Posted By 
By Chris Arthur
(Sponsor Content)
Is all the buzz around marijuana investing deserved? How did the value of marijuana stocks get so high in the first place? Why are they currently on a bit of a low? And with valuations at a discount, is now a good time to get in on the action?
Clearly, there are big risks. But there are also big rewards for investors in this fast-growing new industry. After all, marijuana legalization is scheduled to take place very soon.
Anyway, it seems inevitable at this point. How can you add marijuana to your investment mix? With Canadian investors in mind, we took an in-depth look at these questions.
Legalization isn’t as simple as when the House of Commons votes to create a new marketplace. Many politicians are enthusiastic. However, they know that there are many other considerations and costs involved. For those interested in marijuana investing, it’s top of mind.
The marijuana marketplace has grown up fast, even before legalization
When is the absolute best time to invest in the fast-growing marijuana industry? Actually, that was probably more than a year ago. Canada’s Prime Minister campaigned on legalizing marijuana in the last election. The thinking was to disrupt the black market. At the same time, while they could create a windfall of tax revenue and they’d get a substantial cash infusion from a legalized marijuana industry.
In response to the enthusiasm, investors poured money into cannabis companies. Some of these quickly went from penny stocks to high-flying billion-dollar firms.
For instance, the market cap of the top five cannabis stocks alone grew by 400%. Canopy Growth Corp., the leader in Canada, has a market cap of over $5 billion. If you got in early enough, you saw a 261% return on your investment. Aurora Cannabis had a slightly smaller market cap. However, it posted a 1-year return of 353%. PharmaCan Capital’s stock was up 385%.
The whole reason we saw such startling triple-digit returns for marijuana stocks year? Deregulation. Sooner or later, it’s coming.
A bigger market than just Canada
Marijuana legalization creates a global opportunity. It is not confined to the Canadian marketplace. However, it is a also a unique situation. The usual big gorilla on the block, corporate America, is a no-show. Consider legalization in individual American states like Colorado and California. There, federal law still cuts American companies out of the competition.
That means, for once, Canadians can step over their southern cousins and become global leaders in a brand-new industry. This is green pasture territory. It is a dreamy prospect for investors looking for profit.
The marijuana industry includes over 85 companies with a combined market value of $30 billion. Some believe the global medicinal marijuana marketplace alone could be worth US$31.4 billion by 2021. According to Eight Capital, it could be worth $180 billion by 2025. Some think Canadians might be coming late to this market. Medical cannabis programs started here as early as 2001. If anything, we set the trends.
However, the big growth we have seen so far isn’t likely to continue forever. Investors looking into this industry need to manage their expectations.
Today, marijuana investing is about diversification. After all, there’s volatility. You’re betting on companies that must prove their worth by generating sales. What kind of sales? That’s the billion-dollar question.
Not every marijuana start-up has all the answers. So, what are paying customers really looking for? That is still up for debate.
Overview: Where the marijuana industry is today
There are different kinds of potential customers for marijuana. The first, smaller group is the smokers. But the second group includes people who consume cannabis in other ways. After all, customers can do it through food, beverages, supplements or other means. Also, medical marijuana is a big potential area of growth. Additionally, there are specialty products that cross over into the bigger food and beverage territory.
According to Evolve ETFs’ research, in 2015, there were just five countries where medical marijuana was legalized (or in the process of being legalized). By 2017, that shot up to 25 countries.
Canada is a leader in this sector. It legalized medical marijuana in 1999. The big breakthrough though came in 2015. There were new rules to allow value-added products. The Supreme Court said restricting legal access to only dried products was unconstitutional. This opened up the market with new product lines. That in turn transformed the medical marijuana landscape.
The number of adult Canadians who use recreational marijuana could be about 20 per cent of the population. How do we know this? The government is trying to get a better handle on the actual number. It’s tracking the THC-laced product that winds up in our sewers. Canadians spent $5.7 billion on marijuana for medical and non-medical purposes in 2017. Market studies estimate the value of the Canadian recreational marijuana market in 2018 to be about $7.9 billion.
Beverages will likely be big business for the marijuana industry. Energy drinks and health supplements of every variety will separate themselves from the pack by infusing them with marijuana extracts. Some companies are planning cannabinoid-infused beverages for launch in 2018. These products have huge potential for sales.
It could be an easy way for companies outside the marijuana industry to get a foot in the door in this growing industry. Alcohol giant, Constellations Brands, owner of Corona, purchased a 9.9% stake in Canopy Growth Corp (WEED.TSX).
Risks in marijuana investing
There are still many questions around the legalization process. Uncertainty is sure to prompt additional volatility.
How will government-mandated producers ply their trade? Also, how will testing be carried out? What does quality control even mean for this product? What are the growing risks, such as with insects, pesticides and plant diseases?
A lack of standards from the government and from the emerging companies isn’t helping marijuana investing go mainstream. For instance, there is confusion around basic accounting. Financial statements from marijuana companies may be misleading. That’s the take from a Canadian Business report. Calculating gross margins, for instance, is difficult for a new industry:
“The market for tomatoes is well-established, prices are not in dispute, and a producer can enter into future sales contracts. That’s not the case with recreational marijuana sales, an industry that doesn’t even exist yet. Prices, costs, sales volumes and the quality of inventory are still very much up in the air.”
