Cannabis is an industry that investors have been staying far away from for a while. A lack of any progress on federal marijuana legalization has led to some significant sell-offs. Since 2021, shares of Cresco Labs and Trulieve Cannabis are down about 88%. Curaleaf (CURLF 5.26%) stock has cratered 77%. Green Thumb Industries has technically outperformed the sector, but investors aren't feeling great about its 73% decline, either.
It's been nothing short of a bloodbath for these stocks. Many investors appear to be waiting for more favorable market conditions, possibly even waiting for legalization to occur first. But waiting until legalization to invest in this growing industry could be a big mistake.
Legalization might not help cannabis companies succeed
The temptation for investors may be to wait for legalization, but a legal pot market could drastically change the landscape for the cannabis industry. A big hurdle for multi-state operators (MSOs) in the U.S. right now is that they can't move products across state lines due to the federal ban on pot. They also have limited access to banking services, resulting in marijuana businesses carrying excessive levels of cash, which can make them targets for armed robbery.
Legalization would solve those problems but it would create new ones as well. For one, it could pave the way for much more competition. Large companies from other industries, for instance, could enter the industry (either directly or through investments) and shake it up entirely. As of now, due to the illegality of marijuana, many companies simply avoid cannabis to ensure they don't get crosswise with lawmakers, which would jeopardize not just their banking relationships, but potentially their listings on major stock exchanges as well.
With legalization would come much more red tape and taxes, both of which could make it more difficult for them to turn a profit. According to MjBizDaily, in Canada (where marijuana is legal at the national level), one of the largest creditors of insolvent cannabis businesses is the federal government, which includes the Canada Revenue Agency -- it collects taxes.
Legalization will, at the very least, complicate matters for cannabis investors by bringing in many new variables to account for, potentially making it even more difficult to pick winners.
The case for investing in MSOs before legalization
Right now, many pot stocks are beaten down and trading at incredibly low multiples to sales. Here are just a few examples of cannabis companies that could prove to be bargains in the future:
Data source: YCharts
These valuations are arguably unwarranted given that this is still a growing industry. And while there are challenges for these companies, there are still more states that could legalize recreational marijuana in the future, including Florida and Pennsylvania, which would open up more growth opportunities for them as well.
The nature of pot stocks is that they generally go up and down together. And when there isn't a catalyst to get investors excited about them (e.g., prospects for legalization), the shares tend to fall, which is the direction they have been going in for the past couple of years. If there is hope that legalization will be on the way, that's when the bullishness could return to the industry, leading these stocks to trade at much higher multiples of revenue.
Waiting until legalization happens will mean that investors potentially miss out on the ramp-up in valuations and the increase in share prices. It's one of the main reasons the world's smartest investors suggest not trying to time the markets, because by doing so, you risk waiting too long. Benjamin Graham, who was Warren Buffett's teacher, has famously said that "the intelligent investor is a realist who sells to optimists and buys from pessimists." Right now, there are plenty of pessimists in the cannabis industry, which is precisely why it can be opportune to buy.
Should you invest in pot stocks?
Investing in pot stocks comes with plenty of risks. While there could be opportunities for some of these stocks to generate sky-high returns, many of them won't. Investors who want to invest in the industry should know that the risk is high, and focus on leading businesses that have strong market presences and that are in good financial shape.
Curaleaf is a good example. It has generated positive operating cash flow in three of the past four quarters. It's also a top company in the industry with more than $1.3 billion in revenue during the trailing 12 months, and it has a strong position in 19 states, operating more than 150 dispensaries. That's a leading company and one that could benefit from a more optimistic outlook for the cannabis industry. It's just one example of a stock that may prove to be a good buy at its current valuation.
There will always be some risk in this industry, but you can reduce it by focusing on investing in companies that have strong fundamentals.
