The marijuana industry is officially coming of age. In 16 days, on Oct. 17, 2018, Canada is set to become the first industrialized country in the world to legalize recreational marijuana. In doing so, a path will be laid for pot stocks to generate perhaps $5 billion in added annual sales once the industry is fully up and running. It's this expectation of rapid sales growth that's pushed marijuana stocks notably higher since 2016.
But investing in the marijuana industry isn't without risks. Just take a look at Tilray, which catapulted from around $100 a share to $300 in less than three days on the heels of a short squeeze then promptly gave back all of its gains -- and then some -- over the course of the next three trading sessions. Fortunes could be made and lost in the blink of an eye with volatile marijuana stocks, which means that if you want to invest in this space, you'll probably want to take steps to minimize your risk. Here are eight ways you can do exactly that.
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1. Invest only a small percentage of your portfolio in pot stocks
Probably the smartest move investors can make is to invest only a small percentage of their portfolio in marijuana stocks. As the old adage goes: Never invest more than you're willing to lose. With the industry in need of consolidation and it being unlikely that every pot stock will turn out to be a winner, you should be prepared for the possibility of losing some or all of your investment. If you keep the percentage of your investment in marijuana stocks relatively small, it'll sting less if the industry (or the pot stock you select) goes up in smoke.
2. Consider ancillary players rather than growers
Rather than focusing on direct cannabis players, such as growers, consider investing in ancillary pot stocks that might have other (profitable) businesses. For example, Scotts Miracle-Gro (SMG -0.09%) would give investors exposure to the marijuana industry through its subsidiary, Hawthorne Gardening, which supplies hydroponic solutions, as well as soil, nutrients, and lighting for the medical cannabis industry. What's important here is that Scotts Miracle-Gro generated 89% of its sales from its core lawn and garden segment, which is also very profitable. Therefore, investors could dip their toes in the water with Scotts Miracle-Gro and hope that Hawthorne grows by a double-digit percentage. At worst, they've invested in a company with a proven business model and single-digit lawn and garden growth.
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3. Seek out profitable pot stocks
Another smart way to reduce your investing risk is to seek out profitable marijuana stocks. A good example would be Innovative Industrial Properties (IIPR 0.06%), which owns more than a half dozen medical cannabis grow farms in the United States. Operating as a real estate investment trust, Innovative Industrial Properties has a relatively fixed-cost structure to go along with annual rent increases and management fees. Plus, the company has worked out leases that range between 15 and 20 years. As the icing on the cake, investors in Innovative Industrial Properties are privy to a $0.25 per share quarterly dividend.
4. Diversify across the industry
Building on the initial point that you should invest only a small percentage of your portfolio in marijuana stocks, it'd also be wise that you put that money to work across the industry rather than in just one or two pot stocks. Again, it's far too early to tell what companies will be leaders and which marijuana stocks will fall by the wayside. If you invest in only one or two marijuana stocks, making a poor choice could lead to losing all of your money.
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5. Purchase a marijuana ETF
Perhaps an easier way to get the diversification you're looking for with marijuana stocks is to consider a cannabis ETF, or exchange-traded fund. An ETF would allow investors to get broad-based exposure to the pot industry with a single security. As an example, the Horizons Marijuana Life Sciences ETF has four dozen cannabis stocks in its portfolio and a midrange expense ratio of just 0.75%. If one marijuana stock struggles, it's unlikely to sap your entire investment. ETFs are a smart way to mitigate the volatility that naturally comes with owning marijuana stocks.
6. Avoid short selling
Even if you believe marijuana stocks are overvalued, the riskiest thing you can do is bet against them by short selling (borrowing shares from your brokerage and hoping the share price of a stock goes down). Aside from the fact that short selling involves borrowing from your brokerage and paying interest on what you borrow, your gains are capped at 100% (i.e., a stock can't go any lower than $0). Meanwhile, your losses could be infinite, since a stock has no capped upside. This is the pain that Tilray short sellers have dealt with over the past month and that ultimately pushed the stock up to $300.
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7. Don't use your margin to buy pot stocks
However, you also shouldn't consider using margin to purchase marijuana stocks. Leaning on leverage isn't optimal for two reasons. First, you'll have to pay interest on the money you borrow. And second, leverage has the ability to magnify your gains and losses. If you simply picked the wrong time to bet on marijuana stocks, your use of margin could cost you more than your original investment. In short, stay away from margin when it comes to pot stocks, period.
8. Remember your long-term ethos
Finally, don't forget that you're in this for the long haul. Wild swings in marijuana stocks like Tilray might seem enticing, but they're impossible to predict with any accuracy. Rather, focus on businesses that you believe will have an edge beyond just the next couple of months. My favorite marijuana stock, OrganiGram Holdings, the only large Atlantic-based grower, is utilizing its grow space more effectively than its peers and has upped its production potential significantly this year. If you stick with your long-term ethos, you'll avoid many of the dangers listed above.
