Global marijuana markets are (pardon the pun) growing like a weed. Worldwide spending on cannabis is on pace to top $24 billion in 2019, according to data gathered by Statista. The total is projected to increase to $63.5 billion by 2024, for a compound annual growth rate (CAGR) of 21%. With this type of impressive growth, it's no wonder that many investors are interested in publicly traded cannabis stocks.

What's the best approach to marijuana investing? There are seven key steps:

  1. Understand the types of marijuana products.
  2. Know the different types of marijuana stocks.
  3. Understand the risks of investing in marijuana stocks.
  4. Know what to look for in a marijuana stock.
  5. Evaluate the top marijuana stocks and exchange-traded funds (ETFs).
  6. Invest carefully.
  7. Monitor changing industry dynamics closely.

Here's all you need to know about this seven-step process for investing in the fast-growing marijuana industry.

Marijuana leaf on top of a $100 bill

Image source: Getty Images.

1. Understand the types of marijuana products

There are two broad categories of cannabis products:

  • Medical marijuana
  • Recreational marijuana

Medical marijuana

Also referred to as medical cannabis, medical marijuana currently is broadly legal in 33 U.S. states plus the District of Columbia, and in over 30 countries. A prescription from an authorized healthcare provider typically is required for patients to obtain medical marijuana; it's frequently prescribed for anxiety, depression, pain, and stress. Medical marijuana can be inhaled either by smoking dried flower, or vaping concentrates. It can be consumed via edible products that contain marijuana or cannabis-infused beverages. There are even topical creams and lotions containing marijuana or chemical ingredients from cannabis.

One of the most commonly used medical marijuana products is cannabidiol (CBD), which is among many chemicals in the cannabis plant known as cannabinoids. CBD doesn't have the psychoactive properties of another important cannabinoid, delta-9 tetrahydrocannabinol (THC), but appears to offer several potential health benefits. In June 2018, the U.S. Food and Drug Administration (FDA) approved the first CBD-based drug, Epidiolex, for treating two rare forms of epilepsy, Dravet syndrome and Lennox-Gastaut syndrome (LGS).

The FDA has approved three THC-based drugs -- Marinol, Cesamet, and Syndros -- for the treatment of chemotherapy-induced nausea and vomiting. Marinol and Syndros also received approval for treating AIDS-related anorexia. However, all three drugs are manufactured using synthetic THC rather than compounds from marijuana plants.

Recreational marijuana

Eleven U.S. states plus the District of Columbia have legalized recreational marijuana for adult use so far. Uruguay legalized recreational weed at the national level in 2013. The Canadian parliament voted to legalize recreational marijuana, and that market opened for business in October 2018.

As you might expect, users of recreational marijuana products tend to prefer the psychoactive attributes of THC. Smoking cannabis flower is the most common method of use in key U.S. states that have legalized recreational marijuana. However, vaping concentrates and consuming cannabis edibles have grown in popularity.

2. Know the different types of marijuana stocks

Just as there are different types of marijuana products, there are also different types of marijuana stocks. The three primary types of pot stocks are:

  • Cannabis growers and retailers: These companies, which include Canopy Growth and many others, cultivate cannabis (often in indoor facilities and greenhouses), harvest the crops, and distribute the end products to customers. Some also focus on operating retail stores for selling medical and/or recreational cannabis.
  • Cannabis-focused biotechs: These are biotechs (such as GW Pharmaceuticals) that focus heavily on developing cannabinoid drugs.
  • Providers of ancillary products and services: These companies support marijuana growers by providing products and services such as hydroponics products and lighting systems, a key area of focus for Scotts Miracle-Gro; packaging solutions; and management services.

3. Understand the risks of investing in marijuana stocks

Investing in any type of asset comes with some degree of risk. However, investing in marijuana stocks has several risks that you should understand.

