Everything You've Ever Wanted to Know About Pot Stocks and the Marijuana Industry

With more states in the U.S. legalizing marijuana to varying levels, the drug is entering the mainstream. Naturally, that's left a lot of investors wondering: How can I make money investing in marijuana?

In this episode of The Motley Fool's Industry Focus: Healthcare, analyst Kristine Harjes and Motley Fool contributor Todd Campbell discuss:

• The difference between the popular cannabinoids CBD (cannabidiol) and THC (tetrahydrocannabinol).
• Marijuana's medical applications for cancer and epilepsy treatments.
• Why states like Colorado are eying this market and seeing a big tax opportunity.
• How countries like Uruguay and Canada are at the forefront of legalized recreational and medicinal efforts.
• The pureplay marijuana stocks, including: Canopy Growth (CGC 15.03%), Aurora Cannabis, and Aphria.
• The biotech companies that have exposure to marijuana, including GW Pharmaceuticals (GWPH) and INSYS Therapeutics (NASDAQ: INSY).
• The sneaky ways to invest in marijuana, like Scotts Miracle-Gro Company (NYSE: SMG) and Constellation Brands (STZ 0.74%).

A full transcript follows the video.

This video was recorded on Aug. 1, 2018.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today's the 1st of August, it's Wednesday, and we're talking Healthcare. I'm your host, Kristine Harjes, and I'm joined by fool.com contributor Todd Campbell via Skype. 

The Motley Fool is a data-driven company, and we love combing through our Google Analytics data to see what's getting the most traction on fool.com. Lo and behold, week after week, articles about investing in marijuana make the top of the list. Given the hunger of content about weed, we figured we should give the subject some attention here on Industry Focus: Healthcare. Something tells me that interest in the area is only going to increase from here. What do you think, Todd?

Todd Campbell: I think so. Absolutely. The interest that we're seeing today is more for its use medicinally. For context, to help our listeners, I was going through and looking at some of the history of cannabis. I came across some really fascinating factoids that I felt like our listeners could share over cocktails with their friends this weekend and impress everybody.

Harjes: Let's hear them!

Campbell: Did you know, they have found cannabis seeds in the graves of people in Siberia and Asia going back to 500 BC?

Harjes: I can't believe they last that long.

Campbell: Right. Notice that they didn't say what they did with the seeds after they found them. [laughs] But, obviously, showing that cannabis seeds were very revered, even as far back as that. Really, the industrial use of cannabis stretches even further back than that. They've found Chinese pottery that has impressions that were likely made by hemp rope. Hemp is also part of Cannabis sativa, which is the plant responsible for marijuana, going back to 5,000 BC -- we're talking over 7,000 years of use, at least from the industrial side of things. It's not just in Asia where there's a long history of using cannabis. We also have a pretty long history of using cannabis, specifically hemp, here in the United States, too.

Harjes: Do you have a fun factoid for U.S. use?

Campbell: I certainly do! [laughs] 

Harjes: How did I know? [laughs] 

Campbell: Did you know, the American colonists, the immigrants from the United Kingdom, when they were sent over, the colonists were actually required to grow hemp on some of their farmland? That was because hemp can produce fibers that are incredibly strong and important in creating rope and sails. A big driver of the economy, being able to transport goods back and forth across the ocean. Going all the way back to, prior to the formation of our country, we've been using cannabis, at least for industrial purposes. Actually, at one point, you could actually pay your tax bill in hemp.

Harjes: No way!

Campbell: Yeah! Thomas Jefferson dedicated one acre of his "best ground" on the Poplar Forest estate to the production of hemp.

Harjes: That's crazy. I had no idea, any of those historical factoids.

Campbell: A very long history. Again, this is a healthcare show, so we're tilting toward the use of it medicinally. Even there, there's a pretty long history. You go back to the late 1800s, and it was incredibly common to just walk into a pharmacy or a store and be able to buy cannabis extracts for the use of treating stomach ailments, all throughout the late 1800s.

Harjes: Even given this tenured history, it seems like we're hitting a tipping point now, or in the last few years, at least. Public support for marijuana, both from a medicinal perspective and a recreational perspective, is at an all-time high. Support for medical use in the United States is almost universal. There was a recent poll that put that figure at, 94% of Americans would support medicinal legalization of marijuana. 

