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Legal Cannabis: Which Marijuana Companies Are Worth Considering for Your Portfolio?

By Motley Fool Staff – Nov 12, 2018 at 3:00AM

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The public companies that grow and sell marijuana are getting heavy investor attention, but in an industry where share prices are so speculative, it’s tough to know which stocks are good buys.

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 -- as well as across Canada as of last month. As a result, a number of public companies have sprung up to grow and wholesale the crop. But this early in a newly open market, it's unclear how profitable those businesses might be, and that's led to seriously speculative stock price movements.

In this segment of Motley Fool Answers podcast, hosts Alison Southwick and Robert Brokamp ask David Kretzmann, who heads up the Motley Fool group that focuses on the cannabis business, to offer his best advice on which pot stocks he'd recommend today, whether a marijuana-focused ETF would be a solid choice, and how much of your portfolio should be devoted, at a maximum, to this space.

A full transcript follows the video.

This video was recorded on Nov. 6, 2018.

Alison Southwick: Are there a couple of specific company names or stocks that you want to put out there for any listeners that want to start looking into the industry?

David Kretzmann: Sure. Within the initial companies that we've recommended to people as buy recommendations, we have the pure plays. These are companies that generate the majority of the revenue from cannabis in some shape or form. We then have picks-and-shovels companies. Picks-and-shovels companies we have identified as companies that have a strong, underlying core business that isn't in cannabis, but then the potential opportunity with cannabis is an add-on, or a cherry on top, but it isn't the main thesis behind buying the company.

Starting with a picks-and-shovels company, I think Constellation Brands (STZ 0.60%) is a company that some people will be familiar with. If people have followed this space at all, you might have seen them in the headlines. This is the company behind Corona, the beer, and then a variety of other wine and spirit brands that they have in their portfolio. They've been one of the better-performing alcoholic-beverage companies in the past several years, unlike some of the other bigger players.

Last year they invested a smaller amount into Canopy Growth (CGC -3.52%), which is one of the larger cannabis producers in Canada. Then in August, Constellation Brands reupped that investment in a huge way. They invested an additional $4 billion into Canopy Growth, taking 38% control of Canopy for the seven board seats. Essentially Canopy Growth, today, is the cannabis offshoot of Constellation Brands.

To put that number in perspective, in the first half of 2018, every single cannabis company, public and private, around the world had raised $4.3 billion.

That's the first half of this year, so in a single day, Canopy Growth essentially raised the same amount that every other company had raised. This just puts Constellation and Canopy Growth on a whole other level compared to other companies. So from a picks-and-shovels angle, I like Constellation Brands because this is a company that pays a dividend. They generate an increasing amount of free cash flow, so it's a healthy business. They have a strong core business, but they're also making a fairly aggressive push into cannabis. During the announcement of this investment, they said that they expect the legal cannabis market, on a global scale, to hit $200 billion by 2030, so they see this being a big opportunity, and they're making a substantial bet on it.

That would be the type of company that I start with. It's a business that's easy to understand. You can see where cannabis could complement Constellation Brands, because they have a lot of experience building brands and distribution with a highly regulated product like alcoholic beverages, and it makes sense that they could transfer that knowledge over to cannabis in the coming years. And I like the fact that they're taking a long-term approach to this. They're not investing in cannabis to juice their share price in the short term. They're very much thinking of this from a decade-long perspective, and I think that's the right way, as Foolish investors, we should be thinking.

With pure-play companies, these are obviously much riskier companies. Like I said earlier, a lot of these companies are burning cash, they're unprofitable, and the valuations are likely going to be very lofty no matter which way you slice it. But one company that I do like that's a pure-play cannabis producer in Canada is a company called CannTrust.

This is a company that's still valued at over $1 billion. Their revenue over the past year is still pretty minimal, but they've registered among the most medical cannabis patients in Canada compared to the other bigger producers.

And even though their valuation does sound lofty, like $1 billion for a company that generated about $30 million in revenue over the past year, that valuation's actually really attractive compared to Canopy Growth, or Tilray, or Aurora Cannabis, or some of these other bigger players. I'm not making a valuation argument, necessarily, but compared to some of these other bigger players, I think it is a more attractive price.

They also have a partnership in place with Breakthru Beverage, with is one of the largest private companies in the U.S., and that's a company that is one of the leading beverage distributors in North America. So in the coming years, potentially, CannTrust will be able to plug its cannabis products into that distribution network of Breakthru Beverage.