Legal and political risks

Probably the most important risk to note is that the sale of marijuana remains illegal at the federal level in the U.S. Even though cannabis businesses operate in states that have legalized marijuana for either medical or recreational purposes, there's a threat that the U.S. Department of Justice could clamp down at any time.

This risk was underscored in January 2018 when U.S. Attorney General Jeff Sessions rescinded Obama administration policies that had largely restrained the federal government from intervening in states that legalized marijuana. These Obama-era policies included the Cole memorandum, which instructed federal attorneys to defer to state and local authorities in most cases when it came to prosecuting marijuana-related activities.

Since then, political support has increased for legalizing marijuana at the federal level in the U.S. A bill to do so has gained significant support from both Democrats and Republicans. However, there's no guarantee at this point that this legislation will become law.

In addition, current U.S. federal law places severe restrictions on banks and financial institutions that deal with marijuana-related businesses. As a result, it can be difficult for many U.S. cannabis businesses to raise capital through borrowing, or even to have checking accounts. Although legislation that would ease these restrictions passed the U.S. House of Representatives, it wasn't taken up for review in the U.S. Senate.

Supply-demand imbalances

Many pot stocks have sky-high valuations (what the market thinks the companies are worth), based on expectations of tremendous growth over the next few years. But there's a clear and present danger to achieving those growth expectations: the likelihood of a big supply glut, particularly in Canada.

Most, if not all, of the licensed marijuana growers in Canada have undertaken major expansion initiatives to increase production capacity. While demand should remain greater than supply in Canada in the first year or two after recreational marijuana is legalized, the situation won't last indefinitely. A supply glut in the country is almost inevitably on the way.

What would a supply glut mean for marijuana growers? When supply outstrips demand, prices usually fall. In this scenario, marijuana growers could find their revenue and earnings decreasing, which would likely result in their stock prices falling as well.

The good news: The global demand for marijuana is expected to increase significantly. Germany's medical marijuana market is a key source of this growth, because the country legalized medical cannabis in 2017 and it has the largest population in the European Union. Other countries with large populations that have legalized medical cannabis, such as the United Kingdom, could also drive higher demand.

The bad news: It's quite possible that the increase in global cannabis demand won't happen quickly enough to absorb the ramp-up in capacity by marijuana growers. That would mean that Canadian pot growers would still face the supply-glut scenario, which would likely cause their stock prices to drop.

Over-the-counter (OTC) stock risks

You also should be aware of the risks associated with buying over-the-counter (OTC) marijuana stocks. Companies that are listed on major stock exchanges -- which in the U.S. are the NYSE (New York Stock Exchange, a subsidiary of Intercontinental Exchange) and the Nasdaq -- must adhere to rules that require them to file regular financial statements and maintain minimum market caps (the total value of outstanding shares). These reporting requirements help investors better assess the risks of buying the stocks, while the market-cap requirement helps ensure an acceptable level of liquidity (how easily the stock can be bought or sold without impacting its price). OTC stocks don't have to meet these requirements.

The problem is that many marijuana stocks are only available through OTC trading, rather than through major stock exchanges. It should be noted that while several Canadian stocks are only available over the counter in the U.S., they do trade on Canadian stock exchanges that have financial reporting and minimum market-cap requirements.

4. Know what to look for in a marijuana stock

Treat marijuana stocks like any other stock you'd consider buying. Research the management team, examine the company's growth strategy and competitive position, and check out its financial status. If the business isn't profitable yet, you'll want to make sure that its cash position -- which includes cash, cash equivalents, and short-term investments -- is enough to fund operations well into the future. If it isn't, the company might need to raise cash through a stock offering (and those additional shares would make the value of existing shares decline), or through borrowing (and higher interest costs could place a financial strain on the business).

For marijuana growers, there are unique factors that you also should look into. Find out about the all-in cost of sales per gram, and the cash cost per gram for producing cannabis. The all-in cost of sales per gram includes costs of producing cannabis, while the cash cost per gram excludes amortization, packaging costs, and inventory adjustments. A company with lower costs will be in better shape to compete in times when supply exceeds demand.

