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How to Buy Cannabis Stocks During a Bear Market

By Alex Carchidi - Updated May 19, 2021 at 8:31AM

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Stick to companies with a track record of success where it counts.

With the economic jitters over the last few weeks, investors everywhere are looking over their shoulders for the shadow of a looming bear market. But, even if the market starts to dip consistently, long-term success is still possible with diligent and consistent buying -- assuming you pick the stocks that will perform best over time, that is.

When it comes to cannabis stocks, it's hard enough to pick winners when the market is roaring. And with legalization of cannabis proceeding in the U.S., there will still be quite a lot of revenue growth potential regardless of how the market is behaving. So, today I'll be offering three tips that will help you to keep investing in the cannabis industry successfully, even during a market downturn.

Cannabis farmer consulting tablet and holding large cannabis plant

Image source: Getty Images.

1. Consider companies that pay a dividend

Companies that pay dividends often prove to be more steadfast than those that don't. In short, businesses that have the financial strength to provide habitual payouts to investors are perpetually proving their worth in the form of cold hard cash. And, since the market hates when dividends get cut, dividend payers tend to keep on paying out for as long as they can, providing investors with tangible results regardless of volatility. 

While there aren't too many companies in the cannabis industry that are financially healthy enough to pay a dividend, there are a few that do, and that makes them worth paying attention to during a contraction. Innovative Industrial Properties (IIPR 2.13%) and Scotts Miracle-Gro (SMG 1.42%) are two examples worth noting.

Innovative Industrial buys medicinal cannabis cultivation floorspace and then rents it back to the previous owner, acting as a landlord, whereas Scotts Miracle-Gro sells garden equipment and fertilizers to small-time and commercial cultivators alike. Neither has a dividend that will make you rich -- Innovative Industrial's yield is about 2.8% and Scotts Miracle-Gro's is just over 1% -- but their payouts will likely cushion their stock prices a bit. 

2. Prioritize stocks with sufficient cash and cash flow

Companies without much free cash flow or much cash on hand are especially vulnerable to bear markets. If it's necessary to raise funds by issuing new stock, cash-poor companies will struggle to do so at an attractive price, especially if the cannabis industry is hit harder than others in a downturn. So smart management teams will likely defer any stock offerings until prices have stabilized or increased. This means that they may be forced to take on new debt to continue expanding their operations at the same pace as before. 

In contrast, companies with positive and growing free cash flow, like Innovative Industrial Properties and Ayr Wellness (AYRW.F -8.30%), are less likely to run into this problem. Free cash flows that are growing steadily over time tend to give the market confidence that a stock's finances are sound, which leads to better performance. If the market conditions become difficult, these companies can still expand using their cash on hand, buttressed by their profitable operations.

3. Focus on quality and avoid speculative buys

It's always good advice to buy quality stocks, but investors often need to pay for the privilege. While there's a time and a place for investing in oversold, indebted, or unprofitable companies, during a bear market is probably not it. That's especially true in the context of the cannabis industry, where there are quite a few businesses that are on a long road to profitability that they may not ever reach, like Aurora Cannabis.

Once a company is weighed down by debt and faced with falling share prices during a correction or a bear market, its management's field of options to raise cash becomes dramatically constrained. Eventually, bankruptcy may become a reality.

On the other hand, it's hard to go wrong with a firmly profitable business that's growing at a sustainable pace as a result of targeting attractive market segments and executing plans efficiently. For cannabis stocks, there is an important caveat when it comes to evaluating "quality": Look for competitors that are growing based on the non-adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA).

Many cannabis cultivators include the adjusted figures in their financial reporting, which is calculated with the help of accounting allowances to minimize the effect of swings in cannabis prices. In a bear market, the difference could be palpable, so stick to the stocks where management can demonstrate profitability and earnings growth without any extra slack from accounting tricks.

Alex Carchidi has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Ayr Wellness, Innovative Industrial Properties, and Scotts Miracle-Gro. The Motley Fool has a disclosure policy.

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Stocks Mentioned

The Scotts Miracle-Gro Company Stock Quote
The Scotts Miracle-Gro Company
$82.01 (1.42%) $1.15
Aurora Cannabis Stock Quote
Aurora Cannabis
$1.61 (-3.01%) $0.05
Innovative Industrial Properties Stock Quote
Innovative Industrial Properties
$96.37 (2.13%) $2.01
Ayr Wellness Inc. Stock Quote
Ayr Wellness Inc.
$4.60 (-8.30%) $0.42

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