What are the risks of investing in marijuana stocks? – The madman

Are marijuana stocks just too risky to buy? The correct answer is: it depends.

Different investors have different financial goals. More importantly, different investors have different risk tolerances. Conservative investors will probably not find much to like with most marijuana stocks because of their high level of risk and their volatility. However, aggressive investors might be comfortable buying marijuana shares.

Regardless of your type of investor, it is essential to understand the risks inherent in the stock before buying it. What are the risks of investing in marijuana stocks? Here is what you need to know before you buy.

The basics about marijuana and the cannabis industry

To understand the risks associated with marijuana stocks, it is important to first know something about marijuana itself and the cannabis industry.

Marijuana is the common name used for cannabis sativa plant. This plant contains more than 100 chemical ingredients known as cannabinoids. Delta-9 tetrahydrocannabinol (THC) and cannabidiol (CBD) are two of the major cannabinoids. THC is the main psychoactive ingredient in marijuana. CBD is not psychoactive and it has been found that it has decisive therapeutic benefits in the treatment of forms of epilepsy and that it could also help in different ways, including relieving the condition. Anxiety and insomnia and by reducing inflammation.

A wide variety of products can be made from marijuana. The main types of marijuana products include cannabis flower, oils (including CBD), edible products (including cannabis-infused beverages) and concentrates for steam. In general, marijuana products are used for medical or recreational purposes.

Marijuana for medical purposes has been legalized in several countries around the world, including Australia, Canada, Germany and the United Kingdom. Thirty US states have also legalized marijuana for medical purposes, although it remains illegal at the federal level in the United States.

At present, only two countries allow the legalized use of marijuana for recreational purposes: Canada and Uruguay. Americans' support for the legalization of marijuana for recreational purposes is at its highest level. Nine US states, plus the District of Columbia, have legalized marijuana for recreational purposes to date, others potentially poised to do so.

A large industry has emerged in recent years as more countries and US states legalize marijuana for medical purposes. Many of the companies that support the medical marijuana market have also expanded their activities to markets for marijuana for recreational purposes in states like California and Colorado, as well as in Canada.

What are the different ways to invest in marijuana stocks?

There are many ways to invest in marijuana stocks. The chart below presents six broad categories of investments in marijuana shares, as well as an example of a leading publicly traded company for each category.

Data sources: Yahoo! Finance and Bloomberg. Market cap as of October 26, 2018.

Marijuana growers: The easiest way to invest in marijuana stock is probably to buy shares of a marijuana grower. Canopy Growth is one of the top marijuana growers in Canada. The company is a licensed producer for the medical and recreational marijuana markets in Canada. In addition, Canopy is present in several other countries that allow marijuana for medical purposes, including Germany, which boasts the largest marijuana market outside of North America.

Dissemination of royalties on marijuana: An intriguing investment in direct investment in marijuana growers is buying a position in a royalty company that provides funding to marijuana growers for a percentage of their production. This approach helps small producers obtain financing and helps the royalty company develop various sources of revenue. Auxly Cannabis Group is a leader in this niche market with 13 streaming partners.

Marijuana Distributors: Distribution is a key part of the supply chain of the cannabis industry. This involves the transport of producers, warehousing and transportation to outlets or dispensaries. Origin House, formerly known as CannaRoyalty, is the largest recreational marijuana distributor in California with the largest marijuana market in the world.

Resellers / dispensaries of marijuana: Retailers and marijuana dispensaries place marijuana products in the hands of end-users and patients. MedMen Enterprises is the largest marijuana retailer in the United States with operations in California, Nevada and New York. The company is also expanding in Florida and has a partnership with Cronos Group (NASDAQ: CRON) launch retail stores in Canada. MedMen recently announced the acquisition of PharmaCann, an agreement that will make the merged entity the largest cannabis company in the United States.