Because a supply glut is very likely to impact Canada in the not-too-distant future, checking out the international operations of Canadian marijuana growers is also a prudent move. If a company already has distribution agreements and operations in place in Germany or other high-population countries, it's likely to experience more growth than companies that don't.

In addition, research how many warrants and convertible securities have been issued by the company. Warrants give investors an option to buy shares in the future. Convertible securities can be converted in the future into shares of common stock; for example, convertible debentures start off as loans, but can later be converted into stock. A high number of warrants or convertible securities could mean that the stock will be diluted in the future, potentially causing the share price to drop. Some Canadian marijuana growers have used these methods of raising cash extensively.

5. Evaluate the top marijuana stocks and ETFs

Now for the fun part: digging into the top marijuana stocks. You might also want to check out marijuana-focused exchange-traded funds (ETFs).

Below is a list of top marijuana stocks and ETFs to consider. Note that this list isn't comprehensive, and only includes marijuana stocks with a market cap of at least $200 million.

Type

Company

Market Cap

Marijuana growers and retailers

Canopy Growth Corporation (NYSE:CGC) $7.2 billion
Aurora Cannabis (NYSE: ACB) $2.7 billion
Cronos Group (NASDAQ: CRON) $2.4 billion
Tilray (NASDAQ: TLRY) $1.9 billion
Green Thumb Industries (OTC: GTBIF) $1.8 billion
Aphria (NYSE: APHA) $1.3 billion
Charlotte's Web Holdings (OTC: CWBHF) $915 million
Cresco Labs (OTC: CRLBF) $706 million
HEXO (NYSE: HEXO) (TSX: HEXO) $569 million
Organigram Holdings (NASDAQ: OGI) $406 million
Auxly Cannabis (OTC: CBWTF) $296 million
Medical Marijuana (OTC: MJNA) $218 million

Biotechs

GW Pharmaceuticals (NASDAQ:GWPH) $3.1 billion
Cara Therapeutics (NASDAQ: CARA) $783 million
Corbus Pharmaceuticals (NASDAQ: CRBP) $312 million

Ancillary providers

Scotts Miracle-Gro (NYSE:SMG) $5.7 billion
Neptune Wellness Solutions (NASDAQ: NEPT) $255 million

ETFs

ETFMG Alternative Harvest ETF (NYSEMKT: MJ) $694 million*
Horizons Marijuana Life Sciences ETF (OTC: HMLSF) $441 million*

*Reflects net assets. All data as of Dec. 11, 2019. Data source: Yahoo! Finance.

I'll highlight one stock (or ETF) from each category that I think warrants special consideration.

Grower: Canopy Growth

My view is that there are several good reasons why Canopy Growth is the biggest marijuana grower in terms of market cap. The company has an experienced management team and a huge production capacity, with 10 facilities together claiming more than 4.3 million square feet of growing space. Although Canopy no longer reports its costs per gram, they were very competitive the last time it reported, and the company says that these costs "have been trending lower" as it increases its scale.

Canopy has recreational-marijuana supply agreements lined up with all 10 Canadian provinces. It's also one of the best-positioned marijuana growers in international markets. In particular, the company has a strong foothold in the German medical marijuana market. Canopy currently has operations in 15 countries, including Canada, spanning five continents.

What really separates Canopy Growth from its peers is the company's relationship with major alcoholic-beverage maker Constellation Brands. Constellation invested $4 billion in Canopy in 2018 and named the company as its exclusive global cannabis partner.

Canopy Growth isn't profitable yet because it's investing heavily in expansion efforts. The big investment by Constellation gives Canopy a huge cash stockpile to expand even more into new markets.

Biotech: GW Pharmaceuticals

GW Pharmaceuticals is the first biotech to win FDA approval for a marijuana-plant-based drug -- Epidiolex, launched in the U.S. in late 2018.