Really, it's for use in fairly specific ways that has proven to people that it can actually do some good for reasons that are so far away from the perception that people used to have of it being some hippie drug. There's a genuine medical use for children with epilepsy and cancer patients with pain. I think the increasing use of medical marijuana in these very legitimate ways has changed people's perceptions of it. 

And as support for medical marijuana grows, support for recreational seems to follow. In October 2017, a Gallup poll showed 64% of Americans supporting full legalization. It crosses into both sides of the aisle, making it one of the few issues that has majority support from both Democrats and Republicans.

Campbell: Right. It still remains illegal on a federal level, but a lot of states now are waking up and listening to their constituents and passing laws that at least ease the way to gaining access to its use medically. There's a lot of anecdotal evidence over the years. We go back, like I told you, to the late 1800s, there was anecdotal evidence that supported the use of it in stomach ailments. Anecdotal evidence has been out there for its use in treating cancer and pain. Recently, which I'm sure we're going to talk about later in the show, there was an FDA approval that we talked about a couple of weeks ago on our podcast, of a drug for use in epilepsy that's actually based on one of the chemical cannabinoids in marijuana. 

I think that's one of the things that our listeners need to know. What exactly is marijuana? It's the dried flower from the female form of the Cannabis sativa plant. It's comprised of over a hundred different chemical cannabinoids. The two that are most prevalent, are found most often within that flower, are going to be THC, which is the one responsible for that euphoric high, and CBD, which is a non-psychoactive chemical cannabinoid which has been found, anecdotally, and now with this other drug that just got approved, to be helpful in treating patients with conditions such as epilepsy.

Harjes: Even though all of those cannabinoids are illegal in the United States at a federal level, there are legal and practical reasons why it's been left to states to determine whether they want to allow it. As of today, medicinal use is legal in 30 states, including nine states in which recreational use is also approved.

Campbell: Right. Oklahoma just passed a medical marijuana bill in June, that brought it to 30. Vermont's law for recreational just went into effect in July, which brought that total to nine. Still the minority for recreational use, but definitely a growing momentum nationwide to at least allow its use medically. In many cases, that's going to be for the use of CBD-high strains of marijuana, not high strains of THC, which is the one that causes the high.

Harjes: I think one interesting case study is California, which was actually the first state to approve medicinal marijuana use back in 1996. They just started recreational sales earlier this year. I think it was surprising that other states beat them there, as far as the timeline goes. 

There's an enormous market in California. There's estimated to be an enormous number of sales, up to $7.6 billion in 2022. That's up from an estimated $4.2 billion in marijuana sales last year. So, growing from $4.2 billion last year to $7.6 in 2022, that's some pretty crazy growth, and it's going to lead to pretty significant tax revenue, as well. And that's one of the biggest reasons why, politically, people are making the argument to their representatives that this is a good thing to do.

Campbell: Prior to the show, I was talking to Matt Karnes over at GreenWave Advisors. There are a lot of different estimates that are out there about how big these markets could be, so listeners need to take it with a grain of salt. Recognize that it could be lower or higher, who knows how it'll all play out. We do have some evidence. I'm sure we'll talk about Colorado in a second. 

But, GreenWave is saying $7.6 billion by 2022. And California is the Big Kahuna. 34% of the U.S. market share for marijuana sales is California, and perhaps that's one of the reasons that the Emerald Triangle in California is one of the largest producing areas or regions in the country of marijuana.

Harjes: You mentioned Colorado. That's another huge market. Sales of marijuana there in 2017 topped $1.5 billion. Fun factoid about Colorado, there are more marijuana dispensaries than Starbucks and McDonald's locations combined, which is just insane.

Campbell: That'll impress friends over the weekend, when you tell them that statistic, right?

Harjes: Yeah, write that one down.

Campbell: Absolutely. Colorado and Washington became the first two states to fully legalize marijuana. They did that in 2012. California had been the first state to approve medicinal use, of it, but that happened in 1996. Colorado was a pioneer in the recreational market. 

I think one of the things that a lot of these states are looking at, one of the reasons that you have across-the-aisle support for legalizing marijuana, is that it provides a lot of funding for these states' budgets. Just look at Colorado's experience. They went from collecting $67 million in fees back in 2014, to, so far, in the six months of this calendar year in 2018, over $130 million. Their revenue from marijuana sales has just about doubled in the span of a few years in Colorado.

