The global medical marijuana market is projected to expand by a compound annual growth rate (CAGR) of 22.4% through 2024, according to estimates from ResearchandMarkets.com. That's a market of more than $44 billion that's ripe for the picking for companies that are ready for the challenge.

But what does it take to succeed in the medical marijuana industry? And which stocks are most likely to profit from the industry's growth and are smart picks for investors? Here's what you need to know about investing in medical marijuana.

Marijuana buds and bottle on top of prescription pad.

Image source: Getty Images.

Medical marijuana legalization

Several countries have legalized medical marijuana at the national level. Canada claims the biggest market among these countries, with estimated sales of medical cannabis in 2019 of around $1.7 billion. Germany, however, is likely to overtake Canada as the most important national medical marijuana market within the next few years because of its larger population and wide availability of access.

Marijuana has been illegal in the U.S. since the Marijuana Tax Act of 1937. It has been a Schedule I controlled substance in the U.S. since the passage of the Controlled Substances Act in 1970. Marijuana remains illegal at the federal level in the U.S. However, 33 states have legalized medical marijuana, with more potentially on the way.

California became the first state to legalize medical marijuana in 1996. But the passage of Senate Bill 420 in 2003, which established an ID card system for medical cannabis patients and allowed medical cannabis dispensaries, paved the way for California's thriving medical marijuana market.

Although California claims the largest marijuana market in the U.S., with Colorado ranking second, both states have much larger recreational marijuana markets. Florida is on track to have the largest medical cannabis market in the country with projected sales of $1.7 billion by 2022.

Medical cannabis products

Medical marijuana can be inhaled by smoking dried flower or vaping concentrates, taken orally through oils or edible products (including beverages), or applied topically using cannabis-based creams and lotions.

The two most important ingredients in cannabis used for medical purposes are cannabidiol (CBD) and delta-9 tetrahydrocannabinol (THC). While many patients use CBD products, currently only one CBD-based drug has received U.S. Food and Drug Administration (FDA) approval -- Epidiolex. GW Pharmaceuticals (NASDAQ:GWPH) obtained FDA approval in June 2018 for the CBD drug in treating Dravet syndrome and Lennox-Gastaut syndrome (LGS), both of which are rare forms of epilepsy.

Three drugs containing THC have also been approved by the FDA. Marinol, Cesamet, and Syndros won regulatory approval for treating chemotherapy-induced nausea and vomiting for cancer patients. Marinol and Syndros also received FDA approval for the treatment of AIDS-related anorexia. But while Epidiolex is made from the cannabis plant, all three of these drugs are made synthetically.

How to invest in medical marijuana stocks

One way to gain exposure to medical marijuana stocks is to buy a cannabis-focused exchange-traded fund (ETF), which can be bought and sold like an individual stock but holds multiple stocks like a mutual fund. The primary advantage of investing in such ETFs is that your money is spread across a basket of stocks, providing some downside protection to your investment if one stock plunges. There are some negatives to investing in cannabis ETFs, though, including annual expense fees that eat into your returns and the possibility that your money will be invested in some stocks that you don't like.

Investors who opt to buy individual medical marijuana stocks can choose to buy Canadian or U.S. stocks. Because marijuana is illegal at the federal level in the U.S., companies with operations that violate those laws can't be listed on the major U.S. stock exchanges. However, the stocks of these companies can be bought on less regulated over-the-counter markets and, in some cases, on smaller Canadian stock exchanges.

There are five categories of pot stocks that focus on the medical marijuana industry:

  1. Growers
  2. Extraction services providers
  3. Drug developers
  4. Distributors and dispensaries
  5. Ancillary products and services providers

Growers

Marijuana growers set up greenhouses or indoor facilities where they cultivate plants, which they harvest and then process into products for distribution and sale.

Extraction services providers

These companies extract chemical ingredients from cannabis plants (called cannabinoids), such as CBD and THC, that are used in medical cannabis products.

Drug developers

Cannabis-focused biotechs and pharmaceutical companies develop medicines that are made from cannabinoids. Some companies use cannabinoids extracted from cannabis plants, while others manufacture the cannabinoids synthetically.

Distributors and dispensaries

These companies distribute medical cannabis products produced by growers to retail dispensaries that sell the products to patients. In some cases, the same company that grows medical cannabis also runs distribution operations and dispensaries.

Ancillary products and services providers

Ancillary products and services providers support the other types of medical marijuana businesses by providing products and services that are needed to do business. These products and services can range from consulting and administrative services to fertilizers, hydroponics (growing plants in water), and lighting systems used in cannabis cultivation.

