Is it time to dump marijuana stocks?
The Trump administration is threatening to crack down on federal marijuana law violations. Marijuana stocks are falling as a result.
It's possible that the great marijuana stock surge might be over. But before you sell any marijuana stocks, consider why you bought them in the first place. Here are three major reasons for buying -- and whether or not it makes sense to sell for each one.
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1. Profit from increasing demand
Some investors might have bought marijuana stocks for the same reason some bought computer stocks in the 1980s. They sought to profit from increasing overall demand. The idea behind this thought is that a rising tide lifts all boats. More people will want to buy marijuana, therefore marijuana stock prices will go higher.
For the most part, this approach has worked over the last year or two. However, if the Trump administration succeeds in enforcing federal marijuana laws, demand for legal marijuana isn't going to grow nearly as quickly as it would otherwise. That could be a sufficient reason to sell many marijuana stocks. There are a couple of things to note on this point before selling, though.
First, the White House might not be successful. States like California and Colorado aren't going to raise the white flag of surrender. If the states get the courts to agree that their laws should supersede federal laws on this front, marijuana stocks will still go up.
Second, remember that the risk of increased federal enforcement only impacts U.S. stocks. Canopy Growth (TWMJF +1.27%), for example, operates in Canada rather than the U.S. The company already claims a market cap of roughly $1 billion. Canopy Growth's stock could go significantly higher if recreational marijuana is legalized by the Canadian government as expected.
2. Investing in a business that's better than the competition
The best approach to investing is to find a business that stands above its peers and is positioned for long-term growth. This concept works in marijuana stock investing just like it does in other industries. And there are no doubt some investors who bought marijuana stocks with this idea in mind.
You can make a pretty good case that Medical Marijuana, Inc. (MJNA +0.00%) meets this criteria for marijuana stocks. It was the first publicly traded marijuana stock in the U.S. Medical Marijuana markets a broad array of cannabis products. It owns a sizable stake in Axim Biotechnologies, one of only a handful of biotechs developing cannabinoid drugs.
There's another key distinction for Medical Marijuana: The company's products don't violate federal marijuana laws. That's because these products only use substances derived from cannabis that don't fall under the Controlled Substances Act.
Reduced demand due to a federal crackdown on marijuana laws, however, could still negatively impact Medical Marijuana's growth prospects. That's an important factor to consider in deciding whether or not to hold on to any marijuana stock.
Growth prospects are especially important to think through when a stock trades at a high valuation. Medical Marijuana's market cap, for example, is more than 30 times sales -- not earnings, because the company remains unprofitable. That's a sky-high valuation that could only be remotely justified if tremendous growth was in store.
3. Follow the crowd
The worst reason to buy a stock is because others are doing so. Has this been a driving factor for some to buy marijuana stocks in recent months? Probably so.
If this was the rationale that you used in buying marijuana stocks, the best thing to do is to evaluate the stock based on its own merits rather than what others think about it. Ask the tough questions. Does the company have a solid and sustainable business model? How might federal enforcement of marijuana laws impact growth prospects?
A business and its stock that don't hold up under close scrutiny shouldn't be kept. And that's true regardless of what the crowd is doing.
