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Is It Time to Invest in Marijuana Stocks?

By Keith Speights and Sean Williams - Jul 11, 2018 at 8:10AM

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Two perspectives on investing in the fast-growing -- and risky -- cannabis industry.

There's a bigger buzz about the marijuana industry than ever before. Thanks to a recent vote in Oklahoma, 30 states now have laws in place that broadly allow the legal use of medical marijuana. Nine states plus the District of Columbia have legalized recreational marijuana, with Michigan potentially joining their ranks pending a vote on the issue in November.

That's just looking at home in the United States; Canada's recreational marijuana market opens nationwide in October. Germany, the largest economy in Europe, has an expanding medical cannabis market. Other countries across the world are relaxing laws to allow the legal use of medical marijuana.

With the rapidly changing landscape seemingly pointing toward continued growth in the marijuana industry, is it time to invest in marijuana stocks? We asked two of The Motley Fool's contributors who regularly cover the cannabis industry to address this topic. Here's what they had to say. 

Marijuana leaf with question marks

Image source: Getty Images.

Is this a viable business?

Keith Speights: The short answer to this question is "absolutely." The longer answer is that how viable the marijuana business is depends on the country. The marijuana industry is definitely viable in Canada and Germany, two developed countries that have legalized cannabis at the national level. There are marijuana growers operating quite profitably in these markets, notably including one of the larger players, Aphria (NASDAQOTH: APHQF).

As for the market investors probably care about the most -- the U.S. -- the answer is still "yes." There are certainly serious constraints for the U.S. marijuana industry, particularly with onerous federal regulations about how banks can interact with marijuana businesses. However, there's also a lot of money being made. Last year, $8.5 billion was spent on legal cannabis in the U.S., according to ArcView Market Research and BDS Analytics. That's more than Americans spent on ice cream in 2017. 

I think the question you have to ask about the continued viability of the marijuana industry in the U.S. is whether it's likely that the federal government will attempt to intervene in states that have legalized either medical or recreational marijuana. In my view, that likelihood is pretty low and is getting even lower. There were concerns that Attorney General Jeff Sessions might initiate a federal crackdown on marijuana, but President Trump's public commitment to supporting legislation to let states enforce their own laws appears to have largely laid those fears to rest.

Sean Williams: Today, medical cannabis is legal in more than two dozen markets worldwide -- yet it remains a wholly illicit drug in what would be the most lucrative market in the world, the United States. In countries like Canada, and in states such as Colorado, Washington, and Oregon, the business model does appear to be viable on paper, but it's clearly not without some serious drawbacks that investors need to be aware of.

For example, until Canada passed the Cannabis Act on June 19, practically all marijuana-based businesses had little or no access to basic banking services. It's not that banks had no desire to work with the burgeoning marijuana industry, it's that banks feared criminal and/or financial repercussions if they offered a line of credit, or even a checking account, to a cannabis-based business. In fact, in the U.S., the Senate Appropriations Committee voted to block a banking amendment (21 to 10) last month that would have allowed banks to do business with marijuana companies that were complying with respective state cannabis laws. This lack of access to traditional sources of capital could have a long-term adverse impact on marijuana stocks.

Profitable marijuana businesses also face an unwelcome surprise in the U.S.: Uncle Sam. Despite being an illicit drug, the federal government has no qualms about taxing the income of cannabis businesses operating in states where it has been legalized. What's more, a more than three-decade-old tax section, known as 280E, prohibits businesses that are selling a federally illicit substance from taking normal corporate income tax deductions. This can result in an effective corporate income tax rate of as much as 90%!

So yes, the business model is viable on paper and shows plenty of promise, but it faces disadvantages that seemingly no other industry will have to contend with. 

What does the market look like?

Speights: Again, the answer to this question depends on the country. In Canada, there are a handful of larger marijuana growers with significant production capacity. Canopy Growth (CGC -12.07%), Aurora Cannabis (ACB -38.46%), and Aphria rank at the top. There are also dozens of smaller marijuana growers in Canada, several of which are listed on the Toronto Stock Exchange. In the U.S., most marijuana businesses remain privately owned. 

