The “legalize it” trend is building around cannabis as of late. In 2018, Canada legalized the plant for adult recreational use. Across the United States, there’s a wave of decriminalization or legalization, and more states have had some sort of cannabis reform than not. Now, there’s a strong argument that the federal government will legalize the plant for adult use on a countrywide scale.
The cannabis reform in North America and around the world is leading to the emergence of an entirely new industry. The emergence of the cannabis industry is expected to be a key driver of economic growth and tax dollars, as well as creating several opportunities for investors.
Investing in the cannabis industry, or any other emerging industry, has its perks. Getting in on the ground floor allows investors to take part in strong long-run growth as the industry takes hold, and it’s believed the cannabis sector has plenty of growth ahead. Grand View Research estimates that the industry will be worth well more than $70 billion annually by the year 2027.
Considering the overwhelming potential for growth in the space, investors are excited about getting involved. Before you do so, there are a few details you need to know.
Pro tip: You can earn up to a $2,500 bonus when you open and fund a new trading account from M1 Finance. With M1 Finance, you can customize your portfolio with stocks and ETFs, plus you can invest in fractional shares. Sign up for M1 Finance.
What Are Cannabis Stocks?
Cannabis stocks represent companies that operate in the cannabis sector. When you purchase a cannabis stock, you’re purchasing a small ownership stake in a cannabis company. There are six main types of cannabis companies to consider when investing in cannabis stocks:
- Cannabis Growers. Cannabis growers are often the first type of company that comes to mind when you think of cannabis stocks. These companies are farmers that specialize in the cultivation of the cannabis plant and harvesting of its flowers and leaves. Some cannabis growers sell their finished products directly to consumers. However, the most successful of these companies work through distribution networks, selling their finished products wholesale to cannabis stores.
- Cannabis Stores. While some cannabis stores focus on the sale of products they grow themselves, the vast majority work like any other retailer. These companies purchase cannabis and its derivatives from growers and manufacturers at a wholesale price. They make their money by selling these products to consumers with a markup to their cost.
- Extraction and Manufacturing Companies. Cannabis flower, or dried cannabis that is the most commonly used by consumers, is one side of the cannabis industry, but the industry is a vast one. Consumer uptake of other cannabis-derived products like extracts and edibles is climbing. Several companies focus on this area of the business. These companies purchase cannabis flower and leaves from growers and process these basic materials into final end-consumer products, ranging from pure extracts to edibles, lip balms, salves, and more.
- Equipment Companies. Growing cannabis is a science, and doing it effectively requires the use of growing equipment. This equipment ranges from lighting systems to hydroponic systems, proprietary growing mediums, fertilizers, and more, all of which are specifically designed for the cultivation of cannabis. The companies that create the equipment used in the process of growing cannabis fall into this category.
- Energy Companies. The single largest expense for most cannabis growers is energy. The vast majority of growers prefer growing the crop inside where temperature, humidity, and other climate-related factors can be controlled. Doing so requires the use of high-energy lighting systems, fans, filters, and more. As a result, electricity bills become quite high for these companies. There is a small subsector of the cannabis industry that is emerging with the goal of reducing the energy cost associated with cannabis production through the use of alternatives like solar, wind, and water energy running on its own microgrid. The companies that provide these solutions are energy companies, but tend to cater specifically to the cannabis industry.
- Biotech Companies. Finally, cannabis has long been thought to possess several medicinal qualities. However, it wasn’t until recently that any cannabis-based medications were available on the market. GW Pharmaceuticals made history with the development of Epidiolex, a cannabis-based treatment designed for severe forms of epilepsy, when it was approved in mid-2018. As the pioneer in the space, GW Pharmaceuticals remains the leader, but there are several other biotechnology companies that are now developing treatments using cannabis as a potential option for a wide array of medical ailments.
Cannabis Stock Pros and Cons
The cannabis sector is emerging. That comes with quite a few perks. However, investing in emerging sectors can have its own drawbacks as well. Moreover, the nature of the cannabis sector is different from more traditional sectors like technology, bringing in a unique risk-versus-reward proposition.
