Global cannabis markets have become an exciting area over the past few months for both investors and traders alike, and with the legalization of marijuana in Canada last Wednesday, the sector remains ripe for an explosive wave of growth, expansion, and consolidation.
With worldwide spending on cannabis reaching $9.5 billion in 2017 alone, many experts estimate that this figure will increase to $32 billion by 2022, equivalent to a compounded annual growth rate of 27.5%.
While this projected rate of growth is impressive, as with many young markets in the past, most of the companies that are present today, unfortunately, won’t be around five years from now, and if they are, it’s likely it’ll be in a different form and capacity. For that reason, it’s essential to have a solid grasp of how the cannabis industry works, as well as particular things to look for in a cannabis stock.
Understanding Pot Stocks
For the most part, there are two classifications of cannabis products; recreational marijuana and medical marijuana, with several other niche products within these categories. Medical marijuana can be smoked or inhaled, while also consumed through other methods. One of the most common medical marijuana products is cannabidiol (CBD), with the first CBD-based drug, Epidiolex, approved in June 2018 by the U.S. FDA.
Other drugs such as Marinol, Cesamet, and Syndros have also been approved as well, opening the door for this aspect of the industry to flourish. The difference in legalization between recreational and medical marijuana is that the former has been approved in 30 U.S. states, while only nine approve of recreational marijuana usage at the moment.
With this in mind, there are three different types of marijuana stocks. Cannabis growers, such as Canopy Growth (NYSE: CGC), cultivate cannabis (usually through indoor facilities), harvest their crops, and distribute this to either consumers through dispensaries or act as suppliers to other cannabis companies.
Cannabis-oriented biotech companies, such as GW Pharmaceuticals (NASDAQ: GWPH), focus on developing cannabinoid drugs used primarily in medical marijuana products. Lastly, auxiliary and logistical companies within the cannabis industry exist as well, offering products and services such as lighting systems and hydroponics products to both large-scale businesses as well as individuals. The largest example of this type of company is Scotts Miracle-Gro (NYSE: SMG).
Understanding the Political and Economic Dimensions
The most significant consideration for many investors, especially in countries such as the United States with different laws, is that the potential for a change in the political climate can drastically impact the business.
With past threats from the U.S. Department of Justice heralding a complete shutdown at worst for cannabis businesses operating in the country, it’s understandable why this is such a big deal, and why investors need to keep their eyes out for the latest developments in this front.
When U.S. Attorney General Jeff Sessions rescinded an Obama-era administration policy that restrained the federal government from intervening in states that already legalized marijuana, investors and markets felt the potential threats that this posed on their businesses. As marijuana legalization becomes a possibility in other countries, this will open up further opportunities as well as corresponding risks.
At the same time, understanding the current imbalance between supply and demand is crucial along with how it’s impacting cannabis stock evaluations. The expectation for tremendous growth in and of itself has fueled an optimism in the markets for the value of these companies regardless of the fundamental aspects of the firm.
In the next year or two, a massive explosion of supply capacity will be taking place amongst cannabis growers. However, within the next 2-5 years, supply will match if not expand the total demand, which could lead to a glut.
What this means is that many companies in today’s era have been bolstered by the general sense that demand is going to increase. However, this is a trend that isn’t going to last forever, and when the does excitement clear, many companies are going to find themselves in a difficult position.
Key Signs to Look for in Marijuana Stocks
While researching a cannabis stock isn’t that much different from analyzing another company, there are a few unique factors in the industry that you should look for. For cannabis growers, pay attention to their “all in” cost of sales per gram as well as their cash cost per gram for production. At the same time, major companies differ slightly in how they report metrics. Production Costs as reported in Aphria Inc’s financial statement, for example, is in fact the same metric as the Post Production Costs for MedReleaf’s statements.
Regardless, production costs are the single largest consideration for cannabis producers, but it’s also worth taking into consideration other metrics, including energy costs. Since growing is such an energy-intensive process, lower growing costs are correlated with a better bottom line.
Another thing to look for are supply agreements that these various companies have. In Canada, companies are regulated by Health Canada and require a certification to grow cannabis, but it’s up to the provinces to decide how they will handle the cannabis industry, setting their own individual rules.
Some companies have released the maximum amount of cannabis the province will buy under their agreements but are working on international distribution agreements in places such as Germany and other high-population countries.
Additionally, keeping an eye out for which patents a company has is significant, as new cannabis-related products are being developed by a number of companies, each eager to gain a first to market advantage. The key here, as in other areas, is that investors need to look for companies that develop technology that is top of the line or will be key for the future in the sector, as it will be likely that competitors will use or mimic that innovation.
Lastly, it’s worth noting that the number of warrants and convertible securities issued by a company could indicate a future drop in share prices. Warrants let investors buy shares in the future, while convertible securities can be converted in the future into shares of the company’s stock.
Many Canadian cannabis growers have issued a large number of these securities in order to raise up funds rapidly, and this could mean that in the future (especially in light of some good news or development) a massive dilution of the stock’s price is a looming possibility.
Final Thoughts
Investing in the cannabis sector is a smart idea, but like in all industries (especially in a relatively young one such as this one with its fair share of growing pains), due diligence is important.
Good companies will have solid fundamentals backing them, and unless you’re trading based on chart patterns and other technical indicators, an optimistic outlook for the future isn’t enough for a mediocre company to survive in this industry in the long term.
