How to Invest in Marijuana Stocks

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Global marijuana markets are, pardon the pun, growing like a weed. Worldwide spending on cannabis reached $9.5 billion in 2017, according to ArcView Market Research and BDS Analytics. The total is projected to increase to $32 billion by 2022, a compound annual growth rate (CAGR) of 27.5%.

With this type of impressive growth, it's no wonder that many investors are interested in investing in publicly traded cannabis stocks. What's the best approach for marijuana investing? There are seven key steps:

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    1. Understand the types of marijuana products
    2. Know the different types of marijuana stocks
    3. Understand the risks of investing in marijuana stocks
    4. Know what to look for in a marijuana stock
    5. Evaluate the top marijuana stocks and exchange-traded funds (ETFs)
    6. Invest carefully
    7. Monitor changing industry dynamics closely

    Here's all you need to know about this seven-step process for investing in the fast-growing marijuana industry.

    1. Understand the types of marijuana products

    There are two broad categories of cannabis products: medical marijuana and recreational marijuana. Within these two categories are several specific types of products.

    Medical marijuana currently is broadly legal in 30 U.S. states and in several countries across the world, including Canada and Germany. A prescription from an authorized healthcare provider typically is required for patients to obtain medical marijuana. It's frequently prescribed for anxiety, depression, pain, and stress.

    Medical marijuana, also referred to as medical cannabis, can be inhaled by smoking either dried flower or vaping concentrates. It can be consumed via edible products that contain marijuana or cannabis-infused beverages. There are even topical creams and lotions containing marijuana or chemical ingredients from cannabis.

    One of the most commonly used medical marijuana products is cannabidiol (CBD). CBD is one of many chemicals in the cannabis plant known as cannabinoids. It doesn't have the psychoactive properties of another important cannabinoid, delta-9 tetrahydrocannabinol (THC), but appears to claim several potential health benefits. In June 2018, the U.S. Food and Drug Administration (FDA) approved the first CBD-based drug, Epidiolex, for treating two rare forms of epilepsy, Dravet syndrome and Lennox-Gastaut syndrome (LGS).

    The FDA has has approved three THC-based drugs -- Marinol, Cesamet, and Syndros -- for the treatment of chemotherapy-induced nausea and vomiting. Marinol and Syndros also received approval for treating AIDS-related anorexia. However, all three drugs are manufactured using synthetic THC rather than compounds from marijuana plants.

    Recreational marijuana is currently approved for adult use in nine U.S. states and the District of Columbia. Uruguay legalized weed at the national level in 2013. The Canadian parliament voted to legalize recreational marijuana and now, the Canadian marijuana market is scheduled to open in October 2018.

    As you might expect, users of recreational marijuana products tend to prefer the psychoactive attributes of THC. Smoking cannabis flower is the most common method of use in key U.S. states that have legalized recreational marijuana. However, vaping concentrates and consuming cannabis edibles has grown in popularity.

    2. Know the different types of marijuana stocks

    Just as there are different types of marijuana products, there are also different types of marijuana stocks. The three primary types of pot stocks are:

    • Marijuana growers -- These companies, which include Canopy Growth and many others, cultivate marijuana (often in indoor facilities and greenhouses), harvest the crops, and distribute the end products to customers.
    • Cannabis-focused biotechs -- These are biotechs (such as GW Pharmaceuticals) that focus heavily on developing cannabinoid drugs.
    • Providers of ancillary products and services -- These companies support marijuana growers by providing products and services such as hydroponics products and lighting systems -- a key area of focus for Scotts Miracle-Gro, packaging solutions, and management services.

    3. Understand the risks of investing in marijuana stocks

    Investing in any type of asset comes with some degree of risk. However, investing in marijuana stocks has several risks that you should understand.

    Legal and political

    Probably the most important risk to note is that the sale of marijuana remains illegal at the federal level in the U.S. This means that there's a threat that the U.S. Department of Justice could clamp down at any time on cannabis businesses operating in states that have legalized marijuana for either medical or recreational purposes.

    This risk was underscored in January 2018 when U.S. Attorney General Jeff Sessions rescinded Obama administration policies that largely restrained the federal government from intervening in states that had legalized marijuana. These Obama-era policies included the Cole memo, which instructed federal attorneys to defer to state and local authorities in most cases when it came to prosecuting marijuana-related activities.

