Legal marijuana is probably at or near the top of the list of the fastest-growing industries in North America. Leading cannabis research firm ArcView estimates an annual growth rate of 26% for the legal North American pot market between 2016 and 2021, while investment firm Cowen & Co. anticipates that the U.S. market alone could generate $50 billion in annual sales by 2026. Such consistent growth has investors piling into marijuana stocks and pushing valuations ever higher.

The pot industry's outlook varies by country

But as you probably know, there are some pretty big variances in the pot industry's outlook depending on the country. For instance, the U.S. could very well be the most lucrative market for legal cannabis in the world. Unfortunately, federal law continues to classify marijuana as a schedule I (i.e., wholly illegal) substance, and Attorney General Jeff Sessions has all but declared war on the cannabis industry. In other words, even with rapidly growing sales, it's not exactly a suitable place for investors.

Dried cannabis next to a piece of paper that says yes, lying atop dozens of miniature Canadian flags.

Image source: Getty Images.

Meanwhile, Canada might as well roll out the red carpet for marijuana stock investors. Medicinal cannabis has been legal since 2001, and legislation currently working its way through parliament could legalize recreational weed for adult purchase by this summer. If it's legalized, Canada would become only the second country in the world to have done so, aside from Uruguay, and it would be expected to add $5 billion in annual sales.

Expansion by any means necessary

The expectation of this legalization has created a furor among Canadian cannabis growers to expand their capacity as quickly as possible, and by any means necessary.

Some growers, such as Aphria (NASDAQOTH: APHQF), have been expanding their growing capacity organically. Aphria has a four-phase, more than $100 million project underway that, when complete in January 2019, will span 1 million square feet and yield 100,000 kilograms of cannabis a year.

However, most growers, including Aphria, have turned to acquisitions and strategic partnerships to grow their capacity. In fact, four of the five biggest marijuana acquisitions of all time have occurred within the past four months:

  • Aurora Cannabis (ACB -3.02%) acquiring CanniMed Therapeutics for $852 million;
  • Aphria buying Nuuvera for $670 million;
  • Constellation Brands taking a 9.9% stake in Canopy Growth Corp. worth $191 million; and
  • Aphria buying Broken Coast Cannabis for $185 million.

Mind you, these are just share-based and dollar-denominated deals. There have been numerous strategic partnerships announced, too, including Aurora Cannabis' venture partnership with Alfred Pedersen & Son in Denmark, which is set to yield 120,000 kilograms in annual dried cannabis production. 

Rows of cannabis plants in an indoor commercial grow farm.

Image source: Getty Images.

Chalk up another weed-based acquisition

Not to be left behind, MedReleaf (NASDAQOTH: MEDFF), which went public last year and has almost been exclusively growing by organic means, threw its hat in the ring earlier this week by announcing a major production-expanding acquisition. Something big should have been expected after the company completed a bought-deal financing worth $105 million at the end of January. 

On Monday, Feb. 26, MedReleaf announced that it was acquiring 164 acres of property in Ontario -- where the company's lead production facility (Bradford) is located -- for $17 million in cash (CA$21.5 million) and 225,083 common shares of stock. The acquisition actually comes with two perks.

First, there's an existing greenhouse on 69 acres of the property that can be retrofitted to grow cannabis. When complete, the Exeter Facility, as it's known, should yield 105,000 kilograms of dried cannabis a year. The first harvest is expected by the end of this year. More importantly, this transaction quadruples the company's fully funded annual capacity to 140,000 kilograms a year. We've witnessed Emerald Health Therapeutics and Aphria make similar moves with retrofitting an existing facility in order to save time and money.

Second, the purchase comes with 95 acres of property that can be built out to accommodate a greenhouse facility that's one-and-a-half times larger than Exeter. That could push MedReleaf well above 250,000 kilograms in annual production. All told, MedReleaf could be vying for as much as 10% of the recreational market in Canada. 

A person's hand reaching for a neat stack of hundred-dollar bills in a mouse trap.

Image source: Getty Images.

Don't expect dealmaking to slow, but keep this in mind

Making things even more delectable for Canadian cannabis growers is the fact that a handful of the largest companies have been able to work out export deals to countries that have legalized medical weed. Even if, by some chance, the Canadian market becomes saturated from capacity expansion, large growers will still be able to offload their supply to a growing number of countries that are giving the green light to medical marijuana. In short, dealmaking is incentivized to continue.

There is, however, one word of caution I'd bestow on marijuana stock investors amid this merger-mania within the industry. That word is "dilution."

Right now, most marijuana stocks aren't profitable -- and even if they are, they're generating relatively negligible amounts of operating cash flow. It's not anywhere near enough to fund these massive acquisitions, strategic partnerships, or organic expansions.

In order to make these deals a reality, Canadian pot stocks have had to turn to bought-deal offerings, which are sales of stock, debentures, warrants, or options to an investor prior to the release of a prospectus. Even in instances where common stock isn't sold, convertible debentures, warrants, and options all have the potential to dramatically increase the outstanding share count of marijuana stocks in the years to come. That would have a dilutive effect on existing shareholders. Understand that this doesn't necessarily mean pot stocks won't move higher. But it does imply that there are bigger risks than investors probably realize.