Should You Invest in Marijuana Stocks?

You've no doubt seen firsthand the impressive growth in public support for marijuana, as evidenced by the growing number of states that have legalized the drug for medical or recreational purposes. You've probably heard about the enormous gains marijuana stocks have generated over the past couple of years. You might also be aware of predictions about how large the marijuana industry could become, including a recent projection that the U.S. marijuana market could reach $22 billion by 2022.

If all of these developments have you contemplating the idea of investing in marijuana stocks, you're not alone. Increasing numbers of investors have bought shares of marijuana stocks in anticipation of making huge returns. But should you invest in marijuana stocks? Here's what you need to know to make an informed decision.

What is marijuana?

Before investing in any company, it's a good idea to understand the basics of the business in which the company operates. For marijuana stocks, that means first learning about the marijuana, or cannabis, plant itself.

There are two primary chemicals in the cannabis plant, known as cannabinoids, that investors should especially know about. Delta-9 tetrahydrocannabinol (THC) is the primary psychoactive ingredient in marijuana. Cannabidiol (CBD) is another important cannabinoid that has been found to possess therapeutic benefits.

These two ingredients have been at the forefront of a battle over marijuana. The United States, along with many other countries around the world, prohibit the use of marijuana at the federal level, primarily because of the mind-altering effects and potentially addictive attributes of THC. However, the potential therapeutic benefits of CBD have led 30 U.S. states and countries, including Canada and Germany, to legalize medical marijuana. In addition, nine U.S. states and the District of Columbia also now allow the legal recreational use of marijuana. Canada's recreational cannabis market is scheduled to open on Oct. 17, 2018.

Although marijuana legalization is still somewhat controversial, public support for legalization in the U.S. and other countries has continued to increase. For example, a recent survey from the Center for American Progress, a progressive public policy research and advocacy group, found that 68% of Americans support legalizing marijuana -- a record high level of support. Forty percent of respondents strongly support legalization of the drug.

The spread of marijuana legalization has created a blossoming industry. Businesses have popped up to service every part of the growing industry, from cultivating and growing cannabis (or providing services to the growers), to distribution and retail marketing, and even to biotech development of cannabinoid-based prescription drugs.

The case for investing in marijuana stocks

Many companies in the cannabis industry have opted to "go public," making their shares available for purchase on public stock markets, to raise cash to fuel additional growth. This growth potential is the most compelling reason to consider investing in marijuana stocks.

Canada's vote earlier this year to legalize recreational marijuana has lent significant investor attention to Canadian marijuana stocks. Arcview Market Research and BDS Analytics project that Canadian marijuana sales will jump from around $600 million last year to $5.4 billion by 2022. That's a compound annual growth rate of more than 55%.

Germany legalized medical marijuana in 2017. The country's cannabis market could approach $1.6 billion by 2022, according to Arcview and BDS Analytics, up from only around $9 million last year. This projected growth makes Germany not only the biggest international marijuana market outside of North America but also the fastest-growing marijuana market in the world.

But the biggest prize of all is still the United States. Even with the rapid expansion of marijuana markets in Canada, Germany, and elsewhere, the U.S. still is likely to account for close to three-quarters of total cannabis revenue four years from now.

Overall, there is a possibility that the global marijuana market will more than triple from 2018 to the end of 2022. There will probably be several big winners from this sizzling growth. Investors who accurately pick those winners should be set for some fantastic returns over the next few years.

The case against investing in marijuana stocks

There are two primary arguments against investing in marijuana stocks. One is the risk that the projected growth won't materialize. Another is that marijuana companies' growth potential may already be reflected in their stocks' high valuations.

Will the tremendous growth in global marijuana markets actually happen? Maybe, but it's important to remember that marijuana remains illegal at the federal level in the United States. And the U.S. is the 800-pound gorilla in the global marijuana market.

There's a not-so-insignificant chance that the U.S. government could still crack down on marijuana-related businesses in states that have legalized the drug. U.S. Attorney General Jeff Sessions is a longtime opponent of marijuana legalization. In January 2018, Sessions rescinded Obama administration policies that largely prevented federal agencies from interfering in states that had legalized marijuana.

Sessions isn't the only person who stands opposed to the expansion of the U.S. marijuana industry. The Office of National Drug Control Policy launched a committee engaged in "a secret war on weed," according to a recent report from online news site Buzzfeed. This committee has reportedly requested that federal agencies submit "data demonstrating the most significant negative trends" about marijuana use as part of an effort to derail support for marijuana legalization.

Even if the feds don't intervene, the black market poses another potential threat. California's legal recreational marijuana market opened in January 2018. However, sales ramped up much more slowly than expected, in large part because of the availability of marijuana on the black market at cheaper prices.

