Up … or Up in Smoke?

What follows is a discussion of investment issues involving marijuana stocks, given recent state-level legalizations and increased investor attention. We neither endorse nor pass any judgment on the consumption of marijuana or legalization per se.

Recently, a friend and I were roaming the streets of San Francisco when we saw a huge line. It wasn’t for the new iPhone. It wasn’t even for brunch. No, folks were clamoring to enter a retail cannabis shop. Since marijuana became legal in California on January 1, these establishments have been popping up all over.^[i] Alongside this, financial media and investors are taking notice. So, considering the budding recreational marijuana industry’s potential growth, should investors inhale opportunities in this space? Or is it a bad trip waiting to happen? In my view, it is more of the latter—the cannabis industry isn’t a pot of gold on the other side of the rainbow.

Before you light up your portfolio with those alluring cannabis-related stocks, consider what you are investing in. Most marijuana-related stocks are tiny, falling in the small-cap to micro-cap range. The Marijuana Index tracks about 350 securities listed in the US and Canada that have “more than 50% of their operations focused on the marijuana industry.” Many of these are penny stocks—low-priced, thinly traded and lightly regulated securities occasionally subject to pump-and-dump schemes.^[ii] But even looking at non-penny stocks, these firms are small. Within the US Marijuana Index, only 1 constituent of 17 has a market cap exceeding $1 billion. For comparison, the median market cap of a S&P 500 company is about $20.7 billion. Small cap has its time, but that usually comes early in a bull market. In more mature bulls, we think the biggest, global companies with name recognition and healthy balance sheets are positioned best. There are no big US marijuana-related firms. None can even have full national reach, never mind global.

Folks going gaga over ganja seem to think recreational weed is a potential game-changing product, and they don’t want to miss out on the “next big thing.” But Mary Jane isn’t the only girl in town. Those high on marijuana’s investment potential may be overlooking a simple point: Weed is a smokeable^[iii] good that gives users a buzz. You know what else is smokeable? Cigarettes. You know what else induces a buzz? Booze. This isn’t lost on well-established players in the tobacco and alcohol industries, and they aren’t going to give up market share of recreational buzz-inducing goods very easily. The big conglomerates also have a built-in advantage: They possess the infrastructure and capital necessary to step in and dominate if they deem it worth their while. This has already started, too. Last year, an international drink producer bought a stake in the world’s biggest cannabis company, ostensibly to develop cannabis-infused beverages. If Big Alcohol and/or Big Tobacco do indeed expand to become Big Pot, the biggest winners could be big, boring Consumer Staples stocks, not today’s budding pot pureplays.^[iv]

Right now, though, the biggest point against the marijuana sector is probably its hazy regulatory environment. While marijuana is legal in nine states and Washington, D.C., it is still illegal under federal law—a big sticking point. Some are optimistic about the trend, arguing federal legalization is imminent. Last week, a senator from Colorado said President Trump would “support a federalism-based legislative solution to fix this states’ rights issue once and for all.” However, Attorney General Jeff Sessions has taken a hard line against marijuana after rescinding the past administration’s hands-off approach toward enforcing federal law—though this hasn’t necessarily brought radical change yet.

To showcase regulatory uncertainty’s impact, consider the cloud hanging over Canada. To raise capital, US cannabis companies have generally headed north of the border to Canadian stock exchanges, which are more “420-friendly”—perhaps tied to the widely held expectation for Prime Minister Justin Trudeau to legalize pot this summer.^[v] However, Canadian regulators took note after Sessions shifted toward tougher federal policy. After some deliberation, the Canadian Securities Administrators confirmed in February that companies with US operations would still be allowed to list on Canadian exchanges, so long as those firms made the proper disclosures. However, not all exchanges were on board. The Toronto Stock Exchange (TSX), Canada’s largest stock exchange, hasn’t allowed cannabis companies with US exposure to list—including Canadian companies with assets in the US—arguing US federal law takes precedence. This means cannabis companies seeking to raise money on Canadian capital markets must either list on a smaller exchange—which could limit access to financing—or forfeit the chance to participate in the US marijuana market. While rules can change, the legal questions are major headwinds that could dampen investor demand—and this uncertainty seems unlikely to vanish any time soon.

Right now, pursuing marijuana-related investments smacks of heat-chasing^[vi]—a chronic investing error. Since the start of the year, some experts have argued prime investment opportunities are hiding in the weed(s). Legalized marijuana is going to change health care! Clothing! Blockchain! It will solve the opioid crisis! But the grass isn’t always greener, and investing in something just because it is in the headlines is a backward-looking decision. Markets price in all widely known information immediately, and they don’t wait for investors to blaze through the pros and cons. On a forward-looking basis, marijuana stocks are a limited market with lots of legal uncertainty—better investment options lie elsewhere, in my view. 

I’m not saying marijuana will never have a place in a long-term, growth-oriented portfolio. It could happen in the distant, hazy future. But those high on marijuana-related opportunities may be chasing a half-baked idea.