November 27, 2018

Investing in Cannabis: What You Need to Know About Marijuana Stocks

Marijuana legalization is sweeping over North America. With ten states and Washington D.C. entirely on board with the green revolution, it’s hard to deny the booming cannabis industry. As a nation, we’re moving the needle, and despite marijuana’s illegality at the federal level, investing in the cannabis industry is still somewhat uncharted territory.



We sat down with Chris Tuck, financial advisor for SJK Wealth Management, to discuss how the cannabis mania in both Canada and the U.S. has impacted the growing interest in marijuana stocks as cannabis companies reach the mainstream.

 

What Makes Cannabis Risky?

All stocks carry risk, but investing in the cannabis space can be tricky waters to navigate, especially for those new to the stock market and eager to get their hands on a piece of the green rush.

One of the biggest obstacles for potential investors are the small number of cannabis stocks trading on big exchanges. Because the plant is still illegal on a federal level – classified as a Schedule I drug by the DEA – this has made it difficult for most companies to get listed on the Nasdaq or the NYSE. To raise capital, many companies then trade via penny stocks which presents little regulation and a lower level of scrutiny when compared to major exchanges. 

 

What to Consider When Investing in Cannabis Stocks

There’s very little regulation in penny stocks, especially cannabis penny stocks. So it’s essential to do your due diligence when investing. Consider everything from basic research about the company, to team members, to the company’s website.

One of the best places to start and easiest ways to exercise caution is to see if the stock in question is trading on a major stock exchange. Companies listed on exchanges like Nasdaq, NYSE or even the Toronto Stock Exchange must go through a vetting process, ensuring more regulation and due diligence at the corporate level.

Consider this:

  • Do the individuals on the company’s team have experience in cannabis? Cannabis can be a challenging industry to traverse, and many people outside of the cannabis space don’t understand the industry, so proper experience is non-negotiable.
  • Have team members been involved in scandals through licenses or with other companies?
  • Did team members or leaders have success with any previous companies? Did their success disappear or is it present? If someone is credible, you should have no problem finding his or her background on Bloomberg.
  • Has the company changed names or been rebranded?

Bottom line, be sure to properly vet the company before you purchase stock. It’s not difficult to find information about a company or the team, and if it is, let it serve as a red flag. 

 

Cannabis Mania (U.S. and Canada)

Much like 2017’s cryptomania or the dot-com mania of the 90’s, the cannabis industry is set to follow a similar pattern, meaning a bubble which will inevitably burst. However, just because the bubble bursts, doesn’t necessarily mean it’s over, so you should be particularly cautious not to get caught up in the excitement.

Huge Swings in Cannabis

The bubble has been particularly evident in the cannabis industry over the past year with many stocks doubling and tripling in value seemingly overnight. Shares which were up over 200 percent at the beginning of October, have since dropped nearly 50 percent - all perfectly timed with legalization in Canada. Some of these companies include Tilray, Canopy, Aurora, and Chronos.

Consider the investment phrase, “Buy the rumor, sell the news.” In the case of cannabis, word on the street was the future legalization in Canada (rumor), and on the day of legalization, the stocks dropped precipitously (news).

Advice When Investing

Realizing when you're in a bubble can be difficult. Always exercise caution when it’s a hot topic of discussion. On the flip side, you should also be cautious when talking seems quiet or rumblings become negative.

Don’t fall prey to the classic case of “fear of missing out.” History can be a most excellent teacher, and in this particular example, there’s a lot to learn from the dot-com era. When the bubble burst there was a great deal of opportunity. Many tech companies came out of the aftermath to become vital players today. However, had you bought the stock at the height of the dot-com boom, you’d likely still be upside down on those investments today.

 

Finding Higher Quality Investments

The cannabis industry is highly volatile, so the best and least risky way to invest in this sector is typically to see higher quality ways to do it.

  • Look where the money is flowing -  Money being channeled from large companies or institutions to a particular company is a good indicator of a high-quality investment.
  • Acquisitions or mergers - These business moves might be indicators of something more significant on the horizon.
  • Use Electronically Traded Funds (ETFs) - A basket of stocks like mutual funds or ETFs can allow you to buy some stock in one product, as opposed to investing capital in one company. It’s difficult to predict what the outcome for cannabis companies might be this early on. By using ETFs or mutual funds, you spread your risk instead of putting all your eggs in one basket.

 

Federal Legalization: What’s next?

As the industry expands, the risk will inevitably spread thinner, but what happens when cannabis becomes legal under federal law? There are a handful of important factors to consider when evaluating cannabis stocks.

  • What aspect of cannabis you invest in matters - Unfortunately, cultivation isn’t a great business. The price of marijuana is expected to drop, and many top companies who focused on growing are now closing down.
  • What do you have to offer? - Consider if a company has something of value to contribute to their customers (besides the plant). This might take form as a unique experience, a product centered around the experience or particular brands.
  • Look at assets - Does the company in question own their buildings or do they rent?
  • Is the company vertically integrated? - Maybe this looks like a combination of growing, processing and selling through a dispensary. Any business which has multiple strains of revenue is a safer investment.
  • Consider higher margin areas - With the price of cannabis descending, consider what a company can do to maintain margins and turn a profit. If not through the plant itself, then maybe it's via smoking devices, edibles, or a new concept. Cannabis companies might trade at huge premiums, but as it stands, many are not profitable yet. 

 

Considering One-Off Investments

Cannabis investments don’t need to touch the plant. Direct cannabis investments (or those with cannabis in the name) are considered very volatile. If this isn’t your speed, you might consider one-off investments which could play a role in the cannabis space.

  • Alcohol or tobacco companies - Flipping a switch to cannabis will be easy for these companies, especially tobacco. Some companies are in the works of turning tobacco to hemp farms.
  • Agriculture companies - Much like any other plant, agriculture companies play a huge role in the cultivation process.
  • Snack companies - Unsurprisingly, these companies might see an uptick in sales due to cannabis users with the munchies. For instance, in the first quarter of legalization in Colorado, Nabisco experienced record sales numbers.
  • Electric utility companies - Look into electric utility companies with grow houses or legal cannabis operations in their area. Cannabis is an incredibly power hungry plant, and grow houses will only become bigger and pay a larger electric bill as time goes on.
  • REITs (real estate investment trusts) - Consider REITs specific to the industrial or warehouse space. Newly legalized states and those on the cusp may offer opportunity here.

There’s no doubt massive opportunities exist in the cannabis space, but as with most stocks, there are risks. Cannabis is a long-term play, and as volatile as the industry is, it’s incredibly important to understand personal risk tolerance. Know exactly how much you can afford to lose. Be patient and always talk to an advisor to figure out your risk tolerance.

Disclaimers

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly

Exchange Traded Funds concentrating in specific industries are subject to higher risks and volatility than those that invest more broadly.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

Stock investing involves risk including loss of principal. No strategy assures success or protects against losses.