7 Good Reasons You Shouldn't Buy Marijuana Stocks

The wait is nearly over. In a matter of 17 days (on October 17), recreational marijuana will be legalized in our neighbor to the north, opening the door for sales in licensed dispensaries. With this legalization comes the potential for upward of $5 billion in added annual sales once the industry is fully ramped up. It's this expectation of rapid sales growth, along with profits, that's pushed marijuana stocks ever higher since the beginning of 2016.

But as the stock market has taught investors time and time again, nothing goes up in a straight line. If you've been thinking about buying into the green rush or you're already invested and wondering what you should do with your holdings, here are seven good reasons to not buy marijuana stocks or to consider selling what you own.

1. The black market could sap demand

Perhaps the biggest concern, but one that somehow continuously flies under the radar, is the presence of the black market, even after legalization. Cannabis research firm Arcview found that the black market controlled more than 85% of all weed sales in North America by the end of 2016. Although this figure is liable to skew toward legal channels in the years that lie ahead, it's highly unlikely that black-market marijuana will cede all of its market share. The reason? Price.

In Canada, the federal government is imposing a roughly 10% excise tax atop recreational marijuana sales. This low tax rate -- comparatively, alcohol excise taxes range from 50% to 80% -- is expected to allow adult-use weed to be price competitive with the black market. Unfortunately, this probably won't be the case. Legal channels have to pay excise and income taxes, as well as licensing and sales permit fees, rent, electricity, and so on. The black market has virtually no overhead costs, and it certainly doesn't have to pay any taxes or fees. The black market should easily be able to undercut legal channels on price, making it an attractive alternative for some consumers.

California has offered an even starker example of the power of the black market. Excise, state, and local taxes in some areas of California can add up to as much as 45%, making legal pot significantly pricier than illicit sources. In a recent survey conducted by Marketview Research in California, 18% of cannabis users surveyed admitted to buying pot from an unlicensed source within the past three months. This is a big reason California's recreational marijuana market has underperformed expectations in the early going.

In short, lofty sales targets could come up short as a result of the black market.

2. Oversupply issues are likely

Aside from tax issues, the threat of oversupply is a genuine concern. Though there's little precedence for recreational legalization around the world, a handful of U.S. states do offer worrisome examples of what the future might hold.

Beginning in 2014, Colorado and Washington officially opened their doors to recreational weed sales, with Oregon and California following. In each and every one of these four states, growers have been producing cannabis at a breakneck pace. And in each instance, we've witnessed, or begun to witness in California's case, a precipitous decline in the per-gram price of cannabis.

Why are growers overproducing, you ask? Part of the answer might be that they have no clue what sort of demand to expect. Another possibility is that they want to flood the market with marijuana, push the per-gram price down, and drive out smaller players that can't survive on a smaller margin. This way, bigger players with deeper pockets can gain the upper hand. Also, growers might simply want to take advantage of high per-gram prices in the early going. Regardless of the answer, and even taking into account economies of scale (i.e., as growers expand production, their costs per gram to grow cannabis should fall), this is a recipe for lower operating margins.

3. There's too much competition and not enough differentiation

A third good reason to avoid marijuana stocks is that there's simply too much competition in the industry and not enough differentiation that allows investors to determine what companies will be winners.

One of the most popular pot stocks in recent months has been Aurora Cannabis (NASDAQOTH: ACBFF). Aurora has been using organic construction projects, strategic partnerships, and numerous acquisitions to expand its production portfolio. Following its acquisition of ICC Labs, Aurora Cannabis might be on track for between 600,000 kilograms and 700,000 kilograms of annual yield, once at full capacity. Being the top dog in production could certainly have its perks, including being a go-to partner for brand-name beverage and tobacco companies.

But in order to succeed in the cannabis industry, companies will need to do far more than simply outgrow their peers, especially if oversupply concerns drive down the per-gram price of marijuana. Aurora Cannabis does have a focus on higher-margin medical marijuana patients, but it still has a long way to go to build its brands and create an identity that really stands out in the space. As such, it's a marijuana stock I've suggested investors avoid.