Harjes: Meanwhile, if you look internationally, the Cannabis Act, which regulated recreational use of marijuana, was passed by the Canadian Senate on June 21st of this year. Prime Minister Justin Trudeau expects that consumption will begin on October 17th. That's coming up very quickly. This is noteworthy because Canada is the first major country to take this step of fully legalizing marijuana. There's actually one other country in the world that beat them to that, and that is Uruguay. 

Then, over in Europe, you have a large, growing market in Germany, which legalized medicinal marijuana back in March of 2017. Many suppliers already have a presence in Germany via their partnerships and acquisitions. People are definitely keeping an eye on Europe, in particular, Germany. There's also a huge market in Australia, where medical marijuana has been legal for two years, and possession is mostly decriminalized. There are places all over the world that are embracing marijuana increasingly.

Campbell: As I was going through, I found at least 26 countries that either have lax laws when it comes to marijuana, meaning it's decriminalized, or they outright say it's OK to possess limited amounts of it. You mentioned Canada. Canada is by far the most progressive. They've had that recreational market opened nationally for years. It's the biggest legal market out there, as far as countries go, and it's going to get even bigger later into the year. 

I'd also be keeping an eye on a couple of other countries, too. I'd keep an eye on Mexico. It's still illegal in Mexico, but there has been some chatter with the new Administration that got elected there to at least consider approving medicinal use. I'd also keep an eye on Great Britain. Great Britain has some of the strictest marijuana laws out there, but they recently ordered a review of their approach to medicinal marijuana, following an event back in June where marijuana was seized from a boy who was using it to treat epilepsy, who was then later hospitalized because of seizures. So, they're reviewing their approach to it.

I think this is a global push toward legalizing marijuana, and I think that's why so many of our listeners and the visitors to fool.com are interested in learning more about it and finding out whether or not there are investment opportunities they can take advantage of.

Harjes: It's clear we have a big trend here worldwide as demand for and legalization of marijuana grows. It's no surprise that many investors are looking to profit off of the marijuana industry. One of the most obvious ways to play this trend is by investing in the producers that actually grow the plant.

Campbell: There are some caveats there. We're going to spend a lot of time talking about Canadian producers. The U.S. market is highly fragmented because not all the states have legalized it yet, and still remains illegal on a federal level. That creates all sorts of problems with trying to do cross-border transactions -- doing business in one state vs. another state that has different laws. There's banking regulations that limit the ability to use traditional services that we would think would be commonplace in any retail store today, regardless of whether it's marijuana or not. And, there's some tax implications that are hamstringing the ability of these companies to grow. You can't deduct basic business expenses against the revenue because of the way it's scheduled here in the United States. So, the growers in Canada are probably the best places to focus.

We are indeed talking about what could be a massive market here. With the momentum, theoretically, for legalizing it state by state, you could be talking about tens of billions of dollars in market opportunity. According to GreenWave Advisors, if at least medical marijuana gets passed by 2021, you could see U.S. retail sales of marijuana as high as $35 billion by 2022. You're talking about a very significant market that, who knows, maybe someday could rival the size of the tobacco, spirits, beer and wine markets.

Harjes: If you're looking for specific names of Canadian growers, Canopy Growth Corporation is the largest by market cap. We did an interview with Bruce Linton, the co-founder and chairman and CEO of the company, back in November of 2017. Canopy has 2.4 million square feet of growing capacity, which is triple what it had when it entered the year, which is crazy growth. They have plans for 5.7 million square feet over time. They can produce an estimated 500,000 kg of marijuana, which is pretty substantial. 

Aurora Cannabis is another big name in the space. They acquired another company that used to be huge, and now the combination is even huger. That one was MedReleaf. The acquisition was back in July. They have a 570,000 kg capacity. 

One of the other big guys is Aphria, they're at 230,000 kg in capacity. Quite a handful of different players here that are all duking it out to increase their production capabilities as quickly as possible.

Campbell: Only one of them is traded on the New York Stock Exchange, though. That might give people a little bit more confidence, because obviously, they have to file in accordance with SEC regulations. That would be Canopy, ticker CGC. That's a very intriguing company. I recommend every listener go back in the way-back machine or reach out to us so we can send you a copy of that interview that Kristine did with their CEO. It was a fascinating discussion of where the global market for marijuana could be. 