    Since then, President Trump has publicly stated that he would support legislative efforts spearheaded by Sen. Cory Gardner (R.-Colo), whose state allows legal recreational and medical marijuana, to allow states to enforce their own marijuana laws without fear of federal intervention. However, there's no guarantee at this point that this legislation will become law.

    In addition, current U.S. federal law places severe restrictions on banks and financial institutions that deal with marijuana-related businesses. As a result, it can be difficult for many U.S. marijuana businesses to raise capital through borrowing, or even have checking accounts.

    Supply/demand imbalances

    Many pot stocks have sky-high valuations (what the market thinks the company is worth) based on expectations of tremendous growth over the next few years. But there's a clear-and-present danger to achieving those growth expectations: the likelihood of a big supply glut, particularly in Canada.

    Most, if not all, of the licensed marijuana growers in Canada have undertaken major expansion initiatives to increase production capacity. While demand should be greater than supply in Canada in the first year or two after recreational marijuana is legalized, the situation won't last indefinitely. A supply glut is almost inevitably on the way in the country.

    What would a supply glut mean for marijuana growers? When supply outstrips demand, prices usually fall. Marijuana growers could find their revenue and earnings decrease in this scenario. These decreases would likely result in the stock prices of these companies falling, as well.

    The good news is that the global demand for marijuana is expected to increase significantly. Germany's medical marijuana market is a key source of this growth because the country legalized medical cannabis last year and has the largest population in the European Union. Other countries with large populations that have legalized medical cannabis, such as the United Kingdom (which recently approved cannabis for medical use), could also drive higher demand.

    The bad news, though, is that it's quite possible that the increase in global cannabis demand won't happen quickly enough to absorb the ramp up in capacity among marijuana growers. That would mean that Canadian pot growers would still face the supply-glut scenario, which would likely cause their stock prices to drop.

    Over-the-counter (OTC) stocks

    Investors also should be especially aware of the risks associated with buying over-the-counter (OTC) marijuana stocks. Companies that are listed on major stock exchanges, which in the U.S. are the New York Stock Exchange (NYSE) and the Nasdaq, must adhere to rules that require them to file regular financial statements and maintain minimum market caps (the total value of outstanding shares). These reporting requirements help investors better assess the risks of buying the stocks, while the market-cap requirement helps ensure an acceptable level of liquidity -- which refers to how easily the stock can be bought or sold without impacting its price. OTC stocks don't have to meet these requirements.

    The problem is that many marijuana stocks are only available through OTC trading rather than through major stock exchanges. It should be noted, however, that several Canadian stocks are only available over the counter in the U.S. but do trade on Canadian stock exchanges that have financial reporting and minimum market-cap requirements.

    4. Know what to look for in a marijuana stock

    Treat marijuana stocks like any other stock you'd consider buying. Research the management team, examine the company's growth strategy and competitive position, and check out the company's financial status. If the business isn't profitable yet, you'll want to make sure the company's cash position, which includes cash, cash equivalents, and short-term investments, is enough to fund operations well into the future. If it isn't, the company could have to raise additional cash through a stock offering -- those additional shares will make the value of existing shares decline -- or borrowing (higher interest costs could place a financial strain on the business).

    There are unique factors for the marijuana industry that you also should look into for certain stocks. For stocks of marijuana growers, find out about their "all in" cost of sales per gram and their cash cost per gram for producing cannabis. The "all in" cost of sales per gram includes costs of producing cannabis, while the cash cost per gram excludes amortization, packaging costs, and inventory adjustments. Companies with lower costs will be in better shape to compete in times when supply exceeds demand.

    Because a supply glut is very likely to impact Canada in the not-too-distant future, checking out the international operations of Canadian marijuana growers is also a prudent move. Companies that already have distribution agreements and operations in place in Germany and other high-population countries are likely to experience more growth than those companies that don't.

    In addition, research how many warrants and convertible securities have been issued by the company. Warrants give investors an option to buy shares in the future. Convertible securities can be converted in the future into shares of common stock. For example, convertible debentures start off as loans but can later be converted into stock. A high number of warrants or convertible securities could mean that the stock will be diluted in the future, potentially causing the share price to drop. Some Canadian marijuana growers have used these methods of raising cash extensively.

