Marijuana Stocks and Biotech Stocks Share This Striking Similarity

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There are few, if any, industries that have been as unstoppable as legal marijuana in recent years. Last year alone, voters went to the polls in nine states and wound up passing medical and/or recreational weed initiatives and amendments in all but one. In just 22 years, we've gone from no states having legalized medical or recreational pot to 29 medical and eight recreational states that now allow it. 

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This expansion in the U.S., along with Canada's medical-cannabis market and Mexico's recent legalization of medical weed, has really lifted legal sales. In 2016, according to cannabis research firm ArcView, North American legal pot sales jumped 34% to $6.9 billion. By 2021, legal weed sales should total $21.6 billion, working out to an annual growth rate of 26%. It's this growth rate, and growing favorability toward marijuana according to various polls, that has marijuana stock investors excited about its future. It's also a reason so many pot stocks have vaulted by 100% or more over the past year.

The striking similarity between biotech stocks and pot stocks

The euphoria that surrounds marijuana stocks reminds me of the excitement that I've also seen from biotech investors. Biotech investing is something like Wall Street's roulette wheel. In other words, the odds are clearly against your success, with a majority of drugs failing between the discovery and clinical stages of development; however, if you invest in a company that develops a successful drug, your investment could return many times over. Pot stock investors are looking for similar returns, with legal weed sales growing as rapidly as they are.

But there's actually a more striking similarity between marijuana stocks and biotech stocks than most investors may realize -- and it has nothing to do with investor euphoria or risk-taking. It has to do with how these companies typically raise capital to further their business models.

Biotech stocks are predominantly clinical-stage companies, and close to 90% are losing money on an annual basis. That means these drug developers need a safety net of cash to ensure that they have the financial means to run clinical studies and keep the lights on while they do so. Though a number of channels exist to raise capital, such as debt or licensing deals, it's secondary stock offerings that are the most likely means of raising cash for biotech stocks.

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When it comes to marijuana stocks, the answer to raising capital is very similar: secondary offerings or bought-deal offerings. A bought-deal offering, which is a popular option for Canadian marijuana stocks, is a situation in which a financial firm agrees to purchase shares from an issuer before a prospectus is filed. In the U.S., financial institutions often want next to nothing to do with marijuana-based companies, meaning debt offerings and lines of credit may not even be an option.

This is probably bad news for shareholders

It's pretty evident why biotech and marijuana stocks complete secondary or bought-deal offerings: They need that capital to keep the lights on and expand. Drug developers need the money for research and development, and marijuana stocks are usually looking to boost growing capacity. Unfortunately, issuing shares winds up being nothing more than a necessary evil for shareholders.

Though issuing common stock raises capital, it also dilutes the value of shares held by existing shareholders. This has been particularly apparent with Canadian marijuana stocks. Here's a quick rundown of the outstanding share explosion for three of the largest medical-cannabis producers in Canada, according to data from Morningstar :

  • Aurora Cannabis (NASDAQOTH: ACBFF): 16.2 million (2014) to 279 million (2017).
  • Canopy Growth Corp. (NASDAQOTH: TWMJF): 30 million (2014) to 163.9 million (2017).
  • Aphria (NASDAQOTH: APHQF): 45.4 million (2015) to 111.4 million (2017).

Don't get me wrong: All three of these stocks have significantly increased in value over the trailing year. Investors are anticipating that Canada may legalize recreational pot by July 2018, which comes on top of rapid organic growth in the country's medical-cannabis market. This is why Aurora Cannabis, Canopy Growth, and Aphria have been eager to raise capital to expand growing capacity.

Aurora Cannabis is working on the Aurora Sky project, an 800,000-square-foot, highly automated facility that could produce 100,000 kilograms annually when fully completed.  Aphria has an equally impressive expansion known as Phase IV that'll offer 1 million square feet of capacity and in the neighborhood of 100,000 kilograms of cannabis a year.  Finally, Canopy Growth has been using its capital to buy land for expansion, as well as for acquisitions.

Nevertheless, the huge uptick in outstanding share count for these three Canadian pot stocks may very well have held back what could have been monstrous gains in their share prices had dilution not been so prevalent.

But there's also one key difference between biotech and marijuana that investors need to be aware of: One is legal and one isn't. Even though both industries offer incredible returns if you're lucky enough to be correct, marijuana is still a schedule I substance in the U.S., and recreational pot is still illegal throughout North America. In other words, the longevity of the marijuana business model is very much in question, which makes investing in pot stocks all the more dangerous. If you are going to throw your money behind the green rush, you absolutely need to be aware of the dilution risk you're liable to face as a shareholder.

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