The green flag has officially waved in Canada and legal recreational cannabis sales are off and running as of Oct. 17. The only real question Wall Street and investors have at this point is just how big of an opportunity this legalization could be.
As a reminder, Canada's legalization opens the door for adult-use weed sales domestically, as well as gives growers the opportunity to produce en masse for foreign markets where medical weed is legal. These foreign markets are expected to account for well over half of all annual sales, once the industry is fully up to speed. Though sales estimates vary wildly, which we'd expect given that no industrialized country had legalized marijuana before, Wall Street is looking for $5 billion or more in added annual sales from this legalization.
Three reasons marijuana penny stocks aren't worth your time
Clearly, there are going to be winners. Of course, it's far too early to tell what companies those winners might be. Pot stocks like Canopy Growth Corp., Aurora Cannabis, Tilray, and Aphria stand out for their combination of peak production potential, international infrastructure, long-term supply deals, and partnership potential.
However, as with every "next big thing" investment opportunity, there will be losers, too. Though it's also too early to specifically pinpoint those losers, I'd be inclined to believe that many will be marijuana penny stocks.
Traditionally, a "penny stock" would be defined as having a share price of $5 or less and a relatively low market cap. For the sake of pot stocks, some of which have hundreds of millions of shares outstanding, and thus have reasonable market caps despite a sub-$1 share price, I'm talking about companies with sub-$200 million market caps. With few exceptions, they aren't going to be worth your time.
As I see it, there are three valid reasons to avoid marijuana penny stocks.
1. Marijuana penny stocks are losing money
The first problem with marijuana penny stocks is that they're pretty much losing money across the board. Now, to be fair, pretty much every marijuana stock, regardless of market cap, is losing money. With a few exceptions for fair-value adjustments and one-time asset sales (ahem, Aphria), marijuana stocks are money losers on an operating basis. That should change for some of the larger players as their sales increase and economies of scale come into effect.
However, investors are unlikely to see pot penny stocks turning a profit anytime soon. After all, the reason these companies are small is because they have unclear short-term outlooks or business plans. Considering that the industry already needs time to mature, penny stocks are unlikely to jump right into surging sales or profitability, making them unsuitable for fundamentally focused investors.
2. Funding could be an ongoing concern
Even though the Cannabis Act passed in Canada and the U.S. federal government has taken a hands-off approach in the U.S., obtaining financing for penny stocks could remain challenging.
With recreational marijuana now legal, banks in Canada are free to lend and offer lines of credit to marijuana companies of all sizes. But these financial institutions aren't going to simply throw darts at the dartboard and hope they stick. They'll be looking for tangible growth, a path to profitability, and other signs that they're going to get their money back, with interest. As noted, penny stocks are penny stocks because their business models typically aren't time-tested, and their outlooks are murky, at best.
Arguably, the only source of funding that'll be available to penny stocks is bought-deal offerings in Canada and common stock sales in the United States. These are likely to be dilutive offerings and received at well below a prior day's closing price.
In other words, future funding isn't a given -- and even if it were, it could prove painful to existing shareholders.
3. Trading liquidity and short-term manipulation are a worry
Finally, nearly all marijuana penny stocks trade on the over-the-counter (OTC) exchange, which leaves them prone to high levels of volatility, and therefore short-term market manipulation.
To be perfectly clear, the OTC exchange in the U.S. has done a good job of beefing up reporting and listing standards over the past couple of years. However, they still don't match the reporting and liquidity standards you'd find with, say, the NYSE or Nasdaq. This can leave investors to deal with highly illiquid stocks on the OTC exchange, as well as stocks that get whipsawed by day traders and high-frequency trading programs.
With dozens upon dozens of pot stocks to choose from, there simply aren't any valid reasons for investors to consider marijuana penny stocks.