Cannabis Stock Pros
There are several benefits associated with making the right investment decisions in the cannabis sector. Some of the most important include:
- The Early Bird Gets the Worm. It’s impossible to stress enough the fact that the cannabis sector is an emerging one. If you would have invested in Google upon the emergence of the tech sector, or Amazon.com upon the emergence of the e-commerce sector, you would be rolling in the dough today. The same is possible in the cannabis sector. Making the right decisions in any emerging sector with the potential to be a blockbuster is a process that can create millionaires. The cannabis sector is no different.
- Options for Everyone Regardless of Risk Appetite. Most emerging industry investments are inherently high risk. In some cases, however, investments in the cannabis sector offer relatively low levels of risk. For example, companies that provide equipment to the cannabis sector may fail to capture their intended audience, but these companies can always fall back on providing equipment to other large-scale farmers — yet another booming industry. There are several cannabis companies whose products offer a pivot point should they fail to become a successful player in the cannabis space, adding a safety net for investors who get involved.
- The Feel-Good Effect. Most cannabis investments aren’t based in philanthropy, but some are. Investing in cannabis-related biotechnology stocks gives you an opportunity to profit from the development of potentially life-saving therapies. Making these kinds of investments has the potential to not only result in profits, but lets you feel good about what you’re investing in.
Cannabis Stock Cons
Although there are plenty of positives associated with investing in the cannabis sector, there is no sector without its blemishes. The cannabis sector is no different. Here are the drawbacks you should consider before making an investment in a cannabis stock:
- Poor Balance Sheets. As a growing industry, most companies in the space are spending ridiculous amounts of money on research, development, infrastructure, and other growth-related costs. Unfortunately, this can be painful on a balance sheet. There are a few gems in the sector with compelling balance sheets, but the vast majority of cannabis companies have a balance sheet that leaves quite a bit to be desired.
- Few Clear Winners and Losers. With the cannabis industry being in its infancy, there haven’t been many clear winners or losers in the sector yet. Therefore, most investments in the space are highly speculative, based on the belief that a company will become a winner in the future. Because future-telling isn’t a proven craft, there’s no way to be sure that you’re picking a winner when making an investment.
- Regulatory Risk. The cannabis sector was born of regulatory reform. Should this reform continue to spread, there’s a high likelihood that tremendous growth is ahead for the cannabis industry. If regulatory reform comes to a screeching halt or goes backward, however, investments in the sector today will likely lead to losses tomorrow. As such, investing in the sector puts your investment dollars in the hands of politicians and regulatory authorities, all of which have their own agendas.
Pro tip: If you’re going to add cannabis stocks to your portfolio, make sure you choose the best possible companies. Stock screeners can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Look for Lower-Risk Opportunities
Some investments in the cannabis sector can come with an extremely high risk profile. With poor balance sheets and regulatory risks at the top of the risk list, significant losses are a real possibility. So, if you’re going to invest in cannabis, look for the gems of the industry that offer a relatively favorable risk/reward profile. Some of these types of companies include:
- Multi-Sector Opportunities. There are several companies in the cannabis sector that have the potential to become major players in other industries. Most that fall into these categories are cannabis equipment and energy companies. Equipment companies have the potential to serve farmers of any crop, whereas energy companies have the potential to shift focus and ride the clean-energy wave should anything go wrong in the cannabis sector. Although losses can still occur, investing in companies that have the ability to serve multiple sectors greatly reduces the risk of significant declines in your portfolio value.
- Biotech Opportunities. If you want to invest in the cannabis space while completely averting the recreational regulatory risks, biotech is the place to be. The companies that are using cannabis to create medicine are cut from a completely different cloth than companies serving the recreational side of the market, and so too is their regulatory process. Instead of being at the mercy of authorities making the decision to legalize cannabis or not, these companies operate like any other biotech company, with those who have already been successful in the commercialization of therapies offering a much lower risk profile than most others in the cannabis space.
