The legal marijuana market could be on its way $200 billion in 15 years, according to beer, wine, and spirits giant Constellation Brands (NYSE:STZ). If their projection is anywhere near close to correct, then marijuana stocks could offer investors a shot at investing in an emerging market that could rival tobacco or alcohol someday.

The potential to pocket profits from pot is massive, but that doesn't mean every cannabis company will be a winner. Many will be losers, and more than a few could wind up in bankruptcy. To improve the odds of picking the right cannabis stock to buy, you should make sure that you know:

  • Whether the company's on solid financial footing.
  • Whether marijuana production is climbing.
  • Whether the company's product mix is on point.

No. 1: financial firepower

Canada's marijuana market represents a big market opportunity for cannabis companies, but it's not nearly as large of an opportunity as the United States or major markets in Europe. 

A marijuana leaf.

IMAGE SOURCE: GETTY IMAGES.

Spending on marijuana in Canada totals about $6 billion Canadian per year, according to Statistics Canada. However, the U.S. market is valued at $50 billion and global spending is an estimated $150 billion per year, according to the United Nations. Clearly, capturing a significant share of Canada's market as its new, recreational market matures will be a boon, but capturing meaningful share in America and elsewhere is more important.

The companies likely to benefit most from global legalization are arguably those with the deepest pockets. So it's critical to continuously track changes in these companies balance sheet. As a refresher, a balance sheet is a financial statement that highlights a company's assets, liabilities, and shareholder equity. Evaluating changes in cash and debt can be particularly helpful in making sure you're investing in top-quality companies that can capitalize on the growing market for legal cannabis.

For instance, the industry's deepest pockets belong to Canopy Growth (NYSE:CGC). Last year, Constellation Brands acquired a 38% stake in Canopy Growth for about $4 billion, giving it lots of firepower to invest in new greenhouses, greenhouse automation, cannabis extraction facilities and equipment, product development, clinical research trials, and, importantly, new markets. Canopy Growth has started to flex that financial muscle, but it still has most of the money at its disposal. In December, it acquired Colorado-based hemp company ebbu for CA$425 million, but only CA$25 million of that deal was paid for in cash. The rest of the deal was stock. Also, Canopy Growth announced in January plans to invest in a to-be-built hemp industrial park, but that project is only expected to cost it $100 million to $150 million. As of Dec. 31, Canopy Growth boasted over CA$4.1 billion in cash, plus CA$799 million in marketable securities it can sell, on its balance sheet, so those investments barely dent its stockpile.

Check out the latest earnings call transcripts for Canopy Growth and other companies we cover.

Here are some select balance-sheet items from Canopy Growth.

Metric

As of 12/31/18 As of 3/31/18
Cash $4,115,870 $322,560
Marketable securities $799,418 $0
Short-term debt $18,447 $1,557
Long-term debt $773,049 $6,865

Data source: quarterly corporate filings. Numbers in thousands of Canadian dollars.

No. 2: pot production

It's tempting to spend a lot of time considering the peak pot production figures that cannabis companies are talking about, but investors should remember that those forecasts aren't written in stone. Plans can change, so there's no guarantee a company that's forecasting production will increase from 10,000 kilos today to 100,000 kilos or more in the future will actually deliver on its promise.

Quarterly production is a better measure to track. Specifically, changes in kilos sold and kilos harvested is key, because that shows investors whether a company is already executing on its growth strategy in ways that will allow it to make the most of Canada's maturing market and new opportunities elsewhere, such as in Germany or the United States.

For example, Aurora Cannabis (NYSE:ACB) has taken a two-pronged approach to increasing its marijuana capacity. It's arguably been the most acquisitive pot company, but it's also plowing money back into its most important greenhouses, including Aurora Sky. That approach allowed it to sell nearly 7,000 kilos of marijuana and marijuana equivalent products in the fourth quarter of 2018, up 502% year over year. It also produced 7,822 kilos last quarter, up 550%, putting it in a position for additional growth this quarter.

Here's a look at Aurora's cannabis production and sales.

Metric Most Recent Quarter One Year Before Year-Over-Year Change
Kilograms sold 6,999 1,162 502%
Kilograms produced 7,822 1,204 550%

Data source: quarterly corporate filings. 

In fact, Aurora Cannabis says its marijuana production capacity was 120,000 kilograms per year as of February and that it expects to have 25,000 kilos of marijuana available for sale exiting the quarter ending June 2019. That's potentially good news for investors, because a lot of that new production is coming out of Aurora Sky, where automation is expected to significantly reduce production costs and improve gross margin.

A person using a calculator writes numbers on a sheet of paper.

IMAGE SOURCE: GETTY IMAGES.

No. 3: product mix

Canada's marijuana market probably won't have to worry about marijuana overproduction for a few years, but significant investments industrywide could eventually lead to bumper harvests that cap prices for dried flower. We've already seen that dynamic play out in Colorado, America's longest-running recreational marijuana market. Last fall, the average price for a pound of marijuana was below $800 in Colorado, down from over $2,000 per pound of bud in 2015. 

Avoiding the margin-busting risk of declining marijuana commodity prices will require a focus on finished products that use marijuana as an ingredient, such as edibles, beverages, and oils. Extract-based products historically offer better pricing power than dried flower, so knowing how much of a pot stock's business is coming from finished consumer goods products is critical.

For example, extract products, including oils and softgels, accounted for 33% of Canopy Growth's revenue but just 22% of Aurora Cannabis net sales last quarter. That difference helps explain why Canopy Growth's average price per gram declined by less than Aurora Cannabis' average price in the past year.

Company/Product Selling Price Per Gram, Most Recent Quarter Selling Price Per Gram, Prior-Year Quarter Year-Over-Year Change
Aurora Cannabis, dried cannabis $6.23 $7.86 (21%)
Aurora Cannabis, extracts $10.00 $13.35 (25%)
Canopy Growth, average $7.33 $8.30 (12%)

Data source: quarterly corporate filings. Dollar figures in Canadian.

Eyes on the future

The chance for significant sales growth and potential profit someday makes pot stocks incredibly intriguing investment ideas, but the industry isn't without risks. Momentum toward widespread legalization in key markets, including the U.S., has been building; however, there's no guarantee that will continue or that marijuana will become legal at the federal level in America anytime soon.

Nevertheless, billions of dollars are already transitioning to legal, regulated marketplaces in Canada, and since 80% of the spending in Canada is still occurring on the black market, revenue should continue accelerating for cannabis companies, including Canopy Growth and Aurora Cannabis. It's too early to say definitively which companies will wind up being the most successful in this market, so make sure to watch closely for changes in these companies' balance sheets, production, and product mix for clues to which company will wind up being the best investment.