One of the things that's really interesting about Canopy is, they're focusing significant resources on studying the use of these drugs medicinally. Not only are they looking to take all this production and get it out there on dispensary shelves, they're also spending the time and effort of enrolling patients in clinically controlled trials to see if they can prove out, that anecdotal evidence we were talking about earlier, the value of these medicines.

Harjes: Which suggests another way to play this trend, which is investing in the biotechs that are looking into uses of marijuana in a medicinal realm. One of them that we've mentioned on the show many times is GW Pharmaceuticals, ticker GWPH. We were just talking about them on July 18th of this year, talking about how Epidiolex was FDA approved for certain types of epilepsy. 

Another big name out there that you might want to take a look at is called Insys. This stock has struggled quite a bit. They're down 85% from their 2015 highs. They're not a marijuana pure-play. Their primary drug is SUBSYS, which is a pain medication. There have been all sorts of allegations of illegal marketing and other struggles for the drug. They have a synthetic THC drug called SYNDROS, which is a treatment for chemotherapy-induced nausea and vomiting, and also anorexia associated with AIDS. That was approved in July and essentially has flopped commercially. They have another cannabidiol drug in Phase II. 

There are some interesting marijuana-related things to watch with Insys, but personally, I'm not interested from an investment standpoint, just because of all of their struggles. It's not really clear to me whether they'll be able to right their ship anytime soon.

Campbell: There's new management there, but there's still an overhang of lawsuits and regulatory slaps on the wrist and stuff that we have to work our way through. I would say, of all the pure biotech plays, GW Pharmaceuticals would probably be the best one to approach that way.

Harjes: And then, there are less obvious ways of playing this market, as well. For example, Scotts Miracle-Gro, the fertilizer company. They actually have a tiny part of their business model that is related to marijuana, and that's hydroponics, which they do through their Hawthorne brand. Growth has been kind of slow. If you back out acquisitions, their sales were actually down 30% in the last quarter year over year. But it's not an insubstantial part of their business. They do a couple of hundred million in sales.

Campbell: They just reported their quarterly results last night, and I haven't had a chance to go fully through them, but it looks like sales are clocking in at about $74 million last quarter. That gives you about a $300 million run rate. They were pretty early on in recognizing that momentum was building to legalize throughout the U.S., so they went, out, beginning about three years ago, and started acquiring all sorts of companies to put them together into this Hawthorne brand. 

No word yet on whether or not they plan to IPO that or spin that off to investors someday, but I could see that happening down the road. While business is slowing right now -- we'll talk about overcapacity in a minute, I'm sure, and some of the risks -- it's certainly possible that we over-react the other way, and as more states start to ramp up, demand comes back for Hawthorne.

Harjes: One other less obvious way to play this industry that investors should consider is Constellation Brands. They're an alcohol maker, but they actually own 10% of Canopy. The market for pot in Canada could already exceed the beer market. This is something that the alcohol makers are starting to see. Molson Coors is forming a joint venture with a Canadian cannabis producer. What both Constellation and Molson, with this new joint venture, are looking to do, is develop cannabis-infused beverages for the Canadian market. So, kind of an interesting, "who would have thought of that?" way to get involved.

Campbell: I believe Constellation is the brand behind Corona, correct me if I'm wrong. A massive company. They have a big beer and wine business, and looking out ahead and they're saying, "Wow, CIBC World Markets is saying that pot sales could exceed beer sales at their peak in Canada. We should probably have some exposure to that, so we can take advantage of it." Like you said, as a 10% owner of Canopy Growth, they're able to share all their know-how as far as marketing is concerned and distribution, and hopefully, that helps Canopy Growth establish a foothold and maybe a leadership in the Canadian market.

Harjes: If you put together everything that we've just listed as a potential investment idea, and you think to yourself, "Huh, I see the tailwind, and I don't want to pick an individual stock to play this market," you can always go the ETF route. There's an ETF called the ETFMG Alternative Harvest ETF, ticker MJ. They were the first marijuana-focused ETF listed on the New York Stock Exchange.

Campbell: Their expense ratio is higher than if you went out and bought the S&P 500. Obviously, over time, we've learned that lower-expense investments tend to generate greater wealth for investors. Still, at 0.75, it's not ridiculous. 