Ancillary Services / Supplies Providers: Any industry needs a multitude of service providers and ancillary supplies. The cannabis industry is no exception. Through a series of acquisitions, including the acquisition of Sunlight Supply in April 2018, Scotts Miracle-Gro is the largest supplier of hydroponics (which helps grow liquid and landless crops) to state marijuana growers. -United. The company is also a major supplier of other essential products for the cannabis industry, including fertilizers and lighting systems.

Biotech based on cannabinoids: Biotechs specializing in cannabinoids develop drugs based on chemical ingredients derived from marijuana plants or synthetic versions of these ingredients. GW Pharmaceuticals has become a leading biotechnology company focused on cannabinoids. The company received US regulatory approval for the Epidiolex CBD drug in June 2018 as a treatment for Dravet syndrome and Lennox-Gastaut syndrome, two rare forms of epilepsy.

Risks Of Investing In Marijuana Stocks

Investing in marijuana stocks involves three major risks.

Risks of valuation: Perhaps the most significant risk associated with the purchase of marijuana stocks is that the valuation of these stocks has increased so rapidly that stock prices simply reflect the outlook for inventory growth. The valuation of an action can be evaluated in several ways, including using the price of the stock in relation to earnings, products and cash flow. Investors should note that many marijuana stocks are not yet profitable, which complicates the valuation of stock valuations.

The use of historical sales is also problematic. Canadian marijuana companies such as Canopy Growth, for example, were only generating revenue in the country's medical cannabis market by October 17, 2018. As a result, any valuation measure based on sales by example, the lowest price 12 – monthly sales or 12-month business sales – give the impression that stock prices are ridiculously high. It's a similar story for GW Pharmaceuticals. The historical business history of biotechnology does not include any sales for Epidiolex.

Because historical data is so difficult to use, investors must rely on forward-looking growth projections, such as the price-earnings-to-growth (PEG) ratio or the price-to-sales ratio, to determine whether the shares are reasonably valued. And that opens another Pandora's box.

CEOs of marijuana growers sometimes mention global market sizes of $ 150 billion or more. With such a large potential market, a stock with a market capitalization of about $ 10 billion (the total market value of the outstanding shares of a company) does not seem too expensive. However, it is important to understand that the $ 150 billion figure is based on an estimate of the global marijuana market by the United Nations. including illegal marijuana sales. Most of this illegal use is for recreational purposes, which remains illegal at the national level in all but two countries.

It is possible that one day recreational marijuana will be legalized in much of the world. In the meantime, investors should pay attention to the projections they use to determine the attractiveness of marijuana stocks. What will be the actual size of the marijuana market? Arcview Market Research and BDS Analytics conducted a thorough analysis and estimate that the global marijuana market will grow from $ 9.7 billion in 2017 to $ 32 billion in 2022.

Will all marijuana stocks compete in a $ 32 billion market in the next few years? The United States accounts for $ 23.4 billion of the total. Canadian stocks of marijuana that are listed on the Toronto Stock Exchange can not maintain their listings and carry out significant transactions in areas where marijuana is illegal at the federal level – which, for the time being, includes the United States. This means that the determination of Canadian marijuana stock valuations based on growth forecasts should focus on the Canadian and non-US markets.

It is also important to understand the potential impact of future supply / demand imbalances. An overabundance of supply, a situation in which supply far exceeds demand, is expected for the Canadian marijuana market by 2021 – and perhaps earlier – due to the rapid expansion of the production capacity of many Canadian marijuana growers.

Valuation risks also exist for cannabinoid-based biotechnology stocks. For example, estimates of the maximum annual sales of Epidiolex vary considerably. Some pessimistic analysts believe that the CBD-based drug could generate less than $ 300 million a year. Other highly optimistic analysts expect Epidiolex to record record annual sales of more than $ 2 billion. The estimate you use makes a huge difference in determining how attractive the price action of GW Pharmaceuticals is.

Dilution risks: Dilution occurs when a company issues new shares in order to generate additional capital to finance operations or develop its business. The value of existing shares decreases due to the higher number of shares outstanding, the total number of shares owned by investors, including those held by insiders of the company. .