Investors also should note that major Canadian cannabis companies won't establish significant operations in the U.S. as long as federal anti-marijuana laws are in place. This limits their total addressable market. Although many expect Canadian demand to outpace supply initially, it's likely that within a couple of years there will be a glut of cannabis supply in the country. When that happens, Canadian marijuana stocks could be in trouble if international medical marijuana markets can't absorb all of the excess capacity.

It's possible, of course, that the global marijuana market will grow as quickly as projected. Are marijuana stocks guaranteed to soar if that's the case? Not necessarily. The anticipation of tremendous growth is baked in to the share price of most marijuana stocks. For example, the top three Canadian marijuana stocks currently claim price-to-sales ratios of 159 or greater. Considering that the price-to-sales ratio for any other industry is around 8, marijuana stocks clearly have priced in a whole lot of growth. That alone could be enough to cause investors to steer clear of many of these companies.

In addition, some investors may prefer to avoid marijuana stocks simply because they don't like to buy "sin stocks" -- stocks of companies whose businesses center on a product, service, or industry that some view as immoral or unethical. If you're in this category, you're in good company. Legendary investor Warren Buffett turned down an opportunity years ago to buy a major tobacco company because he didn't want the stigma of investing in tobacco.

What to look for in marijuana stocks

If you think the case for investing in marijuana stocks outweighs the risks, it's important to think about marijuana stocks as you would any other stock you're considering buying. One of the most important things to do is check out the management team. Ideally, executives will have a track record of success and a good reputation ethically and professionally.

While marijuana is a high-growth industry, some companies are in a better position to grow than others. Research a company's business strategy and compare it against its peers. For example, a Canadian marijuana grower focused almost exclusively on the Canadian domestic market isn't as likely to grow as much as a rival with extensive international operations.

Be sure to examine the financial status of each marijuana stock you consider. Many companies in the cannabis industry aren't profitable yet. That's not a deal-breaker, though, if they have a sufficient cash position (including cash, cash equivalents, and short-term investments) to fund operations well into the future -- and they have a solid plan to achieve profitability.

Investors should research some factors that are unique to certain marijuana stocks. Look at the cost structures for marijuana growers. Companies that can grow cannabis at lower costs will be better able to compete on price. For cannabinoid-focused biotechs, identify potential competitors, including other biotechs with non-cannabinoid drugs on the market or in development.

Last, but certainly not least, check out the stocks' valuations. Metrics based on historical performance, such as the price-to-earnings ratio, probably won't be as useful in evaluating most marijuana stocks because much of their value is tied to expectations of future growth.

One useful metric for evaluating marijuana growers that's pretty easy to calculate is the enterprise value-to-production capacity ratio. Enterprise value represents a company's total value, factoring in cash, debt, and other criteria. Production capacity is the projected annual near-term capacity for growing cannabis in kilograms. Dividing these two values gives you a metric that allows you to compare the valuations of stocks of marijuana growers. The main downside of this ratio is that it's only a valuation metric relative to other marijuana stocks. It doesn't tell you if a stock is expensive compared to stocks in other industries.

Strategies for investing in marijuana stocks

Whether you should invest in marijuana stocks depends on your personal investment style, especially your tolerance for high levels of risk. How aggressive of an investor you are is key in determining the strategy you should use for investing in marijuana stocks. Following are six investment alternatives in the cannabis industry that reflect three different investing strategies.

To help you better understand the thought process to go through when considering each of the three marijuana investing strategies, we'll briefly discuss each strategy and which of the stocks listed in the table fit into the strategy.

Investing in pure-play marijuana stocks

Pure-play marijuana stocks are stocks of companies deriving most or all of their revenue from marijuana-related products or services. The potential return for these stocks is very high because of the growth prospects discussed earlier. However, the potential risk for these stocks is also very high because of the possibility that growth won't meet expectations or that growth won't be greater than what is already baked in to the stock prices. Two examples of pure-play marijuana stocks are Canopy Growth and GW Pharmaceuticals.

Canopy Growth: This is the largest Canadian marijuana grower in terms of market cap. The company has a strong management team with solid experience in the industry. Canopy should be in great position to profit in the Canadian recreational marijuana market beginning in October. The company also has operations in multiple international marijuana markets, most notably including Germany.

Although Canopy Growth isn't profitable, that's mainly because the company is investing in expanding its production capacity and overall operations in anticipation of greater demand. The company has plenty of cash on its hands to expand, thanks to a $4 billion investment from Constellation Brands announced in August.