It tracks an index called the Prime Alternative Harvest Index. It comprises 30 different stocks. It uses what's called a modified market cap weight. It will look at the quarterly rebalance of the underlying index, and maybe make some adjustments to make sure that it's not too overweight in any one particular stock. 

That being said, despite 30 stocks being in the index, 10 of them represent about 43% of the fund's assets. So, you're a little bit consolidated in the biggest players. 

Harjes: If you thought that we were generous in what we considered marijuana stocks, these guys had to work to come up with 30 stocks that are even tangentially related to marijuana. In addition to Scott's being in the index, they also have Philip Morris, which doesn't drive any revenue from marijuana that I know of. But, because they make cigarette filters, I think, that's what qualifies them for the index. 

Just an interesting index to look into, even if that 0.75% expense ratio makes you nervous -- and it should. They're heavily exposed to Canada. They also have a lot of American companies. They even have 9% in U.K. companies. So, take a look at what's in that basket, it might give you some more stock ideas.

Campbell: It has about $300 million of assets in that. Again, we're laying out a bullish theme for this, but there are some threats and risks that people should be aware of. Mainly, we don't know what's going to happen in Washington D.C. We could see some sort of a crackdown of what's going on in the individual states that could hamper the growth of this market. I think a little bit of caution is warranted.

Harjes: Absolutely. If you look at the sentiment in Washington, it's certainly not terribly positive for the marijuana industry. Attorney General Jeff Sessions has been very actively opposed to marijuana, as indicated by many words and also some actions, such as rescinding the Cole Memo, which meant that the federal government would be hands-off when it came to the states' decisions to regulate marijuana. Rescinding that opened the door for state-level prosecutors to use their discretion, whether they wanted to levy charges against marijuana businesses. In practice, this is not a huge change for anything, but it does indicate sentiment. That is a bit of an overhanging question mark, particularly in the United States markets. 

There are plenty of other risks that apply internationally, as well, such as the threat from the black market. We mentioned earlier that marijuana sales are a great way to generate tax revenue. Well, that does end up making marijuana more expensive than it would be on the black market, where it's not taxed.

Campbell: Absolutely. Over time ... I mean, I don't buy mason jars off the back of a truck for my weekend beer. I go to the store, even though I'm paying a little bit more than I might be able to get otherwise. Maybe that'll happen with marijuana as it evolves, as well. 

The other risk to mention is the risk of price compression, or a price war, between some of these producers and distributors. It's called weed for a reason. [laughs] It grows really easily. What we've seen is a lot of investment in production that's boosting capacity. As a result, we're seeing a lot of price compression in the per-pound rates. If that trickles through and creates some price cuts at the consumer level, that's great for weed consumers, but it might not be so great for the companies that are actually manufacturing and selling the stuff.

Harjes: Right, there's a lot of competition here. Each of these major growers in Canada is racing to try to expand their production capabilities. Currently, if you add up the numbers, their ability to produce will be pretty significantly higher than what the projected demand in Canada is going to be anytime soon. 

But, if you think about that big picture, I don't see that as much of a problem. We're long-term investors, we know that this industry is only expanding. Plus, as a Canadian producer, you're able to supply countries outside of Canada. Once you add in the expected demand, based on all of the other countries that have active medical marijuana laws, add in all of the countries that are on track to legalize medical marijuana soon, you end up with very sizable demand that shouldn't be any sort of concern for those that look at the supply numbers and note that they're much higher than the current demand for Canadian marijuana.

Campbell: Yeah. That's another reason to not be so concerned about the crazy valuation of these stocks. This is not an industry that a value investor is going to approach. These companies are still generating very inconsistent financial results. The revenue is growing gangbusters, but the profitability is all over the map. I would expect losses for most of these companies as the continue to invest, until they reach that sweet spot of demand. Who knows how quickly that happens in Canada. We should have more insight in the next 12 to 18 months.

Harjes: This industry is so nascent that it's hard to even come up with a valuation for a lot of these companies. Just remember, as you're looking for investment ideas here, that you're investing in a trend. When you look to invest in some companies, maybe make your own basket, maybe consider that ETF, but do know that you're not going to find any value bargains here. But, it might still be worth taking a look anyway.

As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!