In case you haven't noticed, marijuana stocks have been practically unstoppable over the past year. Even with a recent pullback, many of the largest pot stocks (i.e., those with market caps in excess of $200 million in market cap) have doubled or tripled in value. Pushing this budding industry higher is a combination of rapidly rising legal weed sales and a dramatic shift in consumer opinion.
In terms of sales, leading cannabis research firm ArcView is estimating a compound annual growth rate of 26% between 2016 and 2021 in North America. If the projection proves accurate, this will push legal pot sales to almost $22 billion, giving investors plenty of reason to be excited about the profits that growers, distributors, and retailers could generate.
As for consumers, polling has consistently shown that a record number of Americans favor the idea of legalizing marijuana. Gallup, which has been surveying Americans for 48 years, found in October 2017 that an all-time high of 64% of respondents were in favor of legalization. The independent Quinnipiac University found even stronger support for medicinal cannabis in an August 2017 poll, with 94% of those surveyed in favor of it being legal.
Hidden risks pot stock investors have to be aware of
But for all that's worked in favor of marijuana stocks in recent years, there are plenty of risks. Some of these risks, such as profitability eluding most pot stocks, are readily apparent. However, there are quite a few hidden or non-apparent risks that could ultimately destroy shareholder value. Here are five of those hidden risks you should be aware of if you plan to own marijuana stocks.
1. Political shifts
To begin with, investors should understand that political opinion on cannabis can seemingly shift on a dime. Though public opinion has been progressive with regard to legalization, the opinion of lawmakers hasn't been nearly as consistent.
For example, even though 29 states in the U.S. have legalized cannabis in some capacity, including eight that have green-lighted recreational weed, the federal government continues to hold firm on its schedule I classification. Schedule I drugs are wholly illegal, prone to abuse, and deemed to have no recognized medical benefits. Yet, in spite of this classification, certain regulations, such as the Cole memo and Rohrabacher-Farr Amendment (also known as Rohrabacher-Blumenauer), had loosely protected cannabis businesses from federal interference.
Recently, though, Attorney General Jeff Sessions has begun shifting U.S. federal policy to clearly be more anti-cannabis. Sessions rescinded the Cole memo on Jan. 4, 2018, giving state-level attorneys general the discretion to bring marijuana charges against people and businesses, even in the 29 states that are currently "legal."
The point is that political shifts can and do occur, and with cannabis still illegal in most countries around the world, it's really a matter of what party is in office that can dictate marijuana policy.
Though legalization is the goal for pot enthusiasts and investors, it could come with an unexpected downside.
In Canada, Prime Minister Justin Trudeau introduced legislation in April 2017 to legalize recreational pot by the summer of 2018. Medical marijuana has been legal in our neighbor to the north since 2001, and it would appear that Canada has its ducks in a row to push a bill through within the coming months. In other words, progressives outnumber conservatives in parliament, and the Canadian federal government already has a two-year tax-sharing agreement in place with all provinces.
Unfortunately, the expectation of legalization is enticing Canadian growers to expand as quickly as their wallets will allow. Canopy Growth Corp. (CGC -4.98%), the largest marijuana stock by market cap and a company with more than $300 million in cash and cash equivalents, has 3.7 million square feet of greenhouse facilities being constructed or in development. If Canopy Growth remains on track and budget with its expansion efforts, and its peers continue expanding, too, it's possible the market could be flooded with an oversupply of cannabis when recreational weed becomes legal. Even with export channels available to Canopy Growth and a handful of its peers, it could result in plunging wholesale prices and lower margin.
3. Shareholder dilution
Another hidden risk of owning marijuana stocks is the potential for serious intermediate-term shareholder dilution.
Within the U.S., and even in other countries around the world, cannabis-based businesses face serious financing concerns. In the U.S., pot companies have little or no access to basic financial services, meaning they can't gain access to lines of credit, or in many cases even open something as simple as a checking account. Financial institutions that aid marijuana companies could be criminally charged or slapped with a fine, according to a strict interpretation of federal law.
Additionally, pot businesses are taxed to death in the United States. Since they sell a federally illegal substance, U.S. tax code 280E disallows them from taking normal corporate income-tax deductions. For profitable weed businesses, this means having to pay an effective income-tax rate of as much as 70% to 90%. This doesn't leave much left over for capacity or retail expansion and hiring.
The solution for most marijuana stocks is bought-deal offerings or secondary offerings. In Canada, bought-deal offerings -- a sale of common stock, debentures, warrants, or options to an investor or investment firm prior to the release of a prospectus -- are especially common.
Aurora Cannabis (ACB 1.11%) has had no trouble raising a boatload of cash, but it has been drowning its shareholders in new shares in the process. In particular, Aurora Cannabis has been using convertible debentures, which can be converted to common stock at a later date, as a means to raise capital. Having ended its most recent quarter with 489.9 million shares outstanding, its share count has jumped by more than 2,900% since the end of fiscal 2014. Worse yet, with more options, warrants, and convertible debentures on its books, its share count is likely to rise even more in the years to come, diluting investors in the process.
4. Investor emotions
Marijuana stock investors also have to understand that there are some emotionally invested shareholders out there who have the potential to wreak havoc on the share prices of pot stocks.
Unlike cryptocurrencies, which are almost entirely driven by retail investors and left alone by institutional investors, pot stocks are influenced in part by Wall Street's big financial institutions. However, their influence is still considerably smaller than in traditional industries since most marijuana stocks trade on over-the-counter exchanges, are operating in a still-illegal industry, or are trading at penny-stock levels. This gives retail investors a considerably larger presence in pot stocks than most folks might otherwise realize.
The fact of the matter is that retail investors are far likelier to allow their emotions to come into play when buying and selling stock than are institutional investors -- and there are few topics that incite that emotion more than marijuana. At the drop of a dime, emotionally driven investors can push pot stock valuations far higher than makes sense, creating a bubble. Likewise, emotions can push marijuana stocks significantly lower, perhaps below a fair value estimate for their intermediate-term profit potential.
Long story short, expect wild volatility thanks to retail investors.
5. Inexperienced management
Last, but not least, marijuana stock investors should understand that even with capacity expansion, the management teams of nearly all pot stocks are very inexperienced. Of course, that's to be expected with a budding industry that's still illegal in most countries.
A good example is Axim Biotechnologies (AXIM -9.26%), a clinical-stage cannabinoid-based therapeutics developer that was founded in 2010. Axim wasn't born as "Axim Biotechnologies." It was actually known as Axim International when founded, and only changed its name in July 2014 to reflect its new business focus on the treatment of pain, spasticity, anxiety, and other disorders that would benefit from the application of cannabinoid-based products. Prior to this, the company had an organic waste marketable by-product business, which has nothing to do with cannabis.
Are we to believe that in just four years Axim has become a leading cannabinoid drug developer? While the company's pipeline, which is filled with more than a dozen preclinical and clinical studies, could prove its worth at some point in the future, we have to take into account the fact that Axim only entered the cannabinoid-based drug development arena a few short years ago. Its management team and those of numerous other pot stocks are potentially prone to mistakes, which is something investors need to be aware of.