    5. Evaluate the top marijuana stocks and ETFs

    Now for the fun part: digging into the top marijuana stocks. You might also want to check out marijuana-focused exchanged-traded funds (ETFs). Below is a list of top marijuana stocks and ETFs to consider. Note that this list isn't comprehensive and only includes marijuana stocks with a market cap of at least $200 million.

    Type

    Company

    Market Cap

    Marijuana grower

    Canopy Growth Corporation (NYSE: CGC) $5.8 billion
    Aurora Cannabis (NASDAQOTH: ACBFF) $2.9 billion
    Tilray (NASDAQ: TLRY) $2.3 billion
    Aphria (NASDAQOTH: APHQF) $1.9 billion
    MedMen Enterprises (NASDAQOTH: MMNFF) $1.3 billion
    Cronos Group (NASDAQ: CRON) $1 billion
    The Green Organic Dutchman (NASDAQOTH: TGODF) $1 billion
    The Hydropothecary (NASDAQOTH: HYYDF) $728 million
    CannTrust Holdings (NASDAQOTH: CNTTF) $513 million
    Organigram Holdings (NASDAQOTH: OGRMF) $509 million
    Marimed (NASDAQOTH: MRMD) $472 million
    TerrAscend (NASDAQOTH: TRSSF) $398 million
    Auxly Cannabis (NASDAQOTH: CBWTF) $368 million
    iAnthus Capital Holdings (NASDAQOTH: ITHUF) $367 million
    Medical Marijuana (NASDAQOTH: MJNA) $330 million
    CV Sciences (NASDAQOTH: CVSI) $299 million
    Emerald Health Therapeutics (NASDAQOTH: EMHTF) $287 million
    Supreme Cannabis (NASDAQOTH: SPRWF) $277 million
    Smart Cannabis (NASDAQOTH: SCNA) $276 million
    MPX Bioceutical (NASDAQOTH: MPXEF) $234 million
    AusCann Group Holdings (NASDAQOTH: ACNNF) $223 million
    Liberty Health Sciences (NASDAQOTH: LHSIF) $213 million

    Biotech

    GW Pharmaceuticals (NASDAQ: GWPH) $3.7 billion
    Cara Therapeutics (NASDAQ: CARA) $697 million
    Insys Therapeutics (NASDAQ: INSY) $473 million
    22nd Century Group (NYSEMKT: XXII) $313 million
    Corbus Pharmaceuticals (NASDAQ: CRBP) $271 million

    Ancillary provider

    Scotts Miracle-Gro (NYSE: SMG) $4.3 billion
    Namaste Technologies (NASDAQOTH: NXTTF) $318 million
    Kush Bottles (NASDAQOTH: KSHB) $295 million
    Neptune Technologies & Bioressources (NASDAQOTH: NEPT) $220 million
    CannaRoyalty (NASDAQOTH: CNNRF) $203 million

    ETF

    Horizons Marijuana Life Sciences ETF (NASDAQOTH: HMLSF) $797 million*
    ETFMG Alternative Harvest ETF (NYSEMKT: MJ) $383 million*

    I'll highlight one stock (or ETF) from each category that I think warrants special consideration.

    Canopy Growth

    My view is that there are several good reasons why Canopy Growth is the biggest marijuana grower in terms of market cap. The company has an experienced management team and a huge production capacity, with 10 facilities together claiming more than 2.4 million square feet of growing space. Although Canopy no longer reports its costs per gram, they were very competitive the last time it reported, and the company says that these costs "have been trending lower" as it increases its scale.

    Canopy already has recreational marijuana supply agreements lined up with six Canadian provinces and one territory. It's also one of the best-positioned marijuana growers in international markets. In particular, the company has a strong foothold in the German medical marijuana market. Canopy currently has operations in nine countries, including Canada, spanning five continents.

    What really separates Canopy Growth from its peers is the company's relationship with major alcoholic beverage maker Constellation Brands. Constellation recently invested $4 billion in Canopy and named the company as its exclusive global cannabis partner.

    Canopy Growth isn't profitable yet because it's investing heavily in expansion efforts. The big investment by Constellation gives Canopy a huge cash stockpile to expand even more into new markets.

    GW Pharmaceuticals

    GW Pharmaceuticals is the first biotech to win FDA approval for a marijuana plant-based drug -- Epidiolex. The company awaits scheduling of the drug by the U.S. Drug Enforcement Administration (DEA) under federally controlled substance regulations. GW expects to launch Epidiolex in the U.S. by early fall.

