This article was updated on April 7, 2018, and originally published on Nov. 13, 2017.
Few if any industries are growing as quickly as legal marijuana, and investors have taken notice. Back in June 2017, a quick look at the largest dozen marijuana stocks at the time showed an average trailing-year return of better than 330%. While this has since tapered off a bit, many marijuana stocks are still up better than 100% on a trailing-year basis.
Sales growth in legal weed is a big reason investors are so excited. Cannabis research firm ArcView announced 33% sales growth to $9.7 billion in North America in 2017, and its forecast calls for a compound annual growth rate of 28% through 2021 in North America, leading to a market that could near $25 billion. That could presumably lead to big profits for investors.
Underlying this sales growth is a major shift in the way the public views marijuana. Back in 1995, the year before California became the first state to legalize medical cannabis for compassionate use, just 25% of all respondents in Gallup's national survey wanted to see pot legalized. As of October 2017, favorability toward this idea hit an all-time record high of 64%. As favorability toward weed increases, the bull thesis is that it'll put pressure on lawmakers in Washington to consider rescheduling the drug, or risk losing their elected seats.
Marijuana penny stocks: Caveat emptor
However, not all marijuana stocks are created equally. While marijuana penny stocks -- with penny stocks typically defined as stocks trading below $5 a share and/or a $200 million market cap -- have fared quite well, there are four reasons they shouldn't be in your portfolio.
1. Nearly all marijuana penny stocks are losing money
One of the more glaring issues with penny stocks in general, or in this case penny stocks in the cannabis industry, is that they're money losers. Valuation is a reflection of a company's top- and bottom-line results, meaning pot stocks that have a sub-$200 million valuation are there for a reason. Investors remember being lured in by internet-based growth in the late 1990s, only to be crushed by an inability of these fast-growing companies to turn a profit. While some penny stocks in the pot industry could very well be profitable someday, the success stories are likely to be few and far between.
If you want exposure to the marijuana industry with minimal risk, an idea might be to consider Scotts Miracle-Gro (NYSE:SMG). The company's core lawn and garden business accounted for 89% of its sales in 2017, while its burgeoning Hawthorne Gardening subsidiary that focuses on hydroponics (growing plants in a water solvent solution) for the medical-cannabis industry is a fast-growing operating segment, accounting for 11% of total sales.
2. Marijuana isn't legal, in case you haven't noticed
Second, it's important for all marijuana stock investors to remember that cannabis isn't legal at the federal level in the U.S., and it's only legal for medical uses in Canada, Mexico, and a small handful of other countries around the world. Within the U.S., there seems to be next to no chance of having the federal government consider rescheduling the drug with Attorney General Jeff Sessions in office. Sessions is an ardent opponent of pot and has regularly intimated that tougher regulations could be in the industry's future. This is going to make it even tougher for small weed-based companies to ramp up.
3. Many will face funding issues
A third problem facing marijuana penny stocks is funding issues. With most losing money, penny stocks will need excess capital to ensure the lights stay on. Many could turn to common stock offerings, whereby shares are sold to raise cash. While effective at boosting a company's cash position, stock offerings usually dilute the value of existing shares, hurting investors.
It's also worth mentioning that marijuana stocks as a whole face two major disadvantages in the United States. First, U.S. tax code 280E disallows businesses that sell a federally illegal substance from taking corporate income-tax deductions, forcing pot businesses to pay tax on their gross profits as opposed to net profits, assuming they're profitable. Also, most banks want nothing to do with marijuana companies, leaving them with little or no access to lines of credit, loans, or checking accounts.
4. Most are traded on the OTC exchanges
Finally, a majority of marijuana penny stocks are listed on the over-the-counter stock exchanges. While I want to be clear that the OTC exchanges have done a good job of improving listing standards and increasing the required transparency of the companies that are listed for trade, they're still, in some instances, not up to snuff. Getting up-to-date information with regard to cash on hand or cash flow, which are two important things all investors should know about the companies they're considering investing in, isn't always easy.
The exception to the rule are some of the larger Canadian-based marijuana stocks, like MedReleaf (NASDAQOTH: MEDFF), an established and profitable medical cannabis company that's listed on the Toronto Stock Exchange and the OTC U.S. boards. With access to SEDAR, Canada's electronic filing system for company events and press releases, investors can dissect MedReleaf's financials with ease.
Look, investing in marijuana stocks is a risky bet to begin with, given that the primary product is illegal. But your chances of success go way down when you choose highly volatile, potentially illiquid, money-losing marijuana penny stocks. Do yourself a favor and look to put your money to work elsewhere.