What to look for in medical marijuana stocks

In evaluating whether a medical marijuana stock will deliver exceptional returns in the long run, investors should consider many of the same attributes they would for any publicly traded stock: financial status, growth opportunities, and competitive position.

Many medical marijuana companies aren't yet profitable. While that shouldn't disqualify these stocks from consideration for inclusion in your portfolio, the companies should have a defined plan for achieving profitability in the future. When companies aren't profitable, their cash position is more important, because they might need to raise additional capital by taking on debt or issuing new shares.

The problem with increasing debt is that it could negatively impact future earnings if the amount of debt is too high. The primary concern with issuing new shares is that it could cause dilution in the value of existing shares.

One way to think of dilution is to imagine the value of the company as a pie. Issuing new shares is similar to cutting the pie into more pieces. If you had one of the pieces of the pie initially, cutting the pie into more pieces means that your piece will be smaller. That's what happens with stock dilution.

Growth opportunities can vary significantly between different medical marijuana stocks. That's especially the case when companies are limited by the geographical regions in which they can compete. For example, some Canadian companies can't establish significant operations in the U.S. and retain their listings on major stock exchanges while marijuana remains illegal at the federal level in the U.S.

Determining the competitive position of a medical marijuana stock isn't significantly different from doing so for other industries. Important factors to consider are production capacity (for growers), distribution channels, and partnerships.

Top medical marijuana stocks

Five medical marijuana stocks representing each stock category that score well on the three key evaluation criteria and appear to be top picks for investors to consider are:

Stock

Type

Market Cap

Canopy Growth (NYSE:CGC)

Grower $6.7 billion

Valens (OTC: VLNCF)

Extraction services provider $321 million

GW Pharmaceuticals (NASDAQ:GWPH)

Drug developer $3.1 billion

Trulieve Cannabis (OTC:TCNNF)

Distributor and dispensary $1.3 billion

Innovative Industrial Properties (NYSE:IIPR)

Ancillary products/services provider $871 million

Data source: Yahoo! Finance. Market caps as of Dec. 30, 2019.

Canopy Growth

Canopy Growth ranks as the largest marijuana producer in the world by market capitalization -- the total value of the company's outstanding shares. This can be found by multiplying the current price of the stock and the number of shares outstanding on the market. Canopy Growth serves the Canadian medical and recreational marijuana markets and distributes medical cannabis to multiple international markets, notably including Germany. The biggest knock against Canopy Growth is that it can't currently compete in the huge U.S. medical cannabis market.

Although Canopy isn't consistently profitable at this point, the primary reason is that the company continues to invest in building its operating platform and in expanding. For example, Canopy has increased its growing space, made acquisitions to add to its brands and retail capabilities in Canada, and bought businesses to further establish its international operations. With significant growth in global marijuana markets, Canopy should be on a path to generate profits in the future.

Further expansion will require money -- but raising capital won't be an issue for Canopy Growth. The company has a huge cash stockpile thanks to a $4 billion investment by Constellation Brands, the maker of premium beers, wines, and spirits.

The company is one of the top two marijuana producers in terms of annual production capacity, ranking behind only Aurora Cannabis. Canopy claims strong global distribution channels with subsidiaries, joint ventures, and partners that can market its products in countries across the world. And its partnership with Constellation, along with the cash the deal generated, gives Canopy a big advantage over its peers in making acquisitions to cement its leadership position within the cannabis industry.

Valens

Valens is a leading Canadian cannabis extraction services provider. The company has landed multiyear extraction agreements with several top Canadian marijuana growers, including Canopy Growth, HEXO, OrganiGram, and Tilray.

While Valens hasn't delivered positive earnings on a consistent basis in the past, the company should have a solid pathway to profitability. Its revenue will likely keep climbing, and additional efficiencies realized from higher production levels should reduce its costs as a percentage of revenue.

Medical cannabis extraction in Europe, Australia, and Latin America presents great growth opportunities for Valens. The company's top opportunity right now, though, is the second phase of Canada's recreational marijuana market, which includes cannabis derivatives products such as vapes and edibles.

Valens' contracts with top Canadian growers give it a solid competitive edge over rivals. The company also claims the largest extraction capacity in the industry.

GW Pharmaceuticals

GW Pharmaceuticals is the largest cannabis-focused drug developer. The company's first drug, Sativex, is approved in multiple countries for treating spasticity associated with multiple sclerosis but isn't yet approved in the U.S. However, GW's most successful product is CBD drug Epidiolex, which is approved in the U.S. and in Europe.

