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Stock Watch

Reefer Madness: Cannabis Stocks Draw In Investors

Some investors are high on these stocks. But the prospects for cannabis companies are hazy.

Courtesy Tilray

Call it the green rush. Or the green wave. Either way, the movement toward legalized marijuana use in North America is gaining ground. November’s midterm elections saw Missouri and Utah join 31 other U.S. states where medical marijuana is legal. Michigan voters made their state one of 10 (plus the District of Columbia) where recreational use isn’t a criminal offense. Canada recently became the first industrialized nation to legalize recreational marijuana use nationwide.

See Also: Move Over Tech: Marijuana Stocks Are the New Star

The prospect of continuing momentum has investors seeing green in more ways than one, but those who have been riding the green wave thus far have had a wild run. In advance of Canada’s October 17 legalization, Canadian cannabis stocks soared. Canadian pot firm Tilray was trading in the low to mid $20s for much of August before the share price spiked to an intraday high of $300 in September. The shares have since receded dramatically, trading at $100 in early December.

Shares in other major Canadian growers and distributors, such as Canopy Growth and Aurora Cannabis, followed a similar, if less extreme, trajectory: a huge run-up prior to legalization followed by a pullback due to concerns over industry-wide supply shortages. Despite the volatility, some intrepid investors (and some blue-chip companies) are entering the fray. If you are considering cannabis stocks, here’s what you need to know.

What’s the appeal? Analysts at the Arcview Group, a cannabis-focused investment and research firm, estimate worldwide legal cannabis spending will reach $32 billion by the end of 2022, up from an estimated $12.9 billion in 2018. The companies most likely to take advantage of that torrid growth rate are Canadian-licensed marijuana producers, says Vivien Azer, an analyst at investment firm Cowen. Firms such as Aphria, Aurora Cannabis, Canopy Growth, Cronos Group and Tilray have been able to gobble up the majority of supply agreements that allow companies to sell recreational weed in Canada, Azer says, and are likely to be first-movers when it comes to expanding into international markets.

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Major firms are showing interest. In December, tobacco giant Altria announced plans to pay $1.8 billion for a 45% stake in Cronos Group. In August, beer, wine and liquor producer Constellation Brands invested $4 billion in Canopy Growth, upping its stake in the cannabis firm from 9.9% to 38%.

Should I invest in cannabis stocks now? Probably not—it’s still too early. Even the more established players in the cannabis business are going through growing pains. Although nearly all Canadian growers are reporting massive spikes in revenues following legalization, most project little to no earnings in addition to operating losses as they pump money back into expanding their businesses.

The supply shortage following legalization is just one of many hurdles these firms face, says Jason Wilson, president of investment firm Budding Equity. “Post-prohibition, it remains to be seen which companies will be able to execute on all these different levels—from marketing to supply chain to branding,” he says.

Plus, legal cannabis businesses compete not only with each other, but also with long-established black markets, says Charles Feldmann, an attorney whose practice assists medical marijuana business clients. And “black-market distributors don’t have to pay lawyers or accountants or banks or taxes,” he says. With the industry still in its early stages, trying to pick a winner is like playing the lottery, Feldmann says. “If you’re considering investing in pot stocks, it has to be with money you have no problem losing.”

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What makes these stocks particularly risky? Even after pulling back, prominent pot stocks are trading at nosebleed levels. A basket of cannabis stocks tracked by analysts at Wells Fargo trades at an average price that’s 22 times projected 2019 sales. Remember: There are no earnings to speak of. The average price-to-sales ratio for the S&P 500 is 1.9.

Increased volatility stems in part from the fact that pot stocks are owned mostly by individual investors who are often more likely to react to headlines than are institutional shareholders. “It seems like a tweet from the right person can send the market careening in one direction or another,” says Steve White, CEO of Arizona-based cannabis company Harvest Inc.

If I still want to invest in pot stocks, where can I do it? Canadian cannabis firms can list on U.S. exchanges and trade just like any other stock, as long as they don’t have business operations in the U.S. Only a few have opted to do so, so far. You’ll find a handful of cannabis-based biotech firms, both domestic and internationally based, listed on U.S. exchanges as well. Some Canadian firms that haven’t listed stateside trade on the Toronto Stock Exchange and may be available to trade via your online broker.

Because marijuana is a Schedule 1 drug, it’s still federally illegal in the U.S., and American firms can’t list on U.S. exchanges or in Toronto. But these stocks, along with smaller Canadian names, trade on minor Canadian exchanges or on over-the-counter markets. Most are penny stocks that don’t have to adhere to the reporting requirements of major exchanges and should probably be avoided.

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If you must speculate, consider a diversified approach. The ETFMG Alternative Harvest ETF (symbol MJ, $29) holds nearly 40 stocks—mostly cannabis producers, but also makers of fertilizers, pesticides and growing equipment, as well as tobacco firms.

Are there other ways to invest in the green wave? The partnership of Constellation Brands (STZ, $189) with Canopy Growth represents an intriguing opportunity, says Azer. Constellation, known for brands such as Corona beer, Black Box wine and Svedka vodka, eventually plans to produce cannabis-infused beverages and sleep aids. Canopy’s revenues are currently a drop in the bucket at Constellation, so investors bullish on cannabis shouldn’t buy for that reason alone. Nevertheless, the firm is worth considering on the strength of its alcohol business, buoyed by strong demand for its lineup of craft and imported beers. “Constellation is a best-in-class beer stock with a free cannabis option,” says Azer.

Biotech firms might be another way to play cannabis. In June, the Food and Drug Administration announced its first approval of a marijuana-derived drug, Epidiolex, a treatment from GW Pharmaceuticals (GWPH, $125) for rare forms of epilepsy. Although there is huge potential for growth in this field, says Arcview CEO Troy Dayton, it remains to be seen what kind of market exists for these treatments and how willing doctors will be to prescribe them. Analysts at investment research firm Stifel assign a “buy” rating to Cambridge, England–based GW Pharmaceuticals, which trades in the U.S. as an American depositary receipt. But the stock is a risky proposition given that the firm isn’t expected to produce positive earnings until 2020, according to Stifel’s estimates.

What will it take for marijuana investing to take off in the U.S.? Nationwide legalization. A 2018 survey from the Pew Research Center found that 62% of Americans think the use of marijuana should be legalized, up from 31% in 2000. The STATES Act, a bipartisan bill introduced in Congress in 2018, would represent the biggest step yet toward legalization, says Azer. The bill would grant each state the right to regulate the sale of marijuana within its own borders. The law could also pave the way for U.S. firms to have easier access to federally regulated banks and to list on major U.S. exchanges, says Dayton. Opinion among cannabis industry insiders and state regulators is split as to whether the legislation is likely to pass.