There are other problems ahead. For instance, let’s say marijuana products are given roughly the same status as alcohol. How will that affect laws around driving under the influence? Currently, there is no reliable test that is the equivalent to a breathalyzer for alcohol. The only reliable method currently is a blood test. However, taking a roadside blood sample is not legal.
Imagine if legally-buzzed Canadians enjoying “one more for the road” start driving in droves. Tis could create a public safety issue.
Getting regulation right
Licensing is another area where an inconsistent approach among provincial governments is likely to cause business problems. In particular, demand may not meet supply needs.
Media reports have already highlighted a vast gap between the legal supply and expected demand. We can see that from the number of licensees. One reason for legalization is to eliminate the black market that benefits organized crime. Leaving expectant customers for the legal commodity in the lurch seems counterproductive.
However, some prospective marijuana companies can’t start selling right out of the gate. They may find themselves at a disadvantage.
Certainly, undersupply is a problem that government can resolve over the long term. Simply put, the government will approve more licenses over time. But that brings us to the next, even bigger problem: oversupply.
Think about when the retail price of legal recreational marijuana drops from $8 a gram down from overproduction. Most likely, that’s when we are likely to see a culling in the marketplace.
How marjiuana companies will compete
There will be a few ways to come out on top. The first way is to be a super low-cost grower. There’s a lot of supply coming onto the market. Right now, we’re looking at $8 a gram. However, with increasing supply, that could be down to $3 or $4 a gram in the next year.
For recreational weed, a long-term supply gut is not just expected. It’s just about inevitable. By 2020, supply will double or triple expected domestic demand.
At that point, successful players will survive by looking internationally and creating niche products.
Given the market cap, Canadian companies can’t just be focused on the Canadian market. They will have a few years to become global players. But they’ll be looking to regions like Europe, instead of the traditional US market. As for product niches, forward-thinking companies will develop oils or beverage products. Every global beverage company should be looking at partnering with marijuana companies.
But let’s not put the cart before the horse. Before sales, legalization still must happen. And as we’ve mentioned, that is taking a bit longer than investors had hoped.
Mitigating risks: Diversification in marijuana investing
Would you be comfortable with a level of risk where your investment could go up or down 10 per cent in a single day? If not, then marijuana stocks are probably not for you. But that doesn’t mean you can’t get involved in marijuana investing.
“If you’re a new entrant to marijuana investing, then a diversified approach is the only way forward,” says Horizons ETFs Management (Canada) Inc. Senior Vice-President and Head of Sales Strategy Mark Noble. “There’s a lot of single-stock risk. It is only rivalled by blockchain, given the newness of the space and the players.”
North American investors have moved billions into these index funds that mitigate risk through diversification. At the same time, they’re enjoying reduced fees. Of course, we know lower fees improve returns over time.
With that in mind, we reviewed several of the leading marijuana ETFs currently available in Canada. Investors can look for an ETF which provides exposure to a basket of marijuana equities.
Some leading marijuana ETFs
The Marijuana Opportunities Fund from Redwood Asset Management aims to give active exposure to the sector to deal with the predicted volatility. The ETF’s holdings include a large range of companies. Some examples are Medreleaf Corp., Hydropothecary Corp. and Supreme Cannabis Co Inc.
Horizons Marijuana Life Sciences Index ETF [HMMJ/TSX] is the world’s first marijuana ETF. It includes publicly listed life sciences companies with significant business activities in the marijuana industry. It aims to replicate as much as possible the performance of the North American Medical Marijuana Index, net of expenses.
The goal of marijuana ETFs is to minimize risk from speculation, Noble explains. “Look at the underlying holdings and the value of the producer stocks, like Aurora. The prices on these stocks are exorbitant versus their earnings.”
SEED is another marijuana ETF available in Canada. However, it is different from Horizons’ product because it is managed actively. It does not follow a specific index. This allows it to be nimble. It can take advantage of opportunities as they arise.
With risks, come rewards. Possibly, big ones.
There are consolidation opportunities and ‘big pharma.’ And tobacco companies are also considering marijuana. For the diversified equities investor, there may be additional opportunities. For instance, look to biopharmaceuticals, fertilizer, real estate for growers. Additionally, there are other companies that are involved in the infrastructure of the industry.
Marijuana investors will find it as hard to pick winners as it was for investors in past booms. Think of the lead-up to the dotcom tech bubble. For every Yahoo, there were many more examples of also-ran’s like Pets.com and Alta Vista.
This is an industry in its infancy. For current prices, there is a lot of speculation. They may not be representative of ways of valuing products. That explains the volatility. And that brings us back to how investors can reduce risk from marijuana investing risk through diversification by using ETFs.
In the end, investors have options, between passive index tracking or professional active management.
“Our advice to clients is simple: ask yourself, why do you want to get in?” Noble says. “Fear of missing out? You want to get in on revenues already returned? You’re probably already too late to the party. All that pricing potential is already built into the stocks. That’s why diversification may be a smarter play. It’s not the second or third reason. It’s the main reason to get involved in marijuana investing.”
Chris Arthur is a Financial Advisor and Insurance Specialist working for WealthBar, a robo-adviser. He takes the clients’ point of view, anticipating their needs and providing them with the perfect solution. This blog originally appeared on the WealthBar site on April 20, 2018.