4. Share-based dilution is a long-term problem

Though it's been harped on for almost a year now, share-based dilution deserves attention from marijuana stock investors, because it's an ongoing problem.

Prior to the passage of the Cannabis Act on June 19, access to traditional forms of financing through a bank, such as a line of credit or loan, weren't available. This is because banks feared the possibility of facing financial and/or criminal penalties for violating federal law in Canada. In the U.S., there's been even less interaction between financial institutions and cannabis companies.

The only large-scale means of raising capital prior to the Cannabis Act passing was bought-deal offerings. A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors. These offerings were virtually always successful in raising the money needed for marijuana stocks to make an acquisition or expand their capacity.

However, these offerings come with a downside: dilution. All of these cash-raising methods ballooned outstanding share counts, which can weigh on the share price of pot stocks, as well as make it that much more difficult for marijuana stocks to produce meaningful per-share profits. Worse yet, with convertible debentures, options, and warrants still on the books for many marijuana stocks, dilution will be an ongoing issue for years to come. The aforementioned Aurora Cannabis has seen its share count explode from 16 million at the end of fiscal 2014 to around 1 billion today.

5. Tangible profits are still a ways off

Building on the previous point, it's unlikely that we're going to see recurring profitability from marijuana stocks anytime soon, even with Canada about to wave the proverbial green flag.

The first issue, as noted, is that dilution is going to weigh down per-share profits. With more shares outstanding for net income to be divided into, it's likely that earnings per share will disappoint. Plus, with convertible notes, warrants, options, and share-based compensation, outstanding share counts will probably keep rising, pressuring EPS.

Interim profits have also come with an asterisk. Adjusting the value of biological assets has been the only real means of delivering quarterly profits for pot stocks. If examined purely on an operating basis, excluding biological asset value adjustments, pretty much every marijuana stock is losing money. With numerous capacity-expansion projects still ongoing, costs should exceed sales for the foreseeable future.

There's also a good chance that oversupply will begin to push down the per-gram price of weed in the not-so-distant future, which would be bad news for operating margins. Economies of scale will help a bit, but there are no guarantees that marijuana stocks will generate anywhere near the profits that Wall Street or investors hope they will.

6. Regulations could stymie growth

Don't discount the possibility of regulations in Canada putting a partial kibosh on growth in the marijuana industry.

For instance, when the curtain is lifted on Oct. 17, 2018, only dried cannabis and cannabis oils will be available for sale. Other forms of consumption, such as edibles, vapes, cannabis-infused beverages, and concentrates, won't be legal. Wall Street and the industry widely expect Parliament to take up discussion on expanding the consumption options sometime next year, but there are no guarantees that it'll stick to the unwritten time frame expected by investors. If this expansion is delayed, it would mean a longer wait for high-margin revenue products, and it could also stymie the potential for brand-name beverage and tobacco partnerships.

There's also concern that the legalization of marijuana could create safety issues for drivers. Whereas impairment from alcohol can be determined with relative ease thanks to breathalyzers and field sobriety tests by peace officers, that isn't the case with impairment from marijuana consumption. Even with pot breathalyzers in development, the simple fact that Canada has struggled to establish a concrete guideline for peace officers to deal with drivers who may be under the influence is concerning.

7. History suggests we're in a bubble

Finally, history says the meteoric rise in marijuana stocks won't end well.

Although we're not dealing with a new product or technology -- marijuana has been around for a long time, at least in illicit form -- investors have consistently overshot to the upside when the next big thing hits the market. Over the past two decades, we've witnessed internet stocks, business-to-business players, genomics companies, 3D-printing stocks, and most recently blockchain businesses get hammered after failing to live up to lofty expectations. Chances are that marijuana stocks will follow a similar path, making this an industry to avoid for the time being.

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