Marijuana Stocks Are Destroying Shareholder Value

The marijuana industry is budding, and investors are really beginning to take notice. According to Cowen & Co., legal marijuana sales in the U.S. have the opportunity to reach $50 billion annually by 2026, with cannabis research firm ArcView projecting compound annual growth of 26% in North America through 2021. No matter the source, few, if any, industries are growing as quickly as legal marijuana.

Underlying this sales growth potential is a discernible shift in the way the public views pot. What was once a taboo topic that a majority of folks felt should remain an illegal substance, is now a drug that 64% of respondents in Gallup's October 2017 poll believe should be legal for adults to use. Presumably, the higher the favorability for weed goes, the more pressure will be placed on lawmakers in Washington to alter its scheduling. As a reminder, marijuana is currently a Schedule I substance, putting it on par with LSD and heroin.

The result has been incredible gains for marijuana stock investors. More than a dozen pot stocks now boast market caps in excess of $200 million (i.e., out of true penny-stock and small-cap territory), and many have seen their share price double or triple over the trailing year. The green rush has paid off for investors willing to take risks.

Marijuana stocks have a dark secret

However, nearly all marijuana stocks come with a dark secret. Namely, that they're steadily destroying shareholder value despite delivering healthy gains over the past couple of years.

What investors have to realize about cannabis is that in many countries it's still illegal. Despite 29 states having legalized medical cannabis in the U.S., and eight states green-lighting recreational weed, it's entirely illegal at the federal level. In fact, recreational marijuana is illegal in every single country worldwide, save for Uruguay. This makes operating a publicly traded pot business quite challenging.

Most marijuana stocks are losing money and set to face a variety of challenges, especially if operating in the United States. For example, U.S.-based companies are unable to take corporate income tax deductions if they sell a federally illegal substance. This forces them to pay considerably higher income tax rates if they're profitable (which most aren't).

Also, pot businesses have very little or no access to basic banking services. This means they can't get traditional lines of credit, a loan, or even a checking account, from a bank. Financial institutions in this country answer to the Federal Deposit Insurance Corporation, which is a federally created entity. This means banks that offer services to marijuana companies run the risk of federal prosecution or fines at a later date.

Here's how the green rush is destroying shareholder value while simultaneously building it up

Add these factors together and we get one simple conclusion: Marijuana stocks struggle to find consistent funding to keep the lights on given that many aren't profitable. The easiest way for cannabinoid-based drug developers and cannabis cultivators to raise cash is through various types of common stock offerings. These offerings are especially palatable to publicly traded businesses when stock valuations have been going through the roof.

In the U.S., publicly traded companies typically turn to common stock offerings that are underwritten by investment firms and offered to the public. In Canada, marijuana stocks often turn to bought-deal offerings. This is the practice of selling a block of common stock to underwriters at an agreed-upon price prior to releasing a prospectus. Regardless of the method used to raise capital, it means one thing for shareholders: dilution.

Raising capital is a necessity for pot companies looking to expand their operations, but it comes at the cost of reducing the value of existing shares held by investors. Yes, pot stocks have delivered pretty handsome returns for investors thus far, but they could presumably have been even better without a steady stream of dilution.

There's a lesson to be learned here

A perfect example of this is Aurora Cannabis (NASDAQOTH: ACBFF), a Canadian medical cannabis grower that's working on a pricey project known as Aurora Sky. Once complete in mid-2018, Aurora Sky should be able to produce in excess of 100,000 kilograms of dried cannabis a year. This 800,000-square-foot highly automated facility is going to be critical in pushing Aurora Cannabis' long-term pot-growing costs down on a per-gram basis.

In order to fund this project, and the acquisition of a 40,000-square-foot facility acquisition earlier this year, Aurora Cannabis has engaged in multiple (and I mean multiple) bought-deal offerings. Since mid-2014, the company's outstanding share count has catapulted from 16.1 million shares to more than 375 million as of its most recent quarter. Though this capital is needed to help expand growing capacity to meet rising demand, and Aurora Cannabis' stock has shone recently, imagine how well it could have performed without a 2,200% increase in its outstanding share count.

If there's a lesson to be learned in all of this, it's that share offerings are a way of life for most marijuana stocks since they're unprofitable and cut off from traditional means of funding. That doesn't necessarily mean pot stocks are doomed, but it does suggest that investors need to understand this added risk before buying into the industry.

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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.