Cannabis Stocks – Is there more room for growth in the marijuana industry?

Marijuana stocks took off in 2018 – but crashed just as quickly a year later. Another rally began last year when it began to look likely that the Democrats would win the White House and both houses of Congress. So, is this another bubble, or is there room for further gains in the cannabis industry?

Cannabis Industry
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In this article we take a look at the cannabis industry and what investors can do to seperate the likely winners from losers. We also list some of the most promising cannabis stocks for investors to consider.

Canadian vs. US cannabis stocks

Marijuana Industry
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Cannabis stocks have taken investors on a wild ride since 2018 when Canada first announced the legalization of cannabis for recreational use. The announcement in June 2018 and actual legalization later the same year, resulted in a multibillion-dollar industry emerging overnight. Legalization of recreational cannabis in Canada was a textbook case of “buy the rumor, sell the fact”. Most of the Canadian marijuana stocks peaked the same week that legalization became official, and many have not reached the same level again.

In the first year of legalization the industry suffered from oversupply, too few retail outlets and falling margins. The Canadian market is now maturing but still quite saturated, and the industry is consolidating. There are one or two companies that still have strong fundamentals, while the rest have low growth rates and falling margins. Attention has therefore shifted to the US where the legalization process still has some way to go.

State of cannabis legalization in the US

Cannabis Harvest
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The focus of attention for the entire marijuana industry right now is the US. For some time, it has been inevitable that cannabis will eventually be completely legal in the US. The clean sweep by Democrats in the 2020 elections, was widely viewed as putting the final steps in motion to bring about full legalization. Over the course of the last decade, various US states have legalized either medical marijuana, recreational marijuana, or both. As it stands now, marijuana is legal to some degree for medical use in 47 states. It’s also legal for recreational use in 14 of those states.

So, most states allow marijuana for medical use, and a growing number have legalized recreational marijuana. However, cannabis is still completely illegal at the federal level. This has created major challenges for cannabis producers. In particular, banks are not allowed to provide services to cannabis companies, so the industry has to operate with cash only. It has also stopped cannabis companies listing on US exchanges and prevented US funds from investing in cannabis stocks. This in turn has led to the peculiar situation where US cannabis companies are listed on Canadian exchanges, while Canadian cannabis companies are listed on US exchanges.

Last week the SAFE Banking Act was reintroduced to the House of Representatives. The act will allow banks to legally provide services to cannabis companies. It was originally voted on in 2019 but failed to gain support in the Senate. The bill is expected to be passed by both Houses this time around.

Tailwinds driving cannabis stock prices

Cannabis Industry Growth
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Just like healthcare technology stocks, the cannabis industry has the potential to disrupt the multi-trillion dollar healthcare industry. But there are other tailwinds driving the industry due to the legalization timeline. Once the SAFE Banking Act has passed, US cannabis operators will have access to banking services. But further legislative changes will be needed before they can participate in the economy like other businesses.

It is widely believed these changes will be made and that cannabis will be fully legalized at the Federal level at some point. When these changes are made, US cannabis companies will be able to list on US exchanges and US investment funds will also be able to invest in these stocks. This will also allow larger companies, and foreign companies, to acquire or take large stakes in US based cannabis companies for the first time.

It’s also expected that foreign companies will not be able to export cannabis directly to the US – but may be able to do so if they operate local subsidiaries. The cannabis industry around the rest of the world is still in its infancy with fairly ambiguous legislation. If or when the US legalizes marijuana, most countries will probably follow suit. What this means is that substantial investment and M&A activity is still on the horizon – which presents a unique opportunity for retail investors.

Canadian cannabis stocks

Canadian Cannabis Stocks
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As mentioned, the Canadian market is facing oversupply and margins are tight. However, it is worth mentioning the largest Canadian companies as they may be involved in cross border M&A activity in the future.

