Stock Market Analysis

The 3 Must-Knows of Cannabis Stock Investing

Marijuana is a high-growth industry. However, there are a few things you should know before investing in the green rush.

This article originally appears on The Motley Fool, written by Sean Williams.

For years, there wasn’t a hotter investment on Wall Street than cannabis stocks. Investors with the wherewithal and stomach to have invested in some of the most prominent pot stocks in 2016 or 2017 found themselves up, in some cases, by quadruple digits during the first quarter of 2019. In fact, more than a dozen pot stocks rocketed higher by at least 70% in Q1 2019.

Then the wheels came off the wagon. For much of the past 14 months, marijuana stocks have been some of the worst-performing equities on Wall Street. Were it not for the coronavirus disease 2019 (COVID-19) pandemic leading to a collapse in oil demand, thereby plunging many highly indebted drillers into bankruptcy or to the brink of bankruptcy, we’d still be talking about cannabis as the market’s most disappointing industry.

And yet, there’s still plenty of potential.

We know that tens of billions of dollars are conducted in black-market weed sales each year, and it’s very feasible that these dollars can be moved to legal channels over time. Most analysts on Wall Street still believe the global pot industry can reach $50 billion or more in annual sales by 2030, up from the nearly $11 billion in worldwide legal sales registered in 2018.

But if you’re going to invest in this high-growth opportunity, there are three must-knows about cannabis stocks:

1. This isn’t a get-rich-quick scheme, it’s a long-term commitment to a fast-growing industry

First of all, as I began to allude to above, the marijuana industry isn’t some get-rich-quick scheme. Although pot stocks did, at one time, have their market valuations go parabolic, that bubble has burst.

As with any relatively new industry, there are going to be growing pains. For example, Canada has been contending with supply issues since the green flag waved on recreational pot sales on Oct. 17, 2018. Some of these problems have manifested directly from the federal government, with Health Canada delaying the launch of high-margin derivatives (i.e., vapes, edibles, and infused beverages) and slow-stepping the review of cultivation and sales licenses.

But there have also been provincial-level failures, such as Ontario’s regulators leaning on an ineffective lottery system to assign dispensary licenses. We’re more than a year and a half into the legalization of cannabis, and the province with 38% of Canada’s population has just over four dozen retail locations open. That’s unacceptable, and it’s led to supply bottlenecks.

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Within the United States, aside from the fact that the federal government continues to hold firm on its stance of marijuana as a Schedule I (i.e., illicit) drug, high tax rates in a number of legalized states has been the major deterrent to growth. California may be the largest cannabis market in the world by total sales, but it’s pulverizing the pocketbooks of its consumers with a tax rate on legal product that’s well over 40%. This makes it virtually impossible for legal producers and retailers to compete with the illicit industry.

Now, this isn’t to say that the pot industry can’t thrive. It’s just pointing out that all fast-growing industries have challenges they must face and overcome and this doesn’t happen overnight. In order to realize the fruits of what the cannabis industry has to offer investors, you need to be willing to hang onto your pot stocks for years (not days!) and allow your investment thesis to play out.

2. Profitability matters

The second must-know about investing in cannabis stocks is that profitability matters… a lot!

In 2017, and prior to Canada legalizing adult-use weed in October 2018, promises of aggressive capacity expansion were more than enough to keep investors excited about the industry. But once Canada became the first industrialized country in the modern era to green-light adult-use cannabis, promises were no longer enough. With 33 states having legalized marijuana in some capacity as well, Wall Street and investors have plainly signaled that they want tangible results.

For instance, Aurora Cannabis (NYSE:ACB) has long been the most-popular pot stock, and is an absolute favorite among millennials. But the Alberta-based grower has also been losing money hand over fist, and its share price reflects this. Over the trailing year, Aurora’s stock has lost 84% of its value. In that time, Aurora Cannabis has halted construction on two of its largest projects to conserve capital, sold a 1-million-square-foot greenhouse (Exeter), laid off 500 workers, and continued to issue common stock to raise capital. Just as Aurora was aggressively boosting its capacity in 2018, it’s now back-stepping just as quickly to control its cash burn.

On the other hand, U.S. multistate operator Trulieve Cannabis (OTC:TCNNF) has been a money machine for multiple quarters now. Though Trulieve is a multistate operator, 48 of its 50 open dispensaries are located in medical marijuana-legal Florida. By concentrating its efforts in a single state, Trulieve has done an excellent job of effectively branding its products while keeping expenses down. During its most recent quarter, Trulieve’s sales totaled $96.1 million, with $28.9 million in cost of goods sold and $31.1 million in operating expenses. Without any fair-value adjustments or one-time expenses, we’re talking about operating income of more than $36 million! That’s why Trulieve’s shares are up 12% over the trailing year.

3. The U.S. is the best long-term play for investors

The third must-know about cannabis stock investing is that, while you have plenty of companies to choose from, the better long-term play is going to be U.S. pot stocks. Though Canada may have legalized adult-use weed, its peak market potential represents a fraction of what could be possible with legalization in the United States.

Does this mean you should ignore Canada? Absolutely not. However, you’re going to want to be very selective with the companies you choose to invest in. As an example, extraction-service provider Valens (OTC:VLNCF) appears set to benefit from a long-term upswing in derivative usage. Because derivatives offer considerably higher margins than dried cannabis flower, licensed producers will be emphasizing these products moving forward. However, licensed producers need companies like Valens to extract the resins, distillates, concentrates, and targeted cannabinoids used in derivatives. Valens is already profitable, which is a great sign considering that Canadian cannabis derivatives are still in their infancy.

But where the real potential lies is with U.S. cannabis stocks. Green Thumb Industries (OTC:GTBIF) is a perfect example of a company that may have what it takes to become a real long-term winner. Green Thumb has 45 open dispensaries, and licenses to open as many as 96 retail stores in 12 states. This includes Illinois, which recently legalized recreational weed and opened its doors on Jan. 1, 2020, as well as Nevada, which may lead all states on per-capita cannabis spending by mid-decade. With profitability seemingly around the corner, Green Thumb is one of a handful of U.S. pot stocks worth considering for your portfolio.

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MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Green Thumb Industries. The Motley Fool recommends Valens GroWorks. The Motley Fool has a disclosure policy.

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