The marijuana industry has blossomed in front of our eyes in a very short amount of time. This decade alone, we've witnessed 10 U.S. states give the green light to recreational weed and stood in awe as Canada ended nine decades of recreational marijuana prohibition this past October. Once a taboo topic that was swept under the rug by legislators, the cannabis industry is now a legitimate business model that's ripe for investment.
Just how big could the pot industry become? Well, that depends on your preferred source. Investment firm Cowen Group foresees $75 billion in worldwide sales by 2030, with Arcview Market Research and BDS Analytics calling for as much as $31.3 billion in global sales by 2022. For context, this duo estimated 2018 worldwide sales at $12.8 billion. Whichever source you prefer, the bottom line is that there are a lot of revenue dollars to go around and presumably big profits to follow.
The big question is and remains: Which pot stocks should you buy?
Forget brand-name marijuana stocks and focus on small-caps
Mid-cap and large-cap marijuana stocks have been the preference of investors up to this point. Names like Canopy Growth (NYSE:CGC), Aurora Cannabis, Tilray, and Cronos Group (NASDAQ:CRON) have left many of their peers eating dust. But are these really the pot stocks you should own going forward? My argument would be that they aren't.
Rather, I see considerably more opportunity in small-cap marijuana stocks (think $200 million to $1.5 billion in market cap). Here are five solid reasons to buy small-cap pot stocks instead of the well-known quartet mentioned above that Wall Street can't seem to get enough of.
1. Small-caps have a better chance of being profitable
Arguably the top reason to consider small-cap marijuana stocks is that the few companies that have been profitable in early going are considerably smaller in size. Think about this for a moment: Canopy Growth has lost more than 400 million Canadian dollars through the first nine months of fiscal 2019, yet Wall Street has anointed the company with a $16 billion-plus market cap. Does that make sense? Fundamentally, not one bit!
Instead, consider real estate investment trust (REIT) Innovative Industrial Properties (NYSE:IIPR) as a pot stock you can trust. A cannabis REIT is a company that acquires land with growing and/or processing facilities and then leases these assets out for an extended period of time. In Innovative Industrial Properties' case, it has a dozen properties in 10 states, and its original leases range between 15 and 20 years, lending to predictable long-term cash flow. Plus, each lease comes with a built-in 3.25% annual rent increase and a 1.5% management fee tied to the base rent. This means the company can grow via acquisition as well as organically.
Innovative Industrial Properties, while relatively small ($640 million market cap), has been profitable for more than a year now and has raised its quarterly dividend twice since going public in December 2016 on the New York Stock Exchange. You won't find a large-cap pot stock that can deliver results like these.
2. There's less baked-in premium
Secondly, you'll find that small-cap pot stocks have considerably less baked-in premium relative to the aforementioned four Wall Street darlings. Bigger pot stocks have often uplisted to major U.S. exchanges and have had lofty price targets bestowed on them. That's not the case for under-the-radar small-cap marijuana stocks.
One of my favorite hidden gems in the pot industry is OrganiGram Holdings (NASDAQ:OGI), which currently has a market cap of around $750 million. OrganiGram, which is based in New Brunswick, is on track to produce 113,000 kilograms annually at its peak. Comparatively, Cronos Group is likely to generate just a few thousand kilos more in annual production than OrganiGram, but it's lugging around a market cap of more than $3.8 billion. Sure, Cronos Group has a brand-name equity investor in Altria, but the two companies are practically identical in production capabilities, with OrganiGram getting the edge in production costs, in my view.
3. Better buyout potential
Even with Constellation Brands taking a $4 billion equity stake in Canopy Growth and Altria taking a $1.8 billion stake in Cronos Group, neither of these brand-name marijuana stocks is guaranteed to be bought out anytime soon, if ever. It would be considerably easier for large-cap weed stocks or interested parties in the beverage, tobacco, or pharmaceutical industries to gobble up a fast-growing company with a sub-$1.5 billion market cap than it would for Constellation to figure out how to come up with close to $10 billion more in capital to buy the shares of Canopy that it doesn't already own.
For example, HEXO's (NYSEMKT:HEXO) CEO Sebastien St-Louis has been up front that he doesn't know whether his company will be a buyer of other businesses as the Canadian grow industry consolidates or if HEXO will become a buyout candidate. Said St-Louis in an interview with the Montreal Gazette, "In five years there may be four global cannabis companies and whether HEXO is a buyer or a seller on that journey, what matters to us is for our shareholders to participate in that to become one of the four. It's certain that if someone comes and offers a 150 percent premium tomorrow, we are for sale."
With 108,000 kilos of peak annual production and a five-year supply agreement with Quebec for an aggregate of at least 200,000 kilos, HEXO would have a lot to offer a suitor.
4. Plenty of partnership allure
Canopy Growth and Cronos Group may appear to have the edge when it comes to partnership opportunities, but I can assure you that small-cap stocks are just as appealing, if not more so from a valuation perspective, to outside industries looking for a partner.
For instance, Quebec-based HEXO not only landed itself a landmark supply deal within its province, but at the beginning of August, when rumors were swirling about beverage companies looking for partnerships with cannabis companies, it formed a joint venture with alcohol giant Molson Coors Brewing. The 57.5%-42.5% joint venture, in which Molson Coors has a majority stake, will allow the two companies to research and develop cannabis-infused beverages under the brand-name of Truss. With Health Canada set to expand the types of consumption options available to consumers this coming fall, HEXO and Molson Coors could be among the first to put a nonalcoholic cannabis-infused beverage on dispensary store shelves.
Long story short, market cap size isn't indicative of partnership opportunities in the cannabis industry.
5. Small-caps have incredible focus
Last but not least, small-cap pot companies are likely to have much better strategic focus than large- or mid-cap companies. Large-cap Canopy Growth has a presence in more than a dozen overseas countries, is readying to enter the U.S. hemp market, has a partnership with Constellation, has multiple grow sites, and is involved with medical cannabis research. It's arguably stretched thin because it has so much going on at once.
Now, compare this to OrganiGram Holdings, which has just a single grow campus in Moncton, New Brunswick. OrganiGram has been able to fully utilize its grow space by incorporating a three-tiered growing system, thusly allowing the company to produce 113,000 kilos spanning just 490,000 square feet of cultivation space. That yield is roughly double the industry average, and it's likely to push OrganiGram's costs well below those of its peers.
OrganiGram, like its larger peers, has also been focusing on CBD oil production, which carries a higher price and much better margins than traditional dried flower.
The fact is, small-cap pot stocks offer more potential than Wall Street's mid- and large-cap darlings.
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