  • Canopy Growth (Nasdaq: CGC, TSX: WEED) – Canopy Growth established itself as the bellwether amongst marijuana stocks during the initial boom in 2018. The market really took notice when Constellation Brands invested $4 billion in the company. Canopy embarked on an ambitious growth strategy by building some of the largest grow facilities in Canada and opening a large chain of retail stores. It also acquired an option to acquire Acreage Holdings, a US operator, if marijuana is fully legalized in the US. Unfortunately, Canopy Growth has struggled to deliver on its ambitious plans. In fact, it has had to scale back operations and raise new capital. Canopy still accounts for a large share of sales in Canada, but revenue growth and margins are both low for the industry. The stock is probably the best known of all the cannabis stocks and this is why its price has performed well since the US election last year. However, there are far better companies with more growth ahead of them.
  • Aphria Inc and Tilray Inc (Nasdaq: APHA, TLRY) – Two of the largest Canadian marijuana stocks, Aphria and Tilray are in the process of merging into one company. Aphria has managed to grow faster than most of the Canadian stocks, and also has a better gross margin than its peers. Tilray has been an underperformer since the share initially rallied to $300 in 2018. Nevertheless, by merging, the two companies can improve efficiencies and benefit from better economies of scale. The combined entity which will keep the Tilray name, will be the world’s largest cannabis producer when measured using historical revenues. The combined company will also be very well diversified across the entire supply chain for recreational and medical cannabis.
  • The other notable marijuana stocks in Canada are Cronos (Nasdaq: CRON), Aurora (Nasdaq: ACB) and Village Farms (Nasdaq: VFF). These companies are all worth more than $1 billion but are struggling with slow growth and weak margins.

US cannabis stocks

US Cannabis Stocks
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US cannabis producers that operate in multiple sates are known as MSOs (multi state operators). These tend to be the larger companies, while smaller players operate in just one or two states. The companies below are all listed on Canadian exchanges, but trade actively on the US OTC market.

  • Curaleaf Holdings (US OTC: CURLF) – The most ambitious of the US MSOs is Curaleaf Holdings. The company which now has a presence in 23 states, 50 dispensaries and 14 grow states, has grown revenue at an astounding 183% over the last 12 months. It is worth noting that a lot of this growth has come from acquisitions, rather than organic growth. Curaleaf has a market value of $10.5 billion, which means it will be the third most valuable cannabis company in the world once the Tilray/Aphria merger is complete. Because of its aggressive growth strategy, Curaleaf is likely to outperform when sentiment around marijuana stocks is positive. However, if industry growth is slower than anticipated, shareholders may find themselves diluted if the company issues new shares at lower levels.
  • Trulieve Cannabis Corp (US OTC: TCNNF) – Trulieve is one of the few cannabis companies that is actually profitable, particularly amongst the large MSOs. Trulieve has adopted quite a different strategy by focusing on Florida where it now has 42 dispensaries. Florida has so far only legalized medical cannabis – but it is still one of the largest and fastest growing markets in the US. This has allowed Trulieve to achieve economies of scale without spreading itself too thin. The company now has a strong brand in Florida and is well positioned if recreational cannabis is legalized in the state. The fact that Trulieve already has a strong brand means it doesn’t have to spend as much on marketing. This is why the company is one of the most profitable in the industry.
  • Green Thumb Industries (US OTC: GTBIF) – Green Thumb is a company that has pursued a more sensible and conservative growth strategy. It has done this by only making acquisitions at reasonable prices, and only in strategically important states. The Chicago based company has now grown to be one of the largest MSOs, with one of the least volatile stock prices. Green Thumb has also managed to attract some institutional support – a recent private placement of shares worth $100 million was placed with a single investor. This is the type of stock institutions will invest in when they are allowed to.

Smaller US cannabis stocks

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The following three companies have much smaller market values but are also high-quality companies. Smaller companies are generally more speculative, but they are also attractive as acquisition targets. If there are multibagger stocks in the industry they are likely to be the smaller companies.

  • Jushi Holdings Inc (US OTC: JUSHF) – Jushi is a newer cannabis company which is growing by making strategic acquisitions. The company has a significant presence (and 18 retail licenses) in Pennsylvania which is an important and growing US market. This may make it a valuable acquisition target at some point.
  • Vireo Health (US OTC: VREOF) – Vireo Health, which has a market value of $370 million, is a current favorite amongst cannabis investors. The company operates in five states and has four licenses in New York – the current limit for each operator in the state. Vireo has also built a large cultivation facility in Arizona where recreational marijuana was recently legalized.
  • Cansortium Inc  (US OTC: CNTMF) – Cansortium is a small operator with a market value of just $130 million. The company operates in a few states, but most notably in Florida where it has 24 retail outlets. This footprint in Florida alone makes the company an attractive acquisition target.

