5 Things That Really Matter When Investing in Marijuana Stocks

The marijuana industry has come an incredibly long way in a short period of time.

During the mid-2000s, just a third of all Americans polled by Gallup favored the idea of legalizing marijuana on a national level. As of 2018, 2 out of 3 Americans now favor such a move. This favorability toward pot is a big reason we've witnessed an increase in state-level legalizations. Following midterm elections, 32 states have now given the green light to medical marijuana, with 10 of those states also allowing adult-use weed.

Advancements have been even more impressive in our neighbor to the north. In June, Canada passed the Cannabis Act, which put an end to nine decades of recreational pot prohibition. With adult-use cannabis now legal, marijuana stocks are scrambling to get their piece of a multibillion-dollar pie.

Here's what really matters when investing in pot stocks

But what a lot of folks overlook is that there's more to investing in pot stocks and analyzing the marijuana industry than just aggregate cannabis production. If peak production were all that mattered, Aurora Cannabis (NYSE: ACB) would clearly be the largest marijuana stock by market cap, trailed by Canopy Growth (NYSE: CGC) and Aphria. Of course, that's not how things have shaped up -- and the reason for that is there are five far more important things that matter when investing in marijuana stocks.

1. Product diversity

Far more important than peak production is a cannabis grower's product diversity. Although there's little precedence to legalizing recreational marijuana, what few instances we have seen in states like Colorado, Washington, and Oregon have led to rampant oversupply of dried cannabis flower, and a precipitous decline in the per-gram price of weed. Canadian pot stocks that rely too heavily on dried flower run the risk of having their operating margins trampled in just a few years' time.

Rather, companies that focus on higher margin alternative products will be in considerably better shape over the long run. Sure, investors may love Canopy Growth for its annual peak production potential of around 500,000 kilograms, but it's Canopy's acquisition of Colorado-based hemp research company ebbu, and its fast-growing softgel capsule line, that'll be responsible for buoying the company's margins if dried cannabis flower oversupply becomes a reality in Canada.

2. International expansion

Most folks have cheered Canada's legalization of recreational pot. But what they may not realize is that legalization is about way more than just meeting domestic demand.

According to Health Canada, domestic weed demand is only expected to be about 1 million kilograms per year. However, aggregate annual production from the nation's largest growers could well exceed 3 million kilograms within the next two or three years. This means that more than half of all sales are likely to come from foreign markets that have legalized medical marijuana in some capacity. Therefore, pot stocks that have focused on international expansion are in good shape to succeed.

Whereas Aurora Cannabis looks poised to lead all growers in peak annual output, it's the company's presence in 22 countries that's far more impressive. Aurora's creation of a joint venture with Alfred Pedersen & Son in January 2018 should prove especially important. This joint venture will see 1 million square feet of existing vegetable-growing facilities in Denmark retrofitted to cannabis production. The roughly 120,000 kilograms of peak annual output will allow Aurora Cannabis to supply Denmark, and other countries in the Scandinavian region, with high-quality cannabis products.

3. Profits

Now that recreational marijuana is legal in Canada, earnings reports actually matter!

Earlier this year, pot stocks dazzled investors with promises of product diversity, partnerships, and higher output potential. Until recently, Wall Street and investors bought those promises without batting an eye. But things are different now with cannabis having been legalized, and it's time for marijuana stocks to demonstrate to investors that they can live up to those lofty promises.

To date, very few marijuana stocks are profitable, and it's liable to stay that way in 2019 as growers and ancillary businesses spend liberally on building their businesses. There are, of course, a few exceptions.

For example, Innovative Industrial Properties (NYSE: IIPR), a cannabis-based real estate investment trust (REIT), has been profitable for many quarters now. Innovative Industrial Properties own 10 cannabis properties in the U.S. that either grow and/or process medical pot. What's more, the company leases out its cannabis assets for a span of 15 to 20 years, with built-in rental increases and management fees. In other words, Innovative Industrial Properties is a well-oiled cash machine, and its stock performance this year proves it.

4. Financing

Something else that's far more important than production figures is the financial condition of pot stocks -- more specifically, how much cash they have on hand.

As noted, marijuana stocks are probably going to lose quite a bit of money in the coming quarters as they work to finish capacity expansion projects, develop and launch new products, market existing products, build up their brands, expand internationally, and acquire complementary businesses. This suggests that many will be cash flow negative next year.

The reason this is so important is simple: Access to nondilutive means of financing has been limited. If marijuana stocks need to raise capital, they could wind up diluting existing shareholders into smithereens. Marijuana stocks that have a boatload of cash on hand are less likely to dilute investors in the near term with a capital raise than those with dwindling cash piles. It's something investors will want to closely monitor.

5. Partnerships

Lastly, partnerships are growing in importance for the cannabis industry. Not only does landing a brand-name partner add legitimacy to the marijuana industry, but it opens new sales channels internationally and via product development.

A little more than a week ago, Altria (NYSE: MO) announced that it'd be taking a $1.8 billion equity stake in Cronos Group (NASDAQ: CRON), the first pot stock to uplist to a major U.S. exchange. Altria has seen years of declining cigarette volume in the U.S., and the maker of Marlboro cigarettes is looking for a new means to boost its top- and bottom-line results. With electronic cigarettes failing to pack the growth punch that was once forecast of them, Altria appears content to use its abundant operating cash flow to take a stab at the fast-growing weed industry.

As for Cronos Group, it lands a tobacco producer with very deep pockets and decades of knowledge about how to reach consumers. Not to mention, it'll put $1.8 billion into Cronos' coffers once the deal closes, thereby ending any near-term cash concerns.

In sum, there's more for investors to concern themselves with than just aggregate production.

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