Canopy's price-to-sales ratio of 159 shows that the stock has an astronomically high valuation based on its historical performance. Although Canopy stock is a lot more expensive than it was earlier in 2018, though, it still compares well against most of its peers using the enterprise value/production capacity metric discussed earlier.

GW Pharmaceuticals: This company won U.S. Food and Drug Administration approval earlier this year for the first plant-based cannabinoid drug, Epidiolex, in treating Dravet syndrome and Lennox-Gastaut syndrome, both of which are rare forms of epilepsy. The biotech also has another cannabinoid drug, Sativex, that is approved in several countries outside the United States.

GW is by far the biggest cannabinoid-focused biotech with a market cap of close to $4 billion. Whether the stock is valued attractively depends on how well Epidiolex performs. Some are pessimistic about the epilepsy drug's prospects. However, several analysts are bullish about Epidiolex's commercial hopes. Market research firm EvaluatePharma projects that Epidiolex will be one of the 10 biggest new drugs launched in 2018, with 2022 sales of around $1 billion.

One advantage for investors buying GW Pharmaceuticals is that it doesn't face the risk of a federal marijuana crackdown, since the company went through the standard FDA approval process. However, GW could face competition for Epidiolex from non-cannabinoid drugs.

Investing in stocks with marijuana-related businesses

Some investors could prefer to lower their risk (relatively speaking) by investing in stocks of companies that make money in other ways but also have interests in marijuana-related businesses. The primary drawback to this strategy is that returns could be lower than pure-play marijuana stocks if the company's non-marijuana businesses don't grow as much as the marijuana-related businesses do. Two examples of stocks in other industries that have marijuana-related businesses are Constellation Brands and Scotts Miracle-Gro.

Constellation Brands: This large alcoholic beverage company is perhaps best known for its Corona beer. The company made revenue of nearly $7.6 billion in its last fiscal year and reported more than $2.3 billion in earnings during the period.

As mentioned previously, Constellation's connection with the cannabis industry came through its investment in Canopy Growth. Constellation will own 38% of Canopy, assuming it exercises all warrants. The two companies plan to develop cannabis-infused beverages, which could be a tremendous new market in Canada when regulations are finalized next year.

For investors, a key advantage to buying Constellation Brands stock is that it has a lower risk than pure-play marijuana stocks, like Canopy Growth, because of its core beverage business.

Scotts Miracle-Gro: This company has made multiple acquisitions over the past few years, including its purchase of Sunlight Supply in April, to become the top supplier of hydroponics products to the cannabis industry. The company's CEO, Scott Hagedorn, stated recently that Scotts is "distancing ourselves from our competitors and clearly establishing Hawthorne as the market leader" in the cannabis industry.

A sluggish start in California's recreational marijuana market has hurt Scotts stock in 2018 so far. However, the state's market appears to be gaining some steam now. Scotts should also benefit as more states legalize either medical or recreational marijuana.

Over 92% of Scotts Miracle-Gro's total revenue stems from sales of consumer lawn and garden products. This gives the company a steady source of revenue while it waits for sustained growth with its cannabis-focused business.

Investing in marijuana exchange-traded funds (ETFs)

There aren't many exchange-traded fund alternatives available right now that allow investors to buy a basket of marijuana stocks. You might think buying an ETF would reduce your risk level. It could, but it's also possible that if there are only a few winners and the losing stocks could drag down returns despite great performances from the winners. The two ETFs currently available are the Horizons Marijuana Life Sciences ETF and the ETFMG Alternative Harvest ETF.

The Horizons Marijuana Life Sciences ETF attempts to replicate the returns of the North American Medical Marijuana Index. Its biggest holdings include Canopy Growth, GW Pharmaceuticals, Scotts Miracle-Gro, and several of the largest Canadian marijuana stocks. With ETFs, expense ratios are key. Horizons' management fee of 0.75% is relatively high compared with most index ETFs.

The ETFMG Alternative Harvest ETF isn't a pure-play marijuana ETF. Its holdings include several tobacco stocks and stocks of several biotechs that have cannabinoid programs but don't focus primarily on cannabinoid drug development. However, the ETF's top holdings consist of Canadian marijuana growers including Canopy Growth plus GW Pharmaceuticals. ETMFG's net expense ratio of 0.79% is also relatively high compared with other index ETFs.

To invest or not to invest?

Fortunes might be made on marijuana stocks over the next few years. However, it's quite likely that fortunes will also be lost on marijuana stocks. Your decision to invest in these stocks or stay away hinges on how comfortable you are with accepting the risks associated with the high-growth and high-volatility marijuana industry.

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Keith Speights 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.