The marijuana industry encompasses more than just marijuana growers. Suppliers are also part of the ecosystem. Kush Bottles, for example, focuses on selling packaging supplies to cannabis dispensaries and growers in the U.S. Scotts Miracle-Gro (SMG 3.45%) has been gobbling up smaller hydroponics companies and now stands as the go-to supplier for marijuana growers.

There has also been interest from larger companies that previously haven't been involved in the marijuana industry. Last year, Constellation Brands, a large alcoholic beverage maker, bought a 9.9% stake in Canopy Growth. Molson Coors Brewing is reportedly in talks with several other Canadian marijuana growers about an investment and partnership deal.

I don't think the marijuana industry of the future will look the same as today. My view is that we will see more consolidation in Canada. I expect more U.S. companies will opt to list on major stock exchanges. With Constellation Brands already in the fray and Molson Coors perhaps joining as well, I suspect other alcoholic beverage companies may invest in and could potentially even acquire marijuana growers.

In my mind, the biggest question mark is whether big tobacco companies will also move into the marijuana market as there are definitely some similarities between the two industries. So far, there hasn't been any movement on this front, but I wouldn't rule it out. 

Williams: With few exceptions, the global cannabis industry is mostly fragmented. Though the top eight growers in Canada are currently on track to produce in the neighborhood of 1.8 million kilograms of cannabis by 2020 or 2021 -- for context, this could equate to roughly 70% of all Canadian production, by my estimate -- the rest of the worldwide cannabis industry consists of small or privately owned operations.

When examining marijuana stocks in the U.S., one of the first things you'll notice is that U.S.-based pot businesses are barred from being listed on the New York Stock Exchange or Nasdaq. Though exceptions have allowed companies like Canopy Growth, which is based in Canada, to uplist from the over-the-counter (OTC) exchange to the NYSE, most marijuana stocks are found on the OTC boards, which aren't regulated as tightly as the more reputable NYSE and Nasdaq. They're also home to a lot of penny stocks -- i.e., companies with a share price below $5 and/or a market cap below $200 million -- which are known to carry risks.

Though consolidation would be a recipe to lower long-term costs, it's not guaranteed to happen -- even in Canada. Canadian growers have spent so much of their capital expanding their growing capacity that I'd opine very few have much left over to use for acquisition purposes. This might mean the need to naturally thin out the herd over time, rather than consolidate through mergers and acquisitions. If so, that could lead to some unhappy investors in the near and intermediate term as even larger industry players struggle to establish healthy margins.

The make-up of international markets is also going to play a key role. As noted, there are more than two dozen countries that have legalized medical marijuana in some capacity. These markets are expected to play a critical role in gobbling up any oversupply from the domestic Canadian market. Given that no industrialized country has ever legalized adult-use marijuana before, no one, including myself or Keith, knows for sure what to expect from a supply-and-demand perspective. That's worrisome, especially when Canadian growers are counting on foreign markets to purchase well in excess of 1 million kilograms of cannabis by 2020 and beyond.

In sum, consolidation is necessary, but it only becomes viable once we have more answers than questions. 

Marijuana leaf on top of $100 bills

Image source: Getty Images.

Should I invest in marijuana stocks?

Speights: I have been the optimist in our discussion so far, while Sean has taken a more pessimistic view. My optimism remains intact, but my response on this question is a very cautious "yes" -- and only for investors willing to take on a considerable level of risk.

I don't use the word "investors" lightly; you shouldn't buy a marijuana stock to try to make a quick buck. That's trading, not investing. Investors have a long-term perspective. You should thoroughly check out the business fundamentals, the growth opportunities, and the risks for a marijuana stock just like you would any other stock.

I also think investors need to keep the big picture in mind. For example, Canopy Growth is a Canadian marijuana grower, but it's not limited to Canada. Look at all of the markets where the company has opportunities. International medical marijuana markets could potentially be much larger than the total Canadian marijuana market. And cannabis-infused products could generate significant opportunities beyond dried cannabis.