- Cannabis Companies with Strong Partnerships. Recreational cannabis isn’t all risk. If you want to get involved here, look for cannabis stocks that have grabbed the attention of big-money investors. After all, no entity is interested in throwing away billions of dollars. Both Cronos Group (CRON) and Canopy Growth Corporation (CGC) have been the recipient of multibillion-dollar investments, further validating their business models and suggesting that these companies represent strong investing opportunities.
How Much Should You Invest in Cannabis Stocks?
For most people, no single investment vehicle, sector, or stock should represent 100% of your portfolio. In the stock market, diversification is often the key to success.
How much of your portfolio should be allocated to the cannabis sector?
There is no one-size-fits-all answer to that question. Every investor is unique, with their own combination of initial capital, long-term goals, and appetites for risk. So, you and your financial advisor are best qualified to answer that question for you. However, there are a few factors to consider that can help you dial down your allocation strategy as it relates to investing in cannabis.
Pro tip: If you sign up for Motley Fool Stock Advisor you’ll receive their free report, “One Stock for the Cannabis Boom.”
Hedge Your Bets With Bonds
Stocks are the golden assets of the investing community. They can also open your investing portfolio to extreme amounts of risk. Most investors use bonds to shield their overall portfolio from significant losses should the market as a whole, or stocks within the portfolio, take a dive.
If you or your financial advisor haven’t already created a bond allocation strategy, you can start by using your age. A rule of thumb is the percentage of your portfolio that should be invested in bonds reflects your age. So, if you’re 30 years old, you’d keep 30% of your portfolio invested in bonds, with the remaining 70% invested in stocks and other higher-risk assets. This allocation strategy — and variations thereof — reduces risk as you age to help secure a solid income stream upon retirement.
Keep in mind, this is just a starting point and assumes your appetite for risk to be moderate. If you have a high tolerance for risk you might hold fewer bonds, and a low appetite for risk might steer you toward a higher bond allocation.
Choose the Type of Cannabis Companies to Invest In
Cannabis stocks are not all created equal. Some cannabis stocks will come with high levels of risk while others will offer relatively low risk. There are two rules of thumb to keep in mind when investing in either of these categories:
- High-Risk Investments. High-risk cannabis stocks have poor balance sheets or operate specifically in the recreational subsector, opening the door to high regulatory risk. The general rule of thumb is to allocate only 5% of your portfolio to all high-risk investments like these. For example, if you want to invest in two high-risk cannabis stocks that you believe offer about the same potential for growth, you could invest 2.5% of your portfolio in one and 2.5% in the other. However, you would not want to invest more than a total of 5% of your portfolio value across all the high-risk investments you hold.
- Low-Risk Investments. Companies in the cannabis-biotech sector, companies with strong balance sheets, and companies with the ability to pivot and serve other industries represent lower-risk opportunities in the cannabis sector. With these types of investments, the rule would be to invest no more than 5% of your portfolio value in any single stock. For example, if you want to invest in two cannabis stocks, both of which you believe offer the same value proposition, you can allocate 5% of your portfolio to each company, dedicating up to 10% of your entire portfolio value to these investments.
Speak to a Financial Advisor
If you don’t feel comfortable in the development of your allocation strategy, there’s no shame in speaking with a financial advisor. The education that you will receive on allocation is far more valuable than the relatively small cost associated with an hour of a financial advisor’s time.
Investing in the cannabis space can be both exciting and lucrative. On the other hand, it can be quite risky. When making investments in the space, always remember to look at the balance sheet, consider potential pivot points, and look for lower-risk opportunities. If you are going to invest in the riskier opportunities in the cannabis space, make sure that you don’t invest a single dollar you’re not prepared to lose. While higher-risk investments may offer a high reward potential, they can also subject your portfolio to significant losses.
Always remember to do your research and make educated investment decisions to increase your potential for gains and reduce your risk of significant losses.
Do you invest in the cannabis sector? What are your favorite names in cannabis?