected by Wall Street or by investors.

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6. Regulation could slow down growth

Do not overlook the possibility that Canadian regulations will partially halt the growth of the marijuana industry.

For example, when the curtain is lifted on October 17, 2018, only dried cannabis and cannabis oils will be available for sale. Other forms of consumption, such as edible products, vapes, cannabis-infused drinks and concentrates, will not be legal. Wall Street and the industry are widely expecting Parliament to begin discussions on extending consumer options next year, but there is no guarantee that it will meet the unwritten deadlines expected by investors. If this expansion is delayed, it would mean a longer wait for high-income products, which could also hinder the potential for brand and tobacco partnerships.

There is also concern that the legalization of marijuana could create safety problems for drivers. While alcohol-related disorders can be determined with relative ease thanks to breathalyzer tests and sobriety tests conducted by peace officers in the field, this is not the case with alcohol-related disorders. Marijuana use. Even with breathalyzers being developed, the mere fact that Canada has had difficulty in establishing concrete guidelines for peace officers to deal with drivers who may be under influence is a concern.

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7. The story suggests that we are in a bubble

Finally, history says that the explosive increase in marijuana stocks will not end well.

Although we are not dealing with a new product or new technology – marijuana has been around for some time long time, at least in an illicit form – investors have consistently exceeded expectations when the next big thing comes on the market. Over the past two decades, we've seen Internet action, business-to-business, genomics companies, 3D printing companies, and more recently, blockchain companies. Marijuana stocks are likely to follow the same path, making it an industry to avoid at the moment.