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Take A Clear-Eyed Look At Cannabis Stocks

Public opinion continues to shift in favor of legalizing marijuana in much of the country. But investors have reason to be wary of leaping into cannabis investments – at least before they give the industry a long look.

One of the frequent arguments in support of legalizing marijuana is that doing so will convert an under-the-table market into a legitimate one, bringing new tax revenue and the potential for legal investment. The expansion of worldwide spending on cannabis seems to support this argument, at least to some degree. With Canada legalizing recreational marijuana last year and a variety of additional U.S. states (most recently New York) poised to do the same, it seems likely that the move toward acceptance in this country will continue.

That said, there are still many unknowns. The federal government continues to prohibit all uses of marijuana, putting national and state law in conflict for a growing number of jurisdictions. When and how this tension will resolve is not clear. Yet some investors remain eager to invest in marijuana right away, given the potential for significant growth in the sector.

Unfortunately, marijuana investments are, as a class, extremely speculative. This is not particularly a reflection on the underlying product’s value or lack thereof. There are simply a lot of marijuana or marijuana-adjacent companies with very short track records and little useful data for investors hoping to evaluate their prospective future growth. And without a clairvoyant knowledge of how marijuana policy is going to unfold, investors are building their due diligence, at least in part, on guesswork.

There are different types of companies that may fall under the broad umbrella of “marijuana stocks.” These may include growers, who cultivate and distribute marijuana itself; biotech companies that focus on developing cannabinoid pharmaceuticals; and ancillary product and service providers, such as companies that make lighting and hydroponics for growers. Some companies may incorporate the marijuana industry within a wider array of goods or services, too. For instance, garden supply company Scotts Miracle-Gro has made strategic moves to expand its hydroponic business, with a clear intention to sell to marijuana growers expanding their own operations. Each type of marijuana or marijuana-adjacent company faces different challenges and opportunities.

Regardless of when – or if – marijuana becomes legal in the U.S., there is no guarantee any particular company will thrive. Consider last year’s cryptocurrency boom and the subsequent bust. Many investors were convinced that cryptocurrency will one day replace cash and become a mainstream way to conduct commerce. For all we know, this idea may not be fundamentally wrong. But there are hundreds of cryptocurrencies to choose from, and it is almost certain that many of them will fail. How can investors know they have picked the right one? You may have the potential to win big if you happen to pick the company that gains traction – but you have the same potential when you buy a lottery ticket, and no reputable financial adviser would suggest playing the lottery as a viable long-term financial plan.

My colleagues and I have discussed the problems with picking individual stocks and trying to time the market, which extend far beyond the marijuana sector. Individuals rarely if ever have the resources to perform the necessary due diligence on a sufficiently diversified basket of individual stocks. At Palisades Hudson, we often encourage our clients to use mutual funds and exchange-traded funds to build diversification into their investment strategy.

Marijuana-focused ETFs do exist. However, these funds are not substantially safer than individual marijuana stocks. More so than in other industries, many marijuana-based enterprises lack operating experience. And, especially when it comes to companies cultivating marijuana directly, many are producing little if any revenue so far. Even bundling a variety of these stocks together does not guarantee the fund will include any outstanding performers capable of carrying the rest.

For a comparison, consider a fund that is composed entirely of small pharmaceutical or biotech companies. Some of them may be able to hit on a major breakthrough. But many – or even all of them – could fail, due to pressure from larger competitors, other external market forces or poor management. That’s no way to secure a good return. True diversification requires a broader view.

Beyond the company-specific risks involved, marijuana investments present particular risks as a class. For now, any company whose business extends to the United States runs the risk that the Justice Department could clamp down on enforcing existing federal policies. Even if companies can escape the risk of outright shutdown, operating a marijuana-based enterprise in the U.S. currently means the inability to access the banking system, making it difficult or impossible for such businesses to raise capital through borrowing.

An additional reason for U.S. investors to be wary is the necessity of buying most marijuana stocks outside of major stock exchanges, such as the New York Stock Exchange. While the NYSE and Nasdaq now both list at least one purely cannabis-based stock, this is still rare. Some Canadian marijuana stocks trade on Canadian stock exchanges, and some American companies have even gone north in search of a more welcoming environment before going public. But American buyers must buy nearly all cannabis securities “over the counter,” which means the companies involved are not required to adhere to the same rules about reporting and disclosure that govern stocks on major exchanges. This represents another layer of risk.

Last year’s blanket legalization in Canada also may mean that supply could outstrip demand, at least in the short term, as Canadian growers expand their newly legal businesses. This could drive down prices. Other major economies, including Germany and the U.K., have legalized marijuana for medical use, which could contribute to growing availability and increased competition for companies focused on pharmaceutical uses. Marijuana is still a relatively new sector, and it will probably remain volatile for some time. Eventually, supply and demand will likely stabilize, but there is no guarantee a particular company will survive the industry’s growing pains. The young industry also has attracted some outright scams, and the Securities and Exchange Commission has warned investors to be on their guard.

If marijuana becomes legal in the United States and if the global market continues to grow more mainstream, marijuana stocks may one day have a place in a well-diversified portfolio. But those are two major conditions that have not yet fallen into place. For now, wise investors would do well to steer clear.

Vice President and Chief Investment Officer Paul Jacobs, of our Atlanta office, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 12, “Retirement Plans;” Chapter 15, “Investment Approaches and Philosophy;” and Chapter 19, “A Second Act: Starting a New Venture.”

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