Cannabis stocks are exciting for investors because of the long-term growth prospects in the sector. But investing in pot companies can also be challenging and scary, and there are a lot of potential pitfalls.

As is common in young, high-growth business sectors, there's a lot of unprofitability in the cannabis industry as companies spend heavily to grow their businesses and gain market share. Many of these start-ups will fall by the wayside by getting acquired or going out of business. Cannabis has been illegal at all levels for decades, it's still is federally illegal in the U.S., and an array of regulations impede the growth of this market. Pot companies, unable to access traditional means of financing, are starved for cash and often must sell their own stock to raise funds, which dilutes the holdings of earlier investors. And the COVID-19 pandemic has hampered all sorts of retail activity this year, including in the marijuana sector.

Nonetheless, there are some fantastic opportunities for people who want to invest in the legal marijuana industry.

marijuana leaf + stock chart

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A major funding source for cannabis businesses

Like a lot of stocks, Innovative Industrial Partners (IIPR 0.19%) crashed after the market recognized the threat that the COVID-19 pandemic posed to the economy. From a high of $137 a share last year, the stock dropped to $46 in March. However, the stock has bounced back a bit, trading above $70 a share Monday. While the company is still a small-cap, with a valuation of $1.2 billion, it arguably has the strongest financials of any company in this space. This real estate investment trust (REIT) has an incredible profit margin of 52%, while its top-line growth last quarter was an astounding 269%. As a REIT, it's legally required to pay 90% of its taxable income to shareholders annually in the form of dividends. Its dividend yields a healthy 5.78%. 

How is Innovative Industrial so profitable while so many cannabis stocks are in the red? It has skillfully taken advantage of the federal government's stance on marijuana to acquire a lot of valuable property.

Because marijuana is still illegal under federal law, most financial institutions won't work with companies in the sector. As a result, marijuana growers in need of cash only have a few options. One is to sell an equity interest in the business to the public in the form of stock. And the other is to sell their greenhouses and other properties to Innovative Industrial, which will turn around and lease them back to the seller for use. This is how it has acquired 4 million square feet of marijuana industry properties in the U.S. 

Innovative Industrial owns major marijuana farms in 15 states. Some of its tenants include TrulieveCresco Labs, PharmaCann, and Curaleaf. While it's unclear which of these multi-state operators will dominate in the marijuana market in the future, what is increasingly clear is that Innovative will be that company's landlord. This makes IIP an excellent bet on the growth of the legal marijuana industry in the U.S.

A possible winner in marijuana retail

For investors who are willing to take on more risk, Planet 13 (PLNH.F 0.26%) offers an intriguing opportunity. The company operates a high-end marijuana superstore in Las Vegas. While much of the marijuana market in the U.S. is focused on the medical marijuana space, Planet 13 is building its brand on the recreational side.

While your average marijuana dispensary might look like a dentist's office, the "world's largest cannabis store" strives to be an entertainment venue too. That's why the superstore features an LED interactive floor, a 3-D visual experience on the ceiling, and an interactive laser art device which allows the guests to create their own graffiti on the walls. That's not to mention the aerial orb show, the planet water feature, and the giant interactive lotus flowers. 

Right now, of course, the superstore is closed to visitors because of the COVID-19 pandemic -- as is the entire Las Vegas Strip. That's a major reason Planet 13 stock is down 48% year to date. At $1 a share, in fact, the company has reached micro-cap land. However, it's hoping it can successfully shift its retailing operations into deliveries while people are isolated at home. Prior to the outbreak, Planet 13 had fantastic quarterly revenue growth of 241%.         

Of course, Las Vegas is primarily a tourist destination, so it's unlikely that local marijuana deliveries will make up for the closure of the superstore and the near-total absence of visitors to the city. On the other hand, the shutdown is both temporary and already priced into the stock.

What makes Planet 13 such an intriguing investment idea is that the company is highly focused on its entertainment and branding opportunities. Consider that 9% of marijuana sales in Nevada went to this one store! That shows you how powerful its brand is. Not surprisingly, the company has a powerful merchandising operation. It sells everything from Planet 13 t-shirts to its award-winning Dreamland Chocolates brand.

While this young company has yet to turn a profit, investors looking for winners in the marijuana retail space should keep an eye on this business. Planet 13 has a 59% gross margin, and its operations are cash flow positive. In 2020, it hopes to open its first superstore outside of Nevada, in Santa Ana, California. While a lot of multi-state operators are trying to get big fast, Planet 13 is distinguishing itself by developing a strong localized brand, which may pay off in a big way down the road.