Investing in marijuana stocks is often fraught with risk. Because cannabis is a growth industry, many of these businesses simply aren't as stable as investors would prefer.
Thankfully, there are a few pieces of wisdom that you can use to reduce your exposure to downside while helping you identify the cannabis stocks that are the most likely to soar. Let's learn about three of the most critical secrets so that you'll be better prepared to succeed when it's time to invest.
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1. The fair market price of cannabis can make or break margins
The first (and perhaps most important) cannabis stock secret is that the prevailing price of a gram of cannabis on the legal market has an outsized impact on the profitability of cannabis businesses as well as the industry's competitive landscape. Higher prices lead to wider margins (and typically higher share prices) for cultivators, and lower prices do the reverse.
In a nutshell, price fluctuations often outweigh the impact of most other factors when it comes to the performance of cannabis companies. For example, in Green Thumb Industries' (GTBIF -0.99%) third-quarter earnings in 2022, it reported that for its stores that were open for at least 12 months, revenue dropped by 1.6% year over year despite more people visiting its locations and buying more products when they visited compared to before. In other words, even when a business is executing its retail strategy successfully, unfavorable pricing and other industry factors can easily rain on the parade.
The takeaway for investors is to consider investments during times of falling cannabis prices carefully, as the risk of experiencing downside is much higher. Another takeaway is to focus on a company's performance in terms of how successfully it addresses the issues it can control rather than the big-picture numbers it reports, as figures can deceive in light of the changing prices for cannabis.
2. Large-scale operations don't guarantee large-scale profits
A second secret about cannabis investing is that bigger doesn't always mean better.
It's easy to see why investors gravitate toward the companies that claim to be the largest. Take Tilray Brands (TLRY 0.58%) for example. Its operations are spread out over several continents, and its management once boasted of being the world's biggest cannabis company by revenue and geographical footprint. In theory, that means as recreational cannabis is legalized globally, Tilray will have easy access to the newly opened markets, especially in places where it's already competing in the medicinal market, like in Germany. And grabbing as much market share as possible seems like a smart move.
But the company's financial performance tells a different story. Over the last three years of its global market penetration, its quarterly revenue only rose by 33.7%, and its shares fell by 85%. At the same time, its total expenses ballooned as a percentage of its quarterly revenue, and its gross margin deteriorated significantly, sending it deeper into unprofitability.
Those metrics would need to improve substantially before Tilray has any hope of returning capital to shareholders, and in the long run, it's very possible that they will. Still, the lesson is that scaling up operations without being profitable means burning money faster. And in many cases, shareholders end up being on the hook when businesses issue new stock to make up for overly aggressive expansion.
3. Legalization and regulatory changes could be irrelevant or a mixed bag for some companies
The final marijuana investing secret is that the popular assumption that cannabis legalization will lead to a massive rally in cannabis stocks is unlikely to be as accurate as it seems, for at least two reasons.
The most obvious reason is that not all of the publicly traded marijuana businesses compete in all the locales where regulations might change. Stock of a predominantly Canadian operator like Aurora Cannabis might see a bump when states in the U.S. legalize, but it has no ability to generate new revenue from the regulatory changes. Generally, stocks that see their valuations rise without cause are vulnerable to crashing without cause.
Another reason regulatory changes aren't all they're cracked up to be is that they can threaten the business models of established competitors. Marijuana financing companies like Innovative Industrial Properties and AFC Gamma could find it harder to attract new customers for their capital-raising services if cannabis players can raise money more readily from traditional financial institutions in the aftermath of legalization or banking reforms. Such problems are far from guaranteed, but it's something that investors need to appreciate as a risk.