Cannabis ETFs

ETF Investing / Cannabis ETFs
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ETF investing is a more straightforward approach to investing in the cannabis industry. Whether or not you invest directly or via an ETF really comes down to whether you think you can pick the winning companies. ETFs will unfortunately hold the losers too – though their weightings in each fund will diminish with time. These are the three best cannabis ETFs to consider.

  • The ETFMG Alternative Harvest ETF (MJ) is the most established of the cannabis ETFs and has $1.9 billion in assets under management (AUM). The fund invests in US listed companies with exposure to the cannabis industry – so a lot of holdings are ancillary companies rather than actual cannabis producers.
  • The AdvisorShares Pure US Cannabis ETF (MSOS) invests actively in US cannabis producers rather than companies that aren’t 100% exposed to the industry. The fund has AUM of $1.1 billion.
  • The AdvisorShares Pure Cannabis ETF (YOLO) is an actively managed ETF that holds shares in companies with direct and indirect exposure to the industry. The fund’s AUM now total $441 million.

Risks of investing in marijuana stocks

Cannabis Industry Risks
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Pot stocks have some unique tailwinds which make them an attractive industry for investors. But they are also undoubtedly a high reward, high risk opportunity for investors. The industry has arguably already been through two bubbles in the last three years. Some investors have made a lot of money, while others have booked large losses. The early years of the industry were often characterized by reckless management and speculative buying frenzies. It’s probably fair to say that the industry is now maturing.

Some of the companies that looked most promising three years ago are now struggling to stay in business, and their investors have been diluted to the point where they are unlikely to recover their losses. The MJ ETF is now about 50% below its 2018 high, which is probably a fair reflection of the industry as a whole. However, some of the most popular stocks from 2018, including Aurora, Tilray and MedMen, are all trading more than 90% below their 2018 highs. These companies pursued aggressive growth strategies and were never able to deliver on their intended plans.

Risk / Reward Ratio
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One of the biggest risks is dilution. While a company’s stock price is rising, its management can easily sell new shares to fund acquisitions. The problem is that when the price is falling and the company begins to run out of capital, they then have to sell shares at lower prices. This dilutes existing shareholders and puts even more pressure on the share price. Most of the high-flying companies that have run into trouble have also failed to execute on their intended plans. When you are assessing a company, it’s essential to look at how well they are delivering on previous promises, rather than investing based on the latest ambitious plan.

Another risk is the “hot money” factor. Marijuana stocks are a favorite amongst many of the same investors who trade cryptocurrencies, EV stocks and other speculative markets. These markets are all driven by hype rather than fundamentals, and sentiment is often cyclical. This leads to capital flowing back and forth between these markets. As an investor you should keep an eye on the relative performance of these stocks and crypto assets.

Stock picking in the cannabis industry

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The changing dynamics of the marijuana industry mean buy and hold investing is not effective and market timing plays an important role. You will need to be selective and prepared to rotate from one stock to the next. At the time of writing the focus is on the US market and particularly the states that are most likely to legalize recreational cannabis soon. Obviously, this will change with time, so investors need to pay attention to the changing dynamics of the industry.

The role of sentiment and hype mean the price of marijuana stocks can rally well beyond a reasonable stock valuation. It’s worth combining a momentum investing approach with stock picking based on each stock’s underlying business. You can use sentiment rather than valuations to decide when to exit a stock to capture more of the trend. One of the criticisms of the cannabis industry is the fact that ultimately cannabis will become a commodity with low margins, just like corn, wheat and other agricultural products. But cannabis consumers do differentiate between brands based on quality. So, a producer can differentiate themselves by establishing a strong brand.

Cannabis Products
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Companies can also improve their margins by selling high margin cannabis products like vape oils and edibles. In time the best companies will be able to improve their margins, while the weak companies will see their margins continue to shrink. Lastly, you should consider different marijuana stocks depending on your time frame. When sentiment is positive, the most aggressive companies will probably outperform. However, over the long term, the companies with strong organic growth and good margins will deliver the best returns.

Conclusion: Investing in cannabis stocks

Cannabis stocks are one of the few types of growth stocks that aren’t in the tech sector. The industry also has some unique tailwinds due to the process of legalization now unfolding. But, as we have seen over the last few years this is a high risk, high return industry and there are plenty of winners and losers. This makes the industry perfect for active investors prepared to do the research to pick the companies building solid businesses.

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