Investing in Cannabis? Beware These Red Flags

Due diligence is particularly critical when investing in cannabis firms given the numerous regulations the industry faces, as well as a rapidly shifting landscape.

Marijuana leaf
(Image credit: Getty Images)

The cannabis sector continues to demonstrate favorable tailwinds while indicating that there is still significant upside to come. Strong market performance – the Prime Alternative Harvest Index is up 46% year-to-date – is sure to pique the interest of investors.

Before investing in marijuana stocks, however, individuals need to be aware of the red flags that face the industry and the companies therein.

While unique in its federal legal standing, investing in cannabis is similar to any other industry. The principles of conducting sound due diligence remain in effect. In fact, due diligence is much more critical in this nascent space because of the immense regulations the market faces, as well as the many changes under way in this rapidly shifting industry.

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And because marijuana is still federally illegal, there are nuances to investing in cannabis that you must be aware of before making any decisions.

Read on as we discuss red flags to look for when evaluating cannabis investments.

Inexperienced Management Teams

Nascent spaces tend to have their bad actors, and cannabis is no different. Investors must avoid making previous years' mistakes in cannabis, where numerous investors took chances on inexperienced teams and founders. All too often, due to a bad actor or otherwise, these ventures underperformed.

Now, several years into the market's maturation, management teams are evolving. Companies serious about success churned its leadership, bringing in executive team members with the experience needed to scale operations. These new additions are now pivotal parts of the equation that see brands scaling their internal and external processes.

Before investing, look carefully at management teams and executive boards. Identify the seasoned executives with successful track records to back it up. Companies built for success attract successful talent. Follow the talent when investing – in anything, not just cannabis.

Sectors Ripe for Commoditization

State-by-state market fragmentation in the cannabis space amplifies the importance of avoiding commoditized or soon-to-be commoditized sectors. Keep in mind that what applies in one state might not apply elsewhere; cultivation is a prime example, where the space is already commoditized in several states.

Avoiding these marketplaces is wise as no investor wants to find themselves in a race to the bottom.

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Cultivation is far from the only sector of concern. Consider the spaces thriving due to the current federal status of the plant. Sectors that cropped up to solve a problem could go away once legalization occurs on the national level. Areas such as alternative banking for the industry will no longer be needed once federal banking reform passes – which could come in the next few months to years, if forecasts prove accurate.

Unsustainability Post-Legalization

Look beyond a company's footprint when conducting due diligence. Federal regulations prohibit operators from crossing state lines. Companies have built or acquired sprawling, expensive, vertically integrated operations in each state to conduct business in more than one state legally. Today, these ventures are typically regarded as top names in the space, but that strength could become a detriment that investors have to consider.

Redundancies in operations could hinder profitability, especially once federal legalization passes. No longer needed, these large operations that suck sizable resources and capital could begin to drag down profits.

Investors should steer clear of any company that could wind up in this predicament. Avoid investing in such a scenario by assessing how many states a company is currently operating in. Analyze the size of each operation and which states are profitable. Break down the large-scale venture into more manageable chunks to truly see if the investment is worthwhile.

The Wrong Locations

The pickings used to be slim, at just a few legalized states. But as it currently stands, 16 states and Washington, D.C., have legalized adult-use marijuana. The medical market is much more prominent, with 36 states legalizing medical cannabis in some form.

While each new market is exciting for cannabis reform, not all are created equal. Regulations and market prospects vary by state. When looking to invest, markets must hit specific parameters to be deemed worthwhile. Look at the most populous legalized markets to start.

At Entourage Effect Capital, we prefer to invest domestically. California is a prime option, with an emphasis on its population and licensing structure.

Unrealistic Valuations

Press releases are one of the most common forms of investor information. That said, they should not be relied upon as the sole source of company news. Press releases will bend the story to the company’s agenda and could potentially leave out key details an investor should know.

Financial statements help fill information gaps. Combined with press releases, financial reports help provide a complete look into the company's activity and the effects each move has on the bottom line. Although these statements are often dense and can be difficult to parse for a beginner, the prime parameters to assess should be profit and loss (P&L), price-to-book (P/B) ratio, price-to-earnings (P/E) ratio and price/earnings-to-growth (PEG) ratio.

Remember: Underwriting a cannabis company is no different than underwriting a firm in any other industry. While new, exciting and complex, the cannabis space is just like any other investment for the most part, and will only normalize as federal regulations reform.

Matt Hawkins
Contributing Writer,

Matt Hawkins is the Founder and Managing Partner of Entourage Effect Capital. He has 20-plus years of private equity experience and has founded multiple $500 million-plus alternative firms. Matt also serves on the boards of numerous cannabis companies.