The 1 Word That Should Keep Marijuana Stock Investors Up at Night

Investors, in general, have plenty of things to be concerned about. The current bull market is getting long in the tooth. Another economic recession is overdue based on historical patterns. Stock valuations are high overall.

Marijuana stock investors have even more to worry about. There's the possibility that the Trump administration could crack down on marijuana-related companies. Even if that doesn't happen, financial institutions could turn these companies away because of fears about violating current federal laws.

All of these are legitimate reasons for concern. But there's one word that should really keep marijuana stock investors up at night. What's that one word? Commoditization.

The big threat

Do you really care what brand of salt you use? Probably not. The reason why is that one brand of salt is highly unlikely to taste any different than another brand. Salt is either salty or it's not.

Now suppose what happens if more competitors enter the salt market. Because one brand of salt is basically the same as another, the primary way for these companies to compete is based on price. That means prices go down for consumers -- and profit margins go down for the companies.

This is the scenario that seems destined to occur for marijuana growers. Like salt, marijuana is a commodity -- a raw material or agricultural product that is bought and sold. As more states have legalized medical and recreational marijuana, more companies have been attracted to the market.

Over time, the influx of more companies in the market will lead to competition based on price. This scenario is already happening. In Colorado, for example, the average wholesale price for marijuana has fallen significantly as more suppliers entered the market.

The problem for investors is that the marijuana companies that trade publicly aren't immune from the price erosion. If these companies can't grow earnings as fast as initially expected, their stock prices will inevitably decline. That's the huge threat of commoditization.

Most and least impacted

Smaller companies will likely feel the biggest brunt of commoditization. These companies will find it harder to compete on price with larger entities that can wring out greater operational cost savings.

The least impacted companies will be those that can achieve economies of scale and that have marketing budgets to spend on trying to differentiate their products. One U.S. example of this is Medical Marijuana, Inc. (NASDAQOTH: MJNA).

In the first quarter of this year, the company reported revenue of $3.6 million. While that's a drop in the bucket for most publicly traded companies, it's enough to make Medical Marijuana, Inc. a giant among marijuana stocks. The company spent more than $272,000 in the first quarter on marketing its products.

Medical Marijuana, Inc.'s flagship product is Real Scientific Hemp Oil, a cannabidiol (CBD) product. If you look at the website promoting the product, you'll see how the company is implementing its strategy. First, the website states that Real Scientific Hemp Oil is "the world's most trusted CBD oil brand." That's a clear attempt at market differentiation.

The second thing you'll read about Real Scientific Hemp Oil is "Enjoy new lower prices." Price reductions are to be expected with commoditization, as we discussed earlier. Medical Marijuana, Inc., however, is probably in better shape to offer lower prices than its smaller rivals.

Aurora Cannabis (NASDAQOTH: ACBFF) is a Canadian example that employs a similar strategy. The company is one of the top providers of medical marijuana in Canada and is certainly eyeing the prospects of becoming a key player in the recreational marijuana market if legalization efforts are successful.

Aurora reported nearly $5.2 million in revenue in the first quarter of this year. The company spent roughly $2.7 million on sales and marketing. How is Aurora trying to differentiate its medical marijuana? It plays up its "award-winning support staff, culture-minded cultivators, laboratory-tested products, affordable pricing, and network of cannabis educated doctors."

Best bet for investors

Companies that can squeeze out operational efficiencies and effectively market their products have a reasonable chance to survive and thrive in the face of commoditization of marijuana. However, there are no guarantees.

The best bet for marijuana investors could be to take a different approach. In the salt analogy used earlier, the companies that were the most likely to succeed were the ones that didn't sell salt but instead sold to those that did -- for example, packaging companies, equipment companies, etc. Scotts Miracle-Gro Company (NYSE: SMG) serves a similar role for the marijuana industry.

Scotts provides fertilizers, lighting, hydroponics, and other supplies to marijuana growers of all sizes. Its fortunes improve as long as the overall marijuana market expands, regardless of which individual companies make it or don't. And Scotts Miracle-Gro has the scale and marketing prowess to effectively fight against commoditization of the products that it sells.

Marijuana might be a hot commodity -- but it's still a commodity. Smart investors will realize this fact and ensure they're protected from the downsides of commoditization.

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