Billionaire investor Warren Buffett held the annual shareholder meeting for his company, Berkshire Hathaway, earlier this month, and one of the things he pointed out was how dramatically the list of top 20 companies in the world (by market cap) has changed since 1989 -- none of the companies that made the list then are on it today. Selecting a company to invest in isn't easy, and Buffett warns that there is "a lot more to picking stocks than figuring out what's going to be a wonderful industry in the future."
It might be a tough message for growth investors to hear, but it's one they shouldn't ignore. Investors need to look no further than the high-growth cannabis sector for an example of how returns can vary wildly depending on the stock you invest in, despite the broader industry's amazing potential.
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The cannabis industry will be huge, there's no doubt about it
One of the reasons investors love the cannabis sector is because it's a new industry to invest in, and opportunities like this don't come along often. The desire to get in early and lock in some great returns is tantalizing.
Cannabis research company BDSA projects that by 2025 the global cannabis market will be worth $47.2 billion, growing at a compounded annual growth rate (CAGR) of 22% until then. The opportunities over the long term could be even greater: Grand View Research estimates that the market for cannabis pharmaceuticals will grow to $5.8 billion by 2027, and will average a CAGR of 76.8%. Epidiolex, which is now part of Jazz Pharmaceuticals' portfolio after the latter's acquisition of GW Pharmaceuticals, remains the only cannabis-based drug that the U.S. Food and Drug Administration has approved for use thus far. That part of the industry is still in its infancy, with a long way to go.
A big challenge with such an early growth industry is that predicting its size is difficult and requires frequent updates to forecasts. But there's little doubt that investors can earn some amazing returns from investing in cannabis. The problem, however, is that that doesn't mean you can relax your due diligence when selecting a pot stock to invest in.
Not all cannabis companies make for good investments
There are multiple variables investors should consider when investing in a cannabis company, such as which markets it is in, how strong its margins are, whether it is expanding too quickly (or slowly), and many other factors. Over the past year, you could have earned a wide range of different returns from investing in different components of the cannabis sector -- here are just a handful of examples:
The top return on the above chart is from a company that doesn't even sell marijuana -- GrowGeneration simply provides the materials for people to grow cannabis and other crops. Aurora Cannabis, which is a producer, grew by just 7% in value in the past 12 months. A lack of profitability and perhaps too much expansion and cash burn, coupled with frequent share offerings, have kept its stock price down. Many of the top-performing producers have been from the U.S., including Trulieve Cannabis (TCNNF -6.72%), which is up around 300%. That could be due to the more attractive growth opportunities here. BDSA projects that by 2025, the U.S. pot market will be worth $34.5 billion -- nearly six times the value of the Canadian cannabis industry.
Which types of stocks should cannabis investors target?
The segment of the industry you are investing in is important. Much of the hype in the cannabis sector right now surrounds the potential that the U.S. government will legalize marijuana, but there is no time frame as to when that might happen. And that's why I wouldn't invest in a Canadian-based cannabis company today -- until the U.S. pot market opens up, it will be limited to the significantly smaller Canadian pot market.
U.S.-based pot stocks that are already operating there are much safer bets, and can tap into that growth potential immediately. But it's also important to consider cannabis companies that are actually making money and aren't burning through cash. Not only does that lessen the need for share offerings (which lead to dilution for shareholders), but it can help facilitate future growth. And although profitability is elusive for many companies, some are generating strong bottom lines while they are still growing, making them even better buys.
Trulieve is a great example of that: The Florida-based company posted a profit of $63 million in 2020, while more than doubling its top line to $521.5 million. The company has posted 12 straight profitable quarters, so it's no surprise that it has been among the best investments to hold over the past year. And with more growth on its radar in markets like Massachusetts and Pennsylvania, there's little reason to doubt that it will remain a solid investment for the foreseeable future.
There are many other good buys to consider, but the important thing to remember is that an industry's high-growth potential shouldn't be a reason to overlook a company's specific performance or risks.