It's a founder-led company. They have a healthy balance sheet. Again, this is one where it would still be incredibly volatile, but I like the approach the company is taking. When I spoke to their president this summer, he said, "In 18 months or so, I hope that we're not in the business of growing cannabis."

Because when you think about it, no one cares about who grows the coffee for Starbucks or the tomatoes for [Kraft Heinz]. People are really just interested in the end product. So the long-term vision for CannTrust, and also some of these other companies, is really in building brands, because at the end of the day when you're dealing with what could potentially become a commoditized crop like cannabis, the greatest value to be captured will be from the companies that can build those brands that resonate with the end consumers.

So just as you see [Anheuser-Busch InBev] or Budweiser with alcohol, or Starbucks with coffee, or Heinz with tomatoes, I think you're going to see, in the coming years and decades, some pretty powerful global brands be built in a similar way around cannabis and I like the approach that CannTrust is taking to get there. It's not a slam dunk that they will, but I do like the approach that they're taking. So that's one that I look at as a promising pure play company.

Southwick: What if I just want an ETF?

Kretzmann: There are a few ETFs out there. Again, limited track records there, because there hasn't been much of a track record to have in this industry. The one danger with the ETFs is that they're often highly concentrated in the bigger players, and I would say that most, if not all, of the bigger players are trading at some frothy valuations at potentially unsustainable levels.

So you still want to understand what you're buying. I wouldn't blindly buy an ETF. First you'd want to see what their concentration is in the top 10 holdings -- what those companies are -- and if you're comfortable with the idea of having the majority of that ETF be in some of those bigger players.

For me, personally, if you are looking to get exposure to this category, start with a company like Constellation Brands, a more established multinational company that is looking to make some investments in the category. And then if nothing else, the approach that we're taking here at The Motley Fool with our cannabis-investing recommendation service is we're almost building our own ETF, so recognizing that this is a type of industry and given that it is at such an early stage where there will be plenty of losers in the coming years. You're going to see some consolidation. You'll see some companies that fail to gain traction or just won't be able to raise cash, and they'll go bust.

But the thesis that we have here is that there will be eventual long-term winners in the category, and that a majority of the gains will likely come from a small number of winners. It's almost like approaching a venture capitalist where you're making a series of small bets. You recognize that probably at least half of those bets won't work out like the way you hoped, but there will be one or two big winners that more than make up for the losers.

So with an ETF, you might be able to capture that, but I think over the long term if you are interested in the space, it makes a little more sense to build a diversified portfolio among a few of the players and go with that approach. But to each their own. I would just tread carefully with the ETF approach.

Robert Brokamp: If someone's interested in this, how much of their portfolio do you think they should devote to these types of companies?

Kretzmann: It should definitely be a small part of your overall portfolio. Obviously, each person, circumstances, and risk tolerance will be different. I've personally invested in all 10 or eventually 13 of our recommendations by the time this podcast is released, so I've invested my own money in the companies that we've recommended in this space to our members, but I just started with about 5% of my overall portfolio. I'm young. I am adding more money regularly to my investments, so that's the type of risk that I can afford to take.

Even though 20%-40% swings in these stocks, especially the pure plays, isn't all that uncommon -- it's actually probably more than the norm rather than the exception -- for someone who's in or near retirement, or if they're not adding a lot of money to their investments, you just want to take a step back and really be sure anything that you put into the cannabis stocks should be money that you certainly won't need in the next five years, and shouldn't be a substantial part of your overall portfolio. I would say when in doubt, start small. There's no rush.

The way that we're approaching it is this will be something that unfolds in the coming years and decades, and there will certainly be a lot of peaks and valleys along the way. We'll have a lot of hype like we had around Oct. 17 and legalization day in Canada. I'm sure if and when the U.S. federal government decriminalizes cannabis on a federal level, that will be a huge catalyst for the industry, but when in doubt, start small.

Alison Southwick has no position in any of the stocks mentioned. David Kretzmann owns shares of Constellation Brands and Starbucks. Robert Brokamp, CFP owns shares of Starbucks and The Kraft Heinz Company. The Motley Fool owns shares of and recommends Starbucks. The Motley Fool recommends Constellation Brands. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Constellation Brands, Inc. Stock Quote
Constellation Brands, Inc.
$232.66 (0.60%) $1.40
Canopy Growth Stock Quote
Canopy Growth
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