Marijuana stocks were on a tear leading up to the opening of Canada's recreational marijuana market last week. However, pot stocks are tumbling since then and that could have you wondering what's next for this emerging industry. There's little doubt the marijuana market is undergoing significant disruption, but that doesn't necessarily make every marijuana stock worth owning in portfolios.

A little perspective

It's tempting to react to short-term moves in stocks, but it's usually best to be proactive. Instead of buying and selling on the market's whims and whispers, savvy investors ride out tough times like this by sticking to discipline and remaining objective.

A marijuana leaf on top of a $100 bill.

IMAGE SOURCE: GETTY IMAGES.

Admittedly, that's easier said than done. We're hardwired to avoid danger, and as I've written previously, it doesn't matter if that danger comes in the form of a hungry tiger or a declining portfolio balance.

If you're struggling to keep perspective, here are some things to remember:

There's no getting around it, the marijuana market opportunity is real, and since the biggest marijuana stocks are only generating tens of millions in quarterly sales today, they're only in the early innings of profiting from a growing trend toward legalization.

What to do now

If you already own marijuana stocks, then it's time to revisit your portfolio and consider if you own the best marijuana stocks.

If you have an investing diary, review the reasons why you own the stocks you do. If the reasons no longer apply, or the catalyst you were expecting has passed or changed, then review the company's latest filings with regulators to make sure you understand each company's business strategy, finances, opportunities, and risks.

It's also a good time to consider how heavily weighted marijuana stocks are in your portfolio and any use of margin. Marijuana stocks could represent a much larger proportion of your portfolio than initially intended following their rally over the past few months, and if so, then your portfolio could be too risky, particularly if you invest using margin, which allows you to borrow money from your broker to buy stocks. Though margin can increase the value of your account in good times, it can also cause your account value to tumble quickly in bad times.

For instance, a $50,000 investment account owning $100,000 in stock because of margin will climb 20% in value on a 10% move higher. However, a 10% decline will result in a 20% drop in account value and worse, because margin is usually issued at a ratio of 2:1 times the value of your account balance, you could be forced to sell stocks at a loss to keep your broker from selling stocks to keep you in compliance.

Are marijuana stocks expensive?

The old Wall Street maxim, "buy the rumor, sell the news" appears to apply to marijuana stocks now. Shares in cannabis companies rallied ahead of Canada's recreational marijuana market opening and now that that's happened, investors are left without a clear catalyst for what could cause the next marijuana stock rally.

Absent a major event, such as the U.S. legalizing marijuana federally, it's likely that views on the industry's valuation will play a more important role in determining whether marijuana stocks rally or fall.

Unfortunately, most marijuana stocks are expensive when you consider traditional valuation metrics like price-to-book ratio, price-to-earnings ratio, or price-to-sales ratio. For instance, Tilray Inc. (NASDAQ:TLRY) is one of the highest-flying marijuana stocks this year, and even after shares tumbling recently, it still boasts a price-to-book ratio of 233, it doesn't have any earnings to value yet, and its price-to-sales ratio is 363. Those ratios are sky-high, even when you compare them to competitors.

A good argument can be made that traditional valuation metrics don't appropriately value the opportunity ahead of these companies, though. That's because these metrics are based on past results, not projected financials. If estimates for the recreational market in Canada are even close to accurate, then these stocks will see dramatic increases in sales, profit margin, and book value in the future that may justify their current valuation. However, it could be years before that happens.

What's next

If you're wondering what could cause marijuana stocks to rally higher again, here are a few possibilities:

  • Michigan and North Dakota voters could pass recreational marijuana laws in November.
  • Canadian regulators may OK the sale of profit-friendly value-added products like edibles, vapes, and concentrates.
  • A major beverage company could strike a partnership with a cannabis company to develop marijuana-infused beverages.

It's anyone's guess what the voters in Michigan and North Dakota will do, but a Michigan State University survey recently found that 61% of voters favor legalization. It's more of a toss-up in North Dakota, where only 38% of the state's residents favored legalization, according to a Bismarck Tribune poll. 

It's likely Canada will approve the sale of consumer products containing cannabis like beverages, but that isn't expected to happen until 2019. 

Similarly, there's a good chance that beverage and other consumer products companies are considering partnerships with cannabis companies, but investors shouldn't buy stocks based on merger-and-acquisition rumors because there's no telling if deals will happen or when they might happen. 

Overall, the marijuana market is evolving and there's considerable opportunity for cannabis companies to profit. However, this is a long-term market opportunity and investors who don't carefully consider risk could experience significant losses as the market develops. Therefore, marijuana stocks are best suited for risk-tolerant investors. They should only represent a small proportion of your account, and shouldn't be bought on margin.

 

Todd Campbell has no position in any of the stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool recommends Constellation Brands. The Motley Fool has a disclosure policy.