Why work with us
Offerings for RIAs
- Technology & Platforms
- Investing & Wealth Management
- Business Solutions & Support
- Contact us
High times: Don't get burned by cannabis investing
Allan Kunigis, 05/13/2019
The market for legal marijuana is growing rapidly, state by state, bringing with it uncharted territory for investors.
Recently, the focus has grown beyond THC (the component that gets users "high" through psychoactive effects) to cannabinoids (a component that does not get users high, but claims to have health benefits). With the rapid transformation of marijuana from forbidden substance to legal, marketable, taxable and investable product, investment opportunities are burgeoning—and investors are curious. But are cannabis investments prudent for your clients?
Cannabis investing is a dynamic and exciting new area, but it's also volatile and speculative. Investing in cannabis, whether through ETFs, equities or even direct company investment presents huge potential risk. In such a nascent area, where the legal landscape is almost constantly shifting, knowing how to steer your clients can be a challenge.
Marijuana investments “are risky, period," says Mitch Goldberg, a New York state financial advisor and owner of ClientFirst Strategy, Inc. “There are tremendous claims being made of cannabidiol, and many are unproven."
A sober look at risk
Interest in cannabis stocks is coming from a variety of people, some of whom could be charitably described as euphoric and ill informed. (Remember the early Bitcoin frenzy? Early adopters may have won big, but they wound up being in the minority.)
The Latin phrase “caveat emptor," or buyer beware, is particularly relevant for speculative investments such as untested cannabis companies competing for cash in an industry that is only partially legal. So it's important to know what (and who) is driving a company's valuation before investing.
It's unlikely that your clients who may be interested in this industry understand how the industry works, including the different products and what's legal where. To properly inform them, it's important to focus on the right fundamentals like earnings per share, market share and clean balance sheets. You'll also need to understand the unique risks facing the industry, such as lack of access to traditional banking, given that marijuana is still illegal at the federal level.
Many investors, says Matt Karnes, founder of GreenWave Advisors, do not conduct thorough due diligence before investing and seemingly are caught up in the euphoria. “They see a new industry and think there is no downside. 'Let me just invest in marijuana because it's the next big opportunity for substantial gains,' with no other rationale."
When it comes to the young marijuana market, a few clear risk factors emerge. One, says Karnes, is market oversaturation. "Each state operates in its own closed economy with its own regulations such as the number of licenses issued to marijuana growers. Some are unlimited, others set limits. There is dilution risk in states that originally place caps on the number of license awards as it could arbitrarily increase the number of licenses issued, which could saturate the supply and cause prices to plummet."
And what happens when a new state or even the entire country legalizes pot? Which cannabis firms will survive? Karnes' firm focuses on ancillary (and potentially more sustainable) services, such as lab testing and “seed-to-sale software," rather than actual cannabis growers or producers. “Expect consolidation," he predicts. And look for sustainable businesses with strong management.
Another major risk is medical marijuana disruption [each time a new state legalizes] for recreational use. “Right now legal marijuana is defined as either medical or recreational (adult) use," Karnes notes. “When recreational use becomes legal in an existing medical market, as we first observed in Colorado, the medical market is disrupted. Because it is not cost-effective to regulate two markets that are essentially the same, we expect consolidation to continue in states that are fully legal."
Longer term, Karnes expects the medical market to transform into something quite different, with FDA-approved drugs reaching the market after clinical trials, over-the-counter products appearing on shelves, and insurance coverage evolving. That's a vastly different landscape than today, and one that's tough for today's investors to scope out.
Best practices in cannabis investing
In such a new industry and with so many untested players vying for sales and investor dollars, it's critical to come up with a framework for evaluating potential investment opportunities.
|•||Focus on management: Karnes uses a horseracing analogy. “Look at who the jockey is rather than the horse." In other words, check out the management team. Many marijuana experts may not have mainstream business building experience. On the other hand, more traditional entrepreneurs may not know as much about a product that was illegal until recently. With limited historical information on these companies and the overall industry, looking at the track record of the company's managers is a good start.|
|•||Be wary of valuations: Without specific guidelines for evaluating valuations, understanding a company's profitability and prospects is tough.|
“Cable companies are measured on free cash flow," says Goldberg. “Consumer packaged goods companies are measured on profit margin. Social media companies are measured on monthly and daily active users. We don't yet have an accepted way to value the cannabis space." Be wary of any surefire method of valuation because as of now, one does not exist.
|•||Identify indirect ways to invest: You may be able to invest in the marijuana industry without investing in pot companies directly. For example, a number of major corporations have recently taken a stake in marijuana operations:
-Constellation Brands' multibillion-dollar investment in Canopy Growth
-Tobacco and alcohol giant Altria's $1.8 billion investment to acquire a large stake of Canadian cannabis company Cronos
-Molson Coors' joint partnership with The Hydropothecary Corp. to make cannabis-infused beverages in Canada
-Pharmaceutical giant Novartis' global distribution deal with Canadian medical marijuana firm Tilray
Predicting these kinds of partnerships isn't easy. But some industry-watchers believe the deep pockets and business acumen of a larger, more stable partner could be critical to survival and ultimate success in an uncertain market.
|•||Limit your exposure within your alternatives allocation: If you decide to invest directly in pot stocks, it can help to position marijuana as an alternative investment, rather than an equity play, when slating it into a client's overall allocation. Even then, Goldberg notes, “I wouldn't invest in this area expecting to turn serious money into more serious money. If you believe in [the industry], only [invest] with money that you can afford to lose."|
|•||Consider starting with small investments and think about built-in loss protection: Given the riskiness associated with a new industry, it may be prudent to test the waters with a small investment and then scale. And in light of the volatility common to these types of stocks, trigger and stop-loss orders can be an especially good idea.|
|•||Invest in private companies: Investing before a company goes public is a potentially lucrative way to make money on growing firms. But this route is only viable for those who can meet the high investment minimums. Plus, without a lot of publicly available information, it's a riskier strategy, which means due diligence is even more important.|
|•||Diversify with ETFs: The number of marijuana funds is still limited, but these funds can broaden clients' exposure and potentially reduce their risk. Marijuana ETFs tend to include wholly legal operations, so they often invest less in startup marijuana companies and more in the higher-tech medical and research companies, some of which may be doing cannabinoid based research, with no exposure to THC.|
|•||Think about long-term sustainable businesses: Given all that has changed legally regarding marijuana in just a few years, it's possible we'll be looking at widely legal recreational use soon. With that in mind, think about what businesses are sustainable and will still be around “post-prohibition." To do that, Karnes recommends going back to an earlier analogy: Find the best jockeys.|
And be prepared for a potentially wild ride.
Content provided is for educational purposes only and is not intended to be advice for any firm.
Call 800-934-6124 and talk to one of our experienced consultants today.
Complete this form
And we'll reach out to start the conversation.
Thank you for your interest. We treat each inquiry with the highest confidentiality. We're getting your question into the right hands and someone will be in touch with you shortly. We look forward to helping you.