    Market-research firm EvaluatePharma predicts that Epidiolex will become one of the top 10 new drug launches of 2018. Opinions vary about just how successful the cannabinoid drug will actually be, but I think peak sales in the ballpark of $1 billion are possible.

    Most of the company's executives have at least two decades of experience in the pharmaceutical industry. They're familiar with launching new products, including GW's multiple sclerosis drug Sativex, which is approved in more than 25 countries outside the U.S.

    GW Pharmaceuticals isn't profitable at this point. However, the company reported cash and cash equivalents totaling more than $440 million as of the end of June 2018. That's enough to fund operations at least through 2020 while Epidiolex sales grow.

    Scotts Miracle-Gro

    My favorite among the ancillary providers to the marijuana industry is Scotts Miracle-Gro. The company is the leading provider of hydroponics products to cannabis growers. Although the stock has struggled in 2018, I think brighter days are ahead for Scotts as California recreational marijuana picks up momentum and more U.S. states legalize medical and/or recreational marijuana.

    Scotts is led by a veteran team including Jim Hagedorn, who has been CEO since 2001. The company is not only profitable, it pays a dividend currently yielding 2.9%. Scotts' debt of nearly $2.3 billion is higher than I'd like. However, the company borrowed primarily to fund its expansion efforts -- a good thing, in my view -- and is committed to reducing its debt.

    It's also important to know that Scotts Miracle-Gro isn't just focused on the marijuana market. Over 90% of the company's revenue comes from sales of consumer lawn and garden products. I think there's a solid long-term market in that area for Scotts, as well.

    Horizons Marijuana Life Sciences ETF

    Between the two marijuana ETFs included on the table, my preference is the Horizons Marijuana Life Sciences ETF. It's the larger of the two ETFs, and all three of my marijuana stock picks are in the top 10 holdings of this ETF and combine to make up nearly 30% of the fund's total assets.

    One knock against the Horizons marijuana ETF, however, is that its expense ratio of 0.94% is really high compared to many other index ETFs. It's even higher than the 0.79% expense ratio of the ETFMG Alternative Harvest ETF. Also, because of the risks discussed earlier, I think investors are better off choosing the strongest individual stocks rather than buying a marijuana ETF that also holds weaker stocks.

    6. Invest carefully

    What exactly does "invest carefully" in marijuana stocks mean? For some investors, the best approach will be to avoid marijuana stocks entirely. These stocks simply aren't a good fit for conservative investors. Only the most aggressive investors who can tolerate high levels of risk should jump in.

    Even aggressive investors should only buy a marijuana stock after completing the five previous steps. Marijuana stocks are both risky and highly volatile. Putting too much of your investment portfolio into any marijuana stock or ETF isn't wise.

    You might want to consider starting off only with a small position in a marijuana stock. As the cannabis market grows and a company's increasing revenue and earnings confirm your decision to buy the stock, you could then add to your position. If the growth you were counting on doesn't materialize, you should re-evaluate your assumptions.

    Also, some marijuana stocks are arguably safer than others. For example, Scotts Miracle-Gro makes most of its revenue outside of the cannabis industry. The company has been selling lawn and garden products for a long time and doesn't face some of the risks associated with cannabis products in that market. Less-aggressive investors might prefer a stock like Scotts to a more pure-play marijuana stock like Canopy Growth.

    7. Monitor changing industry dynamics closely

    Investors are better off taking a long-term view when buying stocks. That being said, the dynamics in the marijuana industry are rapidly changing. The criteria used in making a buying decision now could be dramatically different just a few months in the future.

    Because of this, I recommend that investors monitor any marijuana stocks or ETFs that they buy, along with the overall industry itself, very closely and frequently. Some changes could be beneficial -- for example, potential relaxation of U.S. federal marijuana laws. Other changes, however, could be bad news, such as the possibility that Germany places restrictions on its medical marijuana market.

    Tremendous growth should be in store for the global marijuana industry. That growth might not come as evenly as investors would prefer, though. Following these seven steps can help you navigate this exciting and challenging opportunity.

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    Keith Speights has no position in any of the stocks mentioned. The Motley Fool recommends Nasdaq. The Motley Fool has a disclosure policy.