FOR THE INVESTOR

Is it Time to Buy Cannabis Stocks?

by David Borun

Zacks | December 11, 2019 
Source: Yahoo Finance

This is a story of the good, the bad and the ugly….and the opportunity.

Let’s take a quick tour through the history of publicly traded cannabis stocks and also take a look at where the opportunities currently lie for investors in this exciting space.

The Good 

As U.S. states and other countries started to allow the medicinal use of marijuana starting 20 years ago, companies sprung up to fulfill the demand for cannabis products to be produced, distributed and sold to patients. The inconsistent patchwork of rules and regulations in various jurisdictions meant that most of these organizations were small, local businesses.

There were some forward-thinking businesspeople who imagined a day when cannabis would be a commercially viable product – both for the medical and recreational markets – and who began to build businesses with a wider reach, many of which would become the publicly traded companies of today.

As public opinion on the use of cannabis shifted and the trend toward legalization began to pick up steam, hundreds of those companies began trading “over-the-counter” (OTC), meaning investors could purchase equity shares, but because they were not listed on major exchanges, and the companies were not subject to the financial reporting requirements and strict oversight that most investors have come to expect.

The vast majority were “penny” stocks, with share prices of just a few cents (or less), and often dubious business prospects. Most of them no longer exist and the investors who envisioned big profits as a result of being in early lost the entire value of their investments.

New industries tend to be prone to boom and bust cycles and marijuana is certainly no exception.

Fast forward to 2019 and 11 U.S. states have legalized the production and sale of recreational marijuana and 33 allow medicinal use. Additionally, the entire country of Canada legalized recreational use in 2018. There are now large, well-capitalized companies operating in both countries and many of them trade publicly.

But there are significant limitations on how an investor might participate.

Major U.S. stock exchanges – quite sensibly – will decline to list any companies who are engaged in illegal activity, and since marijuana remains illegal at the federal level in the U.S., that means no companies who deal directly with marijuana inside the country are traded on the NYSE or NASDAQ.

Currently, the marijuana companies an investor can purchase on those exchanges either operate only in other countries where marijuana is completely legal – most notably Canada – or are U.S. companies that provide ancillary services to the marijuana industry but don’t handle the products themselves. There’s literally even an industry euphemism for that type of business – companies that “Don’t touch the plant.”

Many more companies are now operating in a legal grey area in which they are virtually certain of their immunity from criminal prosecution because they are following the laws of the state in which they do business, yet cannot use traditional banking and credit card services or deduct many expenses when calculating taxes owed, and also cannot list their shares on the major exchanges.

During 2018 and the first few months of 2019, investor interest in marijuana stocks caught fire and most of the publicly listed stocks in the industry saw huge increases in share value, with more than a dozen companies exceeding a billion dollars in market capitalization.

It was definitely another boom.

More . . .

Zacks Responds to Pot Stock “Gold Rush”  

Legalized marijuana, with almost unimaginable profit potential, has swept over all of Canada, down through 33 states plus D.C. This brand-new industry is booming from $9 billion in 2017 to an expected $32 billion in 2020. It could soar above $146 billion by 2025.

Not since the Repeal of Prohibition in 1933 has there been such a release of pent-up demand.

Will you be one of the investors to take full advantage?

The Bad

Because the number of stocks available was so small, and the potential market for cannabis sales was so large, investors quite logically assigned very rich valuations to those companies, expecting that they would soon be sharing an enormous windfall.

It’s the classic growth stock conundrum. If you see a company that has the potential to exponentially grow revenues and earnings, but is still in the growth stage in which they are spending heavily on expansion, you have to take a leap of faith to buy early. If you wait until the money is rolling in, the share price will likely have already risen to reflect a more traditional valuation and the opportunity for huge gains will be gone.

If you buy and you’re wrong however, the losses can add up quickly.

The tide turned for the marijuana stocks early in 2019 as a host of regulatory hurdles, distribution bottlenecks and a still-thriving black market negatively impacted financial results. The optimism about the once-bright future of the cannabis industry began to fade quickly.

While many well-run companies carefully explained the (potentially temporary) factors that prevented them from posting better results, nervous investors quickly grew impatient.

The Ugly   

The uncertain legal status of marijuana in the U.S. has kept most big institutional investors on the sidelines. Institutional ownership tends to smooth out price volatility in a stock because professional investors managing billions of dollars tend to plan their trades carefully and aren’t easily swayed by rumors or emotion.

Institutions enter and exit trades gradually, buying and selling their positions in a controlled manner rather than loading up or dumping their shares all at once.

The large retail-investor ownership of the marijuana stocks helped them tumble quickly once sentiment changed. The same forces that took those stocks up like a rocket conspired to force them down just as quickly.

The ETFMG Alternative harvest ETF (MJ) lost 56% of its value between March and December of 2019 and many individual stocks lost 70% or more. The down move was exacerbated by large short interest as professional traders preyed on the panic in the sector, selling stocks short into the crash.

The Opportunity  

The marijuana industry is far from dead. In fact, it’s arguably in better shape today than it was in March, and there are opportunities to buy many strong companies at a fraction of the value they were trading just 9 months ago.

Many of the regulatory and supply issues that plagued the Canadian market during the first year of legalization are getting worked out and hundreds of new retail stores are opening. In December, the second phase of Canadian legalization will take effect as derivative products hit the shelves for the first time, potentially producing a big sales boost.

There has been progress in the U.S. as well, with the House of Representatives passing a bill that would allow banking access to marijuana companies and on the verge of passing a much wider legalization bill. Though those pieces of legislation face an uncertain fate in the Senate, it’s clear that the regulatory environment is shifting in favor of legal marijuana in the U.S.

Any investor who avoided marijuana stocks over the past two years would be well served to take another look. Right now could well be the opportunity you’ve been waiting for.

How to Pursue the Big Profits  

At Zacks we’re monitoring political developments very closely as well as tracking individual stocks.

This space could skyrocket from $9 billion in 2017 to an expected $32 billion in 2020. Yet only a few growers, pharmaceuticals, financial firms, suppliers – both established and start-ups – are the true innovators and offer exceptional profit potential.

So if you don’t want to devote the constant attention and painstaking analysis to find these often little-known tickers, we can find them for you.

You’re invited to take part in the portfolio service I’m directing, Zacks Marijuana Innovators.

Our approach is aggressive but responsible and vigilant. We’ll pursue double and triple-digit gains, alerting you to what and when to buy and when to sell. I’ll also brief you on breaking market news that directly affects your investments.

Time to Get In  

This is your chance to follow the live buys and sells inside Marijuana Innovators, but please note that the number of investors who take part will be restricted and the deadline is coming up fast. The portfolio closes to entry Sunday, December 15.

Good Investing,

@DavidBorun
Zacks Stock Strategist

David Borun is Zacks’ Cannabis Stock Strategist. He applies 20 years of trading experience and recent concentrated industry analysis to the direction of Zacks Marijuana Innovators.

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