Legal Cannabis: What's the Smart Way to Invest in This New Industry?

What a difference a few years makes. Marijuana has gone from being a strictly illegal commodity virtually everywhere to one that's legal in many U.S. states -- albeit with restrictions and regulations -- and across Canada as of last month. As a result, a number of public companies have sprung up to grow and wholesale the crops. But this early in newly open market, it's still quite hazy how profitable those businesses might be, and that situation has led, inevitably, to seriously speculative stock price movements.

In this segment of the Motley Fool Answers episode, hosts Alison Southwick and Robert Brokamp ask David Kretzmann, who heads up the Motley Fool group that focuses on the cannabis business, to help them identify the best strategies for investing in this hype-driven space.

A full transcript follows the video.

This video was recorded on Nov. 6, 2018.

Alison Southwick: Some of the estimates for growth in the industry -- and, granted, this is from the Cannabis Industry Annual Report, so they might be a little skewed -- but they anticipate that by 2025, between recreational and medical use, cannabis will become a $24 billion industry. Twice as much as wine. Is that just for the U.S.?

David Kretzmann: That's just the U.S.

Southwick: That's bonkers.

Kretzmann: It's a big industry. I think what's interesting about cannabis is that there isn't really any direct comparison for an industry that's manifesting in this way. Obviously it's been illicit or on the black market for almost a century now, but there's no direct comparisons for where cannabis stands today. At this point, you have a lot of different projections and estimates as far as how big the opportunity could be. People trying to figure out how big the black market is in cannabis. What will the legal cannabis market look like?

So all those projections at least suggest that it's a pretty substantial opportunity. Then when you take into consideration the potential global opportunity as more countries legalize medical cannabis and then most likely recreational cannabis down the road, that really should open up legal cannabis to an increasingly mainstream audience and become a bigger industry as a result.

Southwick: So we're talking about investing in cannabis. What really are we talking about? What kinds of companies? I don't imagine I'm just going to hand some money to a hippie standing out in the field in the middle of Oregon.

Robert Brokamp: You could! You could! But it's not a good investment.

Southwick: I could! But I just don't know that that's the right way...

Kretzmann: Probably not encouraged. At this point, Canada really is the haven for a lot of these legal cannabis producers. It's, by far, the most attractive market to raise capital, because these companies can actually go public on the Toronto Stock Exchange, or the TSX Venture Exchange for smaller companies. It's relatively easy to list your shares publicly and access investors that way. And the fact that cannabis is now legal on a national level means that the banks are suddenly supporting cannabis companies, so you're able to get a loan from banks or even have an account with a bank, whereas in the U.S., because it's still criminalized on a federal level, a lot of banks are kind of nervous to get involved in supporting any form of the cannabis industry in the U.S., even though it is legalized in some states.

So you're seeing Canada attract more and more attention, investment, entrepreneurship as a result. You have companies really all along the value chain. Companies are looking to produce cannabis. Companies are looking to distribute cannabis. And oftentimes these companies are actually vertically integrated because, unlike other crops right now, there's not this excess supply of cannabis you can access. So if you want to sell cannabis or sell a branded cannabis product, you also need to grow the cannabis at this point.

Part of what's exciting here is that we are treading new territory, so we'll finally see how this market unfolds over the next year and beyond in Canada. That gives you an idea of the landscape. Right now there's probably over 100 publicly traded cannabis companies in Canada. They're all across the spectrum as far as where their place is in the industry.

Southwick: So there's always a dumb way to invest in something, and hopefully there is a not-dumb, Foolish approach to investing in the potential growth of the cannabis industry. What is your Foolish approach?

Kretzmann: First, let's start with the things that you want to avoid. You have to recognize that there is a lot of speculation here. There's a lot of frothiness, and partly for good reason. Like this is a new opportunity. I personally am increasingly convinced that this is the beginning of a large, legitimate, legal cannabis industry, so I think there is reason to be excited.

But at the same time, we have to tailor our expectations, because the shares of cannabis companies today are not trading based on present-day fundamentals or a track record, because most of these companies have only been in existence legally for three to five years, at most. Now finally, in Canada we have a national recreational market, so there is an increasingly large opportunity there, but the shares of these companies are being priced based on future expectations and hype.

There's undoubtedly a lot of frothiness here. I'm sure people have seen Tilray in the headlines. That's a company that went public in July. They're a Canadian producer, but they went public directly on the Nasdaq. Gained a ton of attention. I think their IPO was initially priced at about $20 a share. It went up to $300 a share within a couple of months, and as we tape this right now, it's around $170 when this airs in a few weeks. Who knows where it will be? It could be at $300 or at $20 for all I know. There's clearly a lot of shorter-term speculation, so with Foolish investors, we don't want to get caught up in that hype. We want to take a long-term, business-focused approach like we do with any other industry or company.

That's what we're trying to do here at the Fool with some of our cannabis investing -- services that we've launched so far this year -- but recognizing that this is still dominated by early stage companies. They're at a riskier stage in their life. They don't have much of a track record, so there will continue to be a lot of volatility.

And as a result, since there isn't much in the way of a track record or present-day fundamentals, a lot of what we have to do is look at the qualitative factors. So get a sense for the leadership teams at these companies. Who's at the helm of the ship? Is there a healthy amount of insider ownership, because we want to be sure that the individuals who are spearheading these companies -- if they don't have a whole lot of conviction or ownership in these companies, why should we as investors?

Then you also want to pay attention to the balance sheet. How much cash does the company have in the bank, because virtually none of these pure-play cannabis companies are actually making any money yet, so they're unprofitable. As a result, they're burning a lot of cash, which isn't necessarily a bad thing, because if you do agree that there is an opportunity here, it makes sense to invest in a production facility. A processing facility. Investing in marketing and brand building. But you want to be sure that the company has enough cash to support that.

So those are some of the factors that we look at. Then, taking a long-term approach, we want to be sure that we're finding companies that are positioning themselves to be a relevant player in the long term. We're not necessarily worried about where the share prices will be in a month, or three months, or even a year. We're more interested in what the odds are that this cannabis company will be a relevant and thriving player in the industry three-plus years from now. So trying to take that long-term approach is kind of the way that we're playing a different game than a lot of the speculation and short-termism that's dominating the category right now.