U.S. sales for Epidiolex have soared even higher than most analysts predicted. GW also won European regulatory approval for the drug in treating Dravet syndrome and Lennox-Gastaut syndrome. The biotech is conducting clinical studies in the hopes of winning additional approved indications for Epidiolex.

Most of the company's executives have at least two decades of experience in the pharmaceutical industry. They're familiar with launching new products, including GW's multiple sclerosis drug Sativex, which is approved in more than 25 countries outside the U.S.

GW Pharmaceuticals isn't profitable at this point. However, the company should have plenty of cash on hand to fund operations while Epidiolex sales grow.

Ancillary provider: Scotts Miracle-Gro

My favorite among the ancillary providers to the marijuana industry is Scotts Miracle-Gro. The company is the leading provider of hydroponics products to cannabis growers. Although the stock struggled in 2018, Scotts was a big winner in 2019 as recreational marijuana picked up momentum in California, and markets expanded in other U.S. states that have legalized medical and/or recreational marijuana.

Scotts is led by a veteran team including Jim Hagedorn, who has been CEO since 2001. The company is not only profitable, it pays a dividend, which currently yields 2.3%. Scotts' debt of close to $1.7 billion is higher than I'd like, but the company borrowed primarily to fund its expansion efforts -- a good thing, in my view -- and is committed to reducing its debt.

It's also important to know that Scotts Miracle-Gro isn't just focused on the marijuana market. Nearly 80% of the company's revenue comes from sales of consumer lawn and garden products. I think there's a solid long-term market in that area for Scotts, as well.

ETF: Horizons Marijuana Life Sciences ETF

Between the two marijuana ETFs included on the table, my preference is the Horizons Marijuana Life Sciences ETF. All three of my marijuana stock picks are in the top 10 holdings of this ETF, and combine to make up nearly 30% of the fund's total assets.

One knock against the Horizons Marijuana ETF, however, is that its expense ratio of 0.87% is really high compared to many other index ETFs; it's even higher than the 0.75% expense ratio of the ETFMG Alternative Harvest ETF. Also, because of the risks discussed earlier, I think most investors are better off choosing the strongest individual marijuana stocks, rather than buying a marijuana ETF that also holds weaker stocks.

6. Invest carefully

What exactly does it mean to "invest carefully" in marijuana stocks? For some, the best approach will be to avoid them entirely; these stocks simply aren't a good fit for conservative investors. Only the most aggressive investors who can tolerate high levels of risk should jump in.

Even aggressive investors should only buy in after completing the five previous steps. Marijuana stocks are both risky and highly volatile; putting too much of your investment portfolio into any marijuana stock or ETF isn't wise.

You might want to consider starting off only with a small position in a marijuana stock. As the cannabis market grows and a company's increasing revenue and earnings confirm your decision to buy the stock, you could then add to your position. If the growth you were counting on doesn't materialize, you should reevaluate your assumptions.

Also, some marijuana stocks are arguably safer than others. For example, Scotts Miracle-Gro makes most of its revenue outside of the cannabis industry. The company has been selling lawn and garden products for a long time, and in that market it doesn't face many of the risks associated with cannabis products. Less aggressive investors might prefer a stock like Scotts to a more pure-play marijuana stock like Canopy Growth.

7. Monitor changing industry dynamics closely

Generally speaking, investors are better off taking a long-term view when buying stocks. That being said, the dynamics of the marijuana industry are rapidly changing. The criteria used in making a buying decision now could be dramatically different just a few months down the road.

Because of this, I recommend that you monitor any marijuana stocks or ETFs that you buy, along with the overall industry itself, very closely and frequently. Some changes could be beneficial -- for example, potential relaxation of U.S. federal marijuana laws. Other changes, however, could be bad news, such as the possibility that European medical cannabis markets don't grow as quickly as expected.

Tremendous growth should be in store for the global marijuana industry. That growth might not come as evenly as you'd prefer, though. Following these seven steps can help you navigate this exciting and challenging opportunity.