This Might Be the Best Marijuana Stock on the Market

There are many ways to play the buzz surrounding California's marijuana legalization, but Scotts Miracle-Gro (NYSE: SMG) may be among the best, even though it's not really in the industry. But if the marijuana business continues to grow as it has and if more states legalize it, which is quite likely, don't be surprised if the lawn and garden leader quickly becomes a top name in pot, too.

Right now, Scotts' relationship with marijuana is somewhat tangential, but its importance to the company's operations and profitability is increasing.

Seeing where the industry was heading

Beginning in 2015, Scotts Miracle-Gro embarked on a spending spree, acquiring leading providers of specialty fertilizers, lighting, grow media, and other supplies for hydroponics. As of the end of its fiscal year last September, it had shelled out more than $500 million in total to buy 10 or so companies, including: Netherlands-based Gavita, a producer of indoor lighting used in greenhouses and hydroponics, for almost $150 million; and Botanicare, a Canadian growing media operation for $93 million. This past October, it paid $72 million for Can-Filters, a wholesaler of indoor ventilation products operating in British Columbia.

All of these businesses have been tucked away in Scotts' Hawthorne division, which houses all of its indoor, urban, and hydroponic gardening assets. It created the unit in 2014 with the express purpose of focusing on "the emerging areas of indoor and urban gardening products."

A grassroots movement

The company may as well have said marijuana, as 2014 was a big pivotal year for the legalization movement, as states from Alaska to Oregon had ballot initiatives, and all eyes were watching what California would do in 2016. No doubt sensing the country's direction, Scotts Miracle-Gro acted to get out in front.

At the end of Scott's fiscal 2017, the Hawthorne business accounted for a little more than 10% of its total $2.6 billion in revenues. (The majority, of course, came from its lawn care business.) But due to all the acquisitions, that amount was more than double the total from the year before, and twice as much as it generates from selling Monsanto's weed killer, Roundup.

In 2016, CEO Jim Hagedorn tolds Forbes that marijuana was "the biggest thing I've ever seen in lawn and garden." While many investors are focusing on growers like Canopy Growth or Aurora Cannabis, with even if some mainstream companies are starting to back them -- alcoholic beverage giant Constellation Brands, for example, took a 10% stake in Canopy -- there are risks associated with their operations.

As state-level legalization spreads and more money flows into the industry, the price of marijuana is going to drop. With more growers and users coming out of the shadows that prohibition made necessary, marijuana may trend toward being a commodity with margins getting thin.

Tools of the trade

Not so the picks-and-shovels aspect of Scotts Miracle-Gro's business. Like the long-ago entrepreneurs who made their fortunes selling the tools miners needed as they headed off in search of gold, Scotts is creating a foundational industry around the equipment every marijuana grower will need, regardless of the size or scope of their operation.

There's far less risk associated in that approach, and with Scotts seemingly on a path toward rolling up all the disparate components under one roof, it's the best marijuana stock on the market.

Of course, at the moment, Scotts consumer business, the lawn care and maintenance sales it makes, needs to remain healthy so that it can continue investing more in hydroponics, grow media, and more. While sales did decline this year slightly, and management expects gross margins to come under pressure, it believes free cash flow will continue to improve and the Hawthorne division should rapidly expand through acquisitions and organics growth.

Although Scotts Miracle-Go carries a premium price, it deserves that valuation in part because it has such a strong position in a promising nascent industry, and the runway ahead of it is so long. There's a good reason why the market is riding so high on Scotts.

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Rich Duprey 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.