Why is dilution often bad for current shareholders? Suppose that a company has 10 million shares outstanding trading at $ 10 per share, which would give it a market capitalization of $ 100 million. If you own 1 million shares, your investment is $ 10 million. Suppose now that the company issues 10 million new shares. Assuming the market capitalization remains constant, each share is now worth $ 5 instead of $ 10 because of the impact of the dilution. Your investment of $ 10 million would not reach more than $ 5 million.

Although dilution is a risk for many types of stocks, it is particularly problematic for many marijuana stocks. Due to legal impediments to access to bank lending, Canadian marijuana companies had little choice to generate capital for financing operations and growth.

Many of these companies have used a so-called "buy-sell" approach whereby an investment bank or consortium commits to buying all the securities it issues at a predetermined price. While this approach allowed marijuana growers to raise the much-needed funds, it also significantly increased the number of outstanding shares and diluted the value of existing shares.

It is possible that the dilution risks of at least some marijuana companies decrease as they become profitable. Meanwhile, dilution remains a serious threat to be taken into account by investors.

Risks of commodification: A risk that particularly affects marijuana growers and royalty companies is the potential for commoditization – when a product becomes indistinguishable from other products. Marijuana is an agricultural crop. And all agricultural crops are commodities.

However, agricultural products are not just agricultural products. Precious metals such as gold and silver are also commodities. The same goes for resources, including crude oil and natural gas. Other types of products can also be standardized, such as memory chips, hard drives and components for laptops. Any product for which price is the sole or dominant differentiating factor among several suppliers is a commodity.

Merchandising weakens the pricing power of producers. In other words, companies can not raise the prices of their products without causing a drop in demand. For example, if a service station significantly increases the price of fuel compared to its competitors, it will lose money because customers will choose to refuel at other gas stations at more competitive prices. low.

When the demand is greater than the supply, trivialization is not a big problem. However, when supply exceeds demand, as will eventually occur in Canada, commoditization can hurt marijuana growers, especially smaller ones who do not achieve the same economies of scale – cost savings. resulting in the size and scope of operations – that the largest producers have.

Risks specific to marijuana stocks in the United States

Some investment risks are specific to marijuana stocks in the United States:

Risks related to prosecution: Although many states have legalized marijuana for medical purposes, recreational marijuana or both, their laws are in direct violation of federal marijuana laws. Under the Obama administration, the official federal policy was to avoid intervening in states that had legalized marijuana.

However, in January 2018, the US Attorney General, Jeff Sessions, overturned the policies of the Obama era. His decision allowed US federal lawyers to sue anyone who owns or sells marijuana – including marijuana for medical purposes. The sessions had a long history of opposition to marijuana before becoming Attorney General. His opposition continued after taking the lead of the United States Department of Justice.

Could sessions instruct the GM to target marijuana companies operating in the United States? Theoretically yes. And that means that a dark cloud hangs over the cannabis industry in the United States. However, there are some obstacles that prevent sessions from taking concrete action.

First, the Rohrabacher – Farr amendment is part of every spending bill passed for the federal government to continue operating since 2014. This amendment prohibits the DOJ from using the money to interfere with the state laws legalizing marijuana for medical purposes.

Second, President Trump has expressed his support for marijuana for medical purposes and his willingness to let marijuana laws for recreational purposes to states. In April, Senator Cory Gardner (R. Colo.) Announced that the President has pledged to support "a legislative solution based on federalism to definitively settle the issue of state rights" – apparently by thwarting the plans. sessions. had to target marijuana companies.

Senator Gardner is co-sponsoring legislation with Senator Elizabeth Warren (D.-Mass.) To prevent the federal government from interfering with states that have legalized marijuana. Colorado and Massachusetts, respectively, from both states of origin have legalized marijuana for medical and recreational purposes.