For now, GW remains unprofitable. That should change in the not-too-distant future, though. The drugmaker's revenue continues to soar thanks to strong demand for Epidiolex, and its bottom line is improving.

Epidiolex is GW Pharmaceuticals' primary growth driver over the near term. The drug should pick up tremendous momentum in key European markets. GW also hopes to win regulatory approvals in the U.S. and in Europe for additional indications, including tuberous sclerosis complex (TSC).

While there are other FDA-approved drugs on the market for Dravet syndrome and Lennox-Gastaut syndrome, Epidiolex stands as a top treatment alternative for the diseases. And because U.S. insurers don't pay for drugs that haven't been approved by the FDA, GW doesn't have to worry very much about competition from off-the-shelf CBD drugs.

Trulieve Cannabis

Trulieve Cannabis is a vertically integrated U.S.-based cannabis company that grows medical cannabis and distributes products to its fully owned retail dispensaries. The company's primary operations are in Florida, where it runs more than 40 medical cannabis dispensaries. Trulieve also has operations in California, Connecticut, and Massachusetts.

Unlike many medical marijuana companies, Trulieve has delivered quarterly profits on a regular basis for more than a year. The company's earnings growth remains strong. As a result, Trulieve boasts a solid financial position with an increasing cash stockpile.

Florida's medical marijuana market is still in its early stages and presents a major growth opportunity for Trulieve. The company also hopes to expand nationally in the U.S. and leverage its initial operations in other states with fast-growing medical marijuana markets.

Trulieve dominates the medical marijuana market in Florida. The company routinely generates close to half of the state's total medical cannabis flower sales. While there are other rivals in Florida, Trulieve appears to be in a good position to maintain its competitive lead.

Innovative Industrial Properties

Innovative Industrial Properties is the leading real estate provider of the U.S. medical cannabis industry. The company is organized as a real estate investment trust (REIT).

REITs present an attractive option for investors to profit from growth in the medical marijuana market because their risk is spread across multiple tenants. Further adding to the attractiveness of REITs, the government mandates that REITs must distribute at least 90% of taxable income to investors in the form of dividends. The good news is that Innovative Industrial Properties has plenty of taxable income to distribute thanks to its consistent profitability. The company's dividend currently yields 5.3%.

Innovative Industrial Properties currently owns properties that are leased to tenants in 14 states. The company's growth prospects include opportunities to build its customer base in the states where it currently operates and to expand into additional states in the future.

The rapidly growing U.S. medical cannabis market is attracting other REITs. However, Innovative Industrial Properties has a head start in establishing the expertise needed to develop properties for medical cannabis businesses, which gives the company a distinct competitive advantage.

Risks for medical marijuana stocks

Perhaps the greatest risk for each of these medical marijuana stocks is that the markets don't expand as quickly as expected. Fewer countries could legalize medical marijuana than has been projected. Strict regulations could be placed on the medical marijuana markets, resulting in patients seeking alternative treatments. If that happens, the stocks would likely plunge, because share prices are based more on significant expectations of future growth than they are on historical performance.

The companies that operate in the U.S. -- Innovative Industrial Properties and Trulieve -- face the possibility that the federal government could intervene in states that have legalized marijuana. That threat appears to be relatively low, however, with solid public support for marijuana legalization.

Drug developers such as GW Pharmaceuticals face the possibility that more effective drugs could be marketed that target the same diseases their cannabis drugs treat. In addition, these companies could experience clinical failures and/or fail to win regulatory approvals for new products or new indications.

Risks common to any stock, regardless of the industry, also apply to each of these medical marijuana stocks. Accounting issues, scandals involving executives, and competitive threats could hurt any of the stocks.

Due to its risky and novel nature, investing in marijuana stocks isn't suitable for all investors. Only the most aggressive investors are best suited for investing in medical marijuana. This means people who can afford to lose the money they invest in these stocks and don't need returns from their position for at least 3 to 10 years. And even these investors should proceed cautiously by limiting the size of their positions in medical marijuana stocks and diversifying across other industries.

Future of medical marijuana

Despite the risks, the long-term prospects of the medical marijuana industry appear to be very good. More countries and U.S. states are recognizing the potential benefits of medical cannabis and, as a result, allowing the legal use and sale of medical cannabis products. More individuals and the broader medical community are also recognizing these potential benefits, driving higher demand for medical marijuana. This presents a terrific opportunity for risk-tolerant investors.