Canada's Recreational Marijuana Approach Is Pure Genius, but It Would Never Work in the U.S.

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The legal marijuana industry is seemingly expanding by leaps and bounds these days. What was once illegal throughout North America a little over two decades ago is now being legalized in dramatic fashion.

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In the United States, 28 states have legalized medical cannabis since 1996, and voters in eight states have given the green light to recreational pot since 2012. In fact, if not for Arizona falling 2% short of passage with its recreational-weed initiative, the pot industry would have been a perfect nine-for-nine this past November on Election Day.

Even more recently, our neighbors to the south announced that they were legalizing medical cannabis. That's no small accomplishment for Mexico considering that the Catholic church is opposed to expanding marijuana use.

And now, Canada, which legalized medical marijuana all the way back in 2001, is seriously considering legalizing recreational weed for adults. A recently introduced bill by Prime Minister Justin Trudeau would allow Canadians ages 21 and up to legally purchase and carry up to 30 grams of marijuana (just over an ounce) beginning on July 1, 2018.

The proposal also has a home-grow option of up to four cannabis plants per household. If it becomes law, Canada would be the first developed country to legalize recreational weed, and only the second country worldwide to do so, behind Uruguay. 

Canada's recreational weed bill is pure genius

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But there's another component to Canada's recreational bill that makes it pure genius. According to Trudeau, though a number of finer points of the bill are still being debated, one of its core components would be a very low sales tax rate on recreational cannabis. Why, you ask? Trudeau's primary focus isn't on revenue generation for Canada, so much as weeding out (pun intended) the black market in his country. 

Price is easily the biggest differentiating factor between legal weed and under-the-table cannabis. People who operate in the black market don't have to worry about paying taxes on the sale of their products, nor do they typically have marketing costs, or traditional brick-and-mortar expenses from having a physical store location. Legitimate businesses do have to contend with these fees and taxes, making it difficult to contend with under-the-table pricing. By settling on a very low sales tax rate, Trudeau believes he'll be giving producers and retailers a reasonable chance of quickly squashing black-market sales by being price-competitive.

Low taxes are a key to success for legal pot sales, but it's also why an identical plan simply wouldn't work in the United States. In the U.S., state governments are very much influenced by the sales tax and licensing revenue generated by legal weed sales when passing legislation. Given how many budget holes there are among the 50 U.S. states, convincing states to lower taxes would be next to impossible.

Take Colorado, as a good example. Colorado was one of the first two states to have legalized recreational weed, and last year, it totaled more than $1.3 billion in total pot sales, a better than 30% year-on-year increase. Tax and licensing revenue generated within the state nearly hit $200 million, which is being funneled to the education system, law enforcement, and in-state drug-abuse programs. Colorado very much needs this tax and licensing revenue.

But as ArcView Market Research data has shown, an estimated $46.4 billion in North American marijuana sales last year -- 87% of total weed sales -- derived from the black market. The higher U.S. taxes are, the more likely the black market will continue to thrive. Making taxes an afterthought in its legislation gives Canada's bill a real shot at legitimizing the cannabis industry... if the bill passes.

Canada's recreational marijuana bill has three major problems

The key word in the previous sentence is "if." Right now, Canada is debating Trudeau's bill, and there are three components to the opposition that could halt or delay its progress

To begin with, conservatives in Canada's Parliament are concerned about the home-grow option in the current bill. While it would only make sense for a recreational legalization bill to allow households to grow their own cannabis, conservatives contend that it would give minors easier access to weed. Adolescent access to pot has long been a sticking point when trying to legalize adult-use marijuana throughout Canada and the U.S.

Secondly, conservatives are also concerned about drivers being impaired behind the wheel. With alcohol, there's a very cut-and-dried method of determining if a person is impaired: a breathalyzer test, along with a field sobriety test. There's a well-defined barrier of 0.08% blood-alcohol content that draws a line in the sand for law enforcement in the U.S. between legal and illegal.

There are no guidelines when it comes to testing for tetrahydrocannabinol (THC), the psychoactive component of cannabis. THC stays in the body for days or weeks, potentially leading to positive readings well after a person has used a cannabis product.

The final issue, which is almost unbelievable, is that Canada may not be able to meet the demand of consumers if marijuana is legalized on July 1 of next year. A handful of its most established medical marijuana producers, such as Canopy Growth Corp. (NASDAQOTH: TWMJF) and Aphria (NASDAQOTH: APHQF), are exporting their product (legally) to overseas markets, which could leave the domestic Canadian market short of supply, and open the door for the black market to continue thriving. 

Canadian marijuana stocks have a shot at success, but a big "if" remains

Canadian consumers are at the center of this debate, along with a handful of cannabis growers. These growers have been aggressively boosting production capacity in response to growth in the medical cannabis market and the expectation that lawmakers would legalize adult-use weed in Canada.

The aforementioned Canopy Growth Corp. is not like its peers in that it's been expanding primarily by acquisition. Its recent purchase of Mettrum Health gave it access to roughly half of all of Canada's medical cannabis customers, and its acquisition of 472,000 square feet of property surrounding its headquarters gives it a means to boost production capacity.

By comparison, Aphria, Aurora Cannabis (NASDAQOTH: ACBFF), and MedReleaf (NASDAQOTH: MEDFF)(TSX: LEAF) have mostly been expanding the old-fashioned way -- organically. Aphria, which is one of the few companies allowed to export its product beyond Canada, is working on a $100 million project known as Phase IV that'll boost capacity to 1 million square feet. Phase IV will boost production to an estimated 75,000 kilograms of cannabis a year.

Aurora Cannabis is working on the Aurora Sky project, which will increase grow capacity from less than 100,000 square feet to nearly 900,000 square feet. Aurora claims it'll be the most automated and high-tech grow operation in the world when completed. Finally, MedReleaf is using the money it raised from its recent initial public offering to expand its Bradford, Ontario facility. 

There's plenty of excitement surrounding these pot stocks. Aphria has delivered five consecutive quarterly profits. Meanwhile, Canopy Growth and MedReleaf will both deliver full-year profits in 2017. These Canadian growers are mostly profitable to begin with (albeit marginally at the moment), and legalizing recreational marijuana would really crank up their margins.

But the big "if" remains: Will Canada's Parliament pass Trudeau's bill? Trudeau has been claiming that he'd legalize adult-use cannabis for years to no avail, so there's still plenty of reason to doubt that Canada will succeed in its efforts to legalize. Canada may have what looks to be a smart foundation for its recreational pot bill, but it's going to take time -- and the passage of this bill -- before I'd suggest giving Canada's marijuana stocks a real look for your investment portfolio.

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Sean Williams has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.