The amendment Rohrabacher – Farr however has only temporary effect. It is possible that a budget bill would be passed without amendment, which would allow the DOJ to use funds to sue marijuana companies for medical purposes. In addition, the amendment does not prevent the Department of Justice from engaging businesses in the marijuana market for recreational purposes.

There is no guarantee that Gardner and Warren's laws will be passed by Congress. Until the US federal laws are revised, the possibility for the government to sue marijuana-related businesses remains a possibility.

Risks related to obtaining banking and financial services: Even though companies operating in the cannabis sector in the United States are not being sued, they face another permanent risk: obtaining banking and financial services. Because the sale of marijuana is illegal at the federal level, banks or other financial institutions handling money from businesses related to marijuana could be accused of money laundering (c & # 39; that is to say, to conceal the origin of illegally manufactured money).

Many banks have chosen to avoid dealing with marijuana companies because of the risks of federal statute violations. As a result, marijuana companies have been forced to operate only in cash. One of the disadvantages is that it makes companies more vulnerable to theft. An even bigger problem, however, is that it limits their ability to obtain the capital needed for expansion.

Some banks and credit unions have chosen to do business with US companies active in the cannabis industry. As a result, the risks of marijuana businesses getting banking and financial services are not as important as before.

In addition, some US companies have attempted to circumvent the issue of raising capital by listing on Canadian stock exchanges. MedMen, for example, is based in California, but its shares are listed on the Canadian Securities Exchange (CSE). Unlike the Toronto Stock Exchange, the CSE does not prohibit marijuana companies operating in the United States from being publicly traded.

Alternatives to reduce your risk level

Can investors reduce the risks associated with investing in marijuana stocks? Perhaps. Here are three alternatives that could potentially reduce the risks of investing in marijuana stocks.

Buy only marijuana stocks with a lower known level of risk: One obvious way to reduce the risks associated with buying a marijuana stock is to choose only stocks with a lower known risk level. For example, Canadian marijuana stocks are not exposed to risks specific to the US cannabis industry. In the world of marijuana stocks in Canada, some are more valued than others. Some are also already profitable or are on the verge of being, which should reduce their risk of dilution.

This approach, however, has a major disadvantage: all marijuana stocks will likely face at least one of the major risks. Nevertheless, buying only marijuana stocks with a lower level of risk should improve your chances of success in the long run.

2. Buy Exchange Traded Funds: Another approach to potentially reduce your risk is to buy an exchange-traded fund focused on marijuana. ETFs are investment funds containing a basket of securities that can be traded as a single share. Two marijuana ETFs are currently available:

The main advantage of ETFs is that they offer more diversification than buying just one or a few securities. However, marijuana ETFs also have some disadvantages:

1. They have relatively high expense ratios (costs charged to investors for managing the fund as a percentage of the fund's total assets).
2. They are heavily weighted by marijuana stocks with very high valuations.
3. Their holdings mainly include stocks that do not focus on the US market – the largest marijuana market in the world.

Buy stock of companies with a main business outside of the cannabis industry: Can you expose yourself in a limited way to the cannabis industry? Yes, by buying shares in companies that participate in the marijuana markets for medical or recreational purposes, but that have major activities outside the cannabis industry.

Scotts Miracle-Gro is an example of this approach. Although Scotts is the leading supplier of marijuana growers in the United States, the company still earns more than 90% of its total revenue from its lawn and garden consumption business.

Another example is Constellation Brands (NYSE: STZ). The company is a major manufacturer of alcoholic beverages and, in its last fiscal year, had sales of nearly $ 7.6 billion, including Corona beer and Modelo beer. However, Constellation is also present in the cannabis industry, thanks to its 38% stake in Canopy Growth.

Risk vs reward

The risks associated with investing in marijuana stocks are real and can not be ignored. At the same time, however, these risks must be weighed against the potential benefits offered by marijuana stocks.

The global cannabis industry continues to grow by leaps and bounds. There will be both winners and losers, as in any other sector. Being aware of the risks and finding ways to limit them can help you improve your chances of choosing the winners.