Personally, I've been generally bullish on the largest Canadian marijuana growers. I think Canopy Growth, Aurora Cannabis, and Aphria are in the best position to capitalize on the recreational market in Canada and in the global medical marijuana market. 

Also, keep in mind that the marijuana industry involves more than just marijuana growers. In my opinion, Scotts Miracle-Gro is one of the best ways to invest in the expansion of the industry. Scotts' Hawthorne Gardening subsidiary, which focuses on the cannabis industry, made $287 million last year. And that's before the company acquired Sunlight Supply, the top hydroponics products supplier in the U.S. Marijuana sales in the U.S. are projected to reach at least $22 billion by 2022 -- jumping more than 150% in just four years. I think Scotts Miracle-Gro should benefit tremendously from this growth. 

But all of the stocks that I've mentioned have a lot of growth baked into their share prices. That makes them riskier than they'd otherwise be. That's especially the case for the Canadian marijuana growers. Even though I have been positive overall about these stocks in the past, their fortunes beyond 2020 depend on how quickly international marijuana markets expand. 

Williams: Probably not. Practically every investment that looks to be the greatest thing since sliced bread (3D printing, genome decoding, and business-to-business internet commerce, to name a few) gets hyped through the roof by Wall Street only to come back to Earth after top- and bottom-line results fail to match utopian expectations. I suspect that'll be the case with pot stocks, regardless of the country of origin.

One of the grim realities I anticipate marijuana stocks could face in Canada is that many won't be nearly as profitable as expected. This belief is backed up by the fact that Wall Street earnings-per-share estimates for fiscal 2019 have fallen across the board. Ultimately, that's a problem when we're dealing with companies valued at high double-digit or triple-digit forward P/E ratios, or in the case of Canopy Growth, an expected EPS loss in fiscal 2019.

One reason for falling profit forecasts is the expectation that dried cannabis will be commoditized over time. In Colorado, Washington, and Oregon, the per-gram price for dried cannabis plummeted not long after legalization, leading me to believe that this is likely to be the case in Canada once a backlog of licensing applications and sales permits are dealt with by the Canadian government. Companies focused on cannabis alternatives, such as oils and extracts, should be able to offset some of the weakness associated with declining cannabis prices, but commoditization could leave an undeniable mark on the industry and its bottom line.

We also can't overlook the lengthy impact share dilution will have on this industry. Access to financing has been extremely limited, causing Canadian growers to turn to bought-deal offerings. This involves the sale of common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors prior to the release of a prospectus. Though it's been a great way to raise capital, it's also ballooned the outstanding share counts of publicly traded pot stocks. In less than five years, Aurora Cannabis' outstanding share count may catapult from 16 million to around 1 billion, assuming its $2.5 billion all-share buyout of MedReleaf goes through.

Worse yet, stock options, warrants, and convertible debentures can be exercised for months or years to come, meaning this dilutive impact on existing shareholders isn't likely to abate anytime soon.

Still, if you're intent on keeping an eye on one marijuana stock with potential, I'd encourage that stock to be small-cap OrganiGram Holdings (OGI -4.13%). Though OrganiGram has diluted investors by turning to bought-deal offerings, it also has among the lowest costs in the industry thanks to its three-tiered production facility in Moncton, New Brunswick. OrganiGram's management has also made higher-margin alternatives like cannabis oils a priority. A forward P/E ratio of 29 appears reasonable given the expectation of strong sales growth over the next three to five years.

Ultimately, this is an industry that has a lot of maturing to do, and I would suggest investors keep to the sidelines until we have more clarity on supply, demand, and overall profitability. 

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Stocks Mentioned

The Scotts Miracle-Gro Company Stock Quote
The Scotts Miracle-Gro Company
$96.48 (3.45%) $3.22
Aurora Cannabis Stock Quote
Aurora Cannabis
$1.68 (-38.46%) $-1.05
Canopy Growth Stock Quote
Canopy Growth
$4.88 (-12.07%) $0.67
OrganiGram Holdings Stock Quote
OrganiGram Holdings
$1.16 (-4.13%) $0.05

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