Marijuana's Catch-22: Is There No Way for Cannabis to Succeed?

By Markets Fool.com


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By most accounts, the marijuana industry is growing like a weed.Since California became the first state to legalize medical cannabis in 1996, two dozen additional states have also legalized medical pot, and four states -- Colorado, Washington, Oregon, and Alaska -- along with Washington, D.C., have legalized the sale of recreational marijuana.

This is pretty exceptional considering that public support for the nationwide legalization of marijuana stood at just 36% in 2005. Today, according to Gallup's most recent poll, 60% of Americans approve of the idea of fully legalizing marijuana.

The industry and state governments appear to be benefiting, as well. A recently released financial report from Cowen & Co. estimated that legal pot sales are currently worth $6 billion, with the investment bank predicting that legal sales could explode to $50 billion by 2026. For you math-phobic people, that's a compounded annual growth rate of nearly 24% over the next decade.

In Colorado, the government wound up adding $135 million in marijuana tax and licensing revenue to its coffers in 2015, with sales of legal weed topping $1 billion on a trailing 12-month basis. Looking ahead, the November elections will feature nine states voting on a marijuana initiative, five of which are looking to legalize recreational pot.

California, one of the five states voting on recreational cannabis, is of particular importance because the state itself represents the eighth-largest GDP in the world. If approved, California could generate approximately $1 billion in extra revenue per year thanks to recreational marijuana tax revenue.

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Yet, in spite of this seemingly rapid growth, the cannabis industry could be facing a Catch-22 that ensures it struggles to expand no matter what the future holds for the drug.


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If the status quo continues...

It might seem as if the cannabis industry would be just fine if the status quo were to continue. However, the industry is facing a number of inherent disadvantages that could make long-term success a major challenge.

As a refresher, earlier this year the U.S. Drug Enforcement Agency rejected two petitions that had called for a rescheduling of marijuana from its current schedule 1 (i.e., illicit) status to something less stringent. The DEA claimed in its rejection of the petitions that marijuana had no medical benefits, no clear studies to back up any claim of medical benefits, and that the chemical composition of marijuana was still largely unknown, making the safety of cannabis-based medicines difficult to understand. Because of this rejection, and the fact that the DEA often takes years to review marijuana's scheduling (this wasn't the first request to reschedule marijuana), it's likely the drug will remain as schedule 1 for some time to come.

What does this mean? To begin with, it relegates expansion to statewide ballot initiatives, referendums, or the legislative process. This is a potential problem given that 14 of the 25 states that haven't legalized medical cannabis don't have the initiative and referendum process available. Half of these states tend to lean Republican -- which is a party that often opposes marijuana's expansion -- while the legislatures in the remaining seven states are politically divided, meaning expansion in more than a dozen states may be unlikely.

Additionally, most financial institutions want nothing to do with the pot industry because they fear future prosecution from the federal government. Even though most legal states have extensive workarounds that banks can use to offer basic banking services, such as checking accounts and lines of credit, to cannabis-based businesses, just 3% of the nation's roughly 6,700 financial institutions are currently working with the cannabis industry. This forces most marijuana companies to deal solely in cash, which is both a security concern and an expansion inhibitor.

Pot businesses also face a big disadvantage come tax time. U.S. tax code 280E disallows businesses that sell illicit substances from taking normal business tax deductions. In other words, as long as marijuana remains a schedule 1 substance, the businesses that sell legal marijuana products are almost assuredly going to be unable to take any corporate income tax deductions, requiring them to pay tax on their gross profits instead of net profits. This, too, constrains industry expansion.


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If marijuana is rescheduled...

But the real Catch-22 becomes apparent when examining what would happen if the DEA adjusted its scheduling on marijuana and moved it to schedule 2. In one respect, a schedule 2 status would recognize cannabis as having medical benefits, which is something the medical marijuana community has fought for over a long period of time. However, it would also open Pandora's Box.

Moving pot to schedule 2 would push a potential laundry list of regulations on the medical marijuana industry by essentially putting the drug under the tight control of the U.S. Food and Drug Administration. A schedule 2 drug is considered to be highly addictive, and would therefore be closely regulated by the FDA.

For example, the FDA would be able to approve and regulate the labeling and packaging of marijuana, which could include changes to the manufacturing and marketing process for cannabis companies to ensure it stays out of the hands of minors and is not misidentified as something else (edible marijuana products vs. non-marijuana foods, as an example). The FDA could also closely monitor the growth and processing of marijuana as it does in a similar fashion with the manufacturing of pharmaceutical products.

But the biggest potential issue if marijuana is rescheduled is that the FDA could require cannabis businesses to demonstrate via FDA-approved studies that medical cannabis provides the benefits that the industry has implied. There have been smaller clinical studies examining cannabis that have shown benefits in treating epilepsy, type 2 diabetes, certain types of cancer, and Alzheimer's disease, to name a few ailments -- though none of these studies were to the standards that the FDA will accept. Most have been conducted by researchers at universities or hospitals. If the cannabis industry is forced to run expensive clinical trials, it could run most small players out of business.


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Investors can't win under either scenario

No matter what the future holds for the cannabis industry, barring a full de-scheduling of the drug, investors are likely to lose out.

If the status quo continues -- which should be expected for at least a few years after the DEA recently declined to reschedule marijuana -- marijuana companies will likely face major tax disadvantages and ongoing financing and expansion concerns. The status quo does have the benefit of allowing small businesses to thrive, but there's very little in the way of viable investment opportunities for investors to consider since most businesses are quite small.

If the drug is de-scheduled, big companies could prevail, but they'd still probably struggle with tight regulations and higher costs. These costs are expected to be passed along to the consumer and would probably widen the cost disparity between the legal marijuana market and the black market.

As long as this Catch-22 exists, marijuana remains an investment opportunity best left untouched.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.

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