How to Profit Off the Marijuana Industry

The U.S. marijuana retail market could reach $35 billion by 2022, according to GreenWave Advisors, and if it does, there are going to be plenty of money-making opportunities available to investors.
In this clip from The Motley Fool’s Industry Focus: Healthcare, analyst Kristine Harjes is joined by contributor Todd Campbell to discuss various investment options, including medical marijuana stocks like GW Pharmaceuticals (NASDAQ:GWPH), Canadian cannabis growers like Canopy Growth (NYSE:CGC), and backdoor pot stocks like The Scotts Miracle-Gro Company (NYSE:SMG). Are these investment ideas right for your portfolio?

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Kristine Harjes: It’s clear we have a big trend here worldwide as demand for and legalization of marijuana grows. It’s no surprise that many investors are looking to profit off of the marijuana industry. One of the most obvious ways to play this trend is by investing in the producers that actually grow the plant.

Todd Campbell: There are some caveats there. We’re going to spend a lot of time talking about Canadian producers. The U.S. market is highly fragmented because not all the states have legalized it yet, and still remains illegal on a federal level. That creates all sorts of problems with trying to do cross-border transactions — doing business in one state vs. another state that has different laws. There’s banking regulations that limit the ability to use traditional services that we would think would be commonplace in any retail store today, regardless of whether it’s marijuana or not. And, there’s some tax implications that are hamstringing the ability of these companies to grow. You can’t deduct basic business expenses against the revenue because of the way it’s scheduled here in the United States. So, the growers in Canada are probably the best places to focus.

We are indeed talking about what could be a massive market here. With the momentum, theoretically, for legalizing it state by state, you could be talking about tens of billions of dollars in market opportunity. According to GreenWave Advisors, if at least medical marijuana gets passed by 2021, you could see U.S. retail sales of marijuana as high as $35 billion by 2022. You’re talking about a very significant market that, who knows, maybe someday could rival the size of the tobacco, spirits, beer and wine markets.

Harjes: If you’re looking for specific names of Canadian growers, Canopy Growth Corporation is the largest by market cap. We did an interview with Bruce Linton, the co-founder and chairman and CEO of the company, back in November of 2017. Canopy has 2.4 million square feet of growing capacity, which is triple what it had when it entered the year, which is crazy growth. They have plans for 5.7 million square feet over time. They can produce an estimated 500,000 kg of marijuana, which is pretty substantial.

Aurora Cannabis is another big name in the space. They acquired another company that used to be huge, and now the combination is even huger. That one was MedReleaf. The acquisition was back in July. They have a 570,000 kg capacity.

One of the other big guys is Aphria, they’re at 230,000 kg in capacity. Quite a handful of different players here that are all duking it out to increase their production capabilities as quickly as possible.

Campbell: Only one of them is traded on the New York Stock Exchange, though. That might give people a little bit more confidence, because obviously, they have to file in accordance with SEC regulations. That would be Canopy, ticker CGC. That’s a very intriguing company. I recommend every listener go back in the way-back machine or reach out to us so we can send you a copy of that interview that Kristine did with their CEO. It was a fascinating discussion of where the global market for marijuana could be.

One of the things that’s really interesting about Canopy is, they’re focusing significant resources on studying the use of these drugs medicinally. Not only are they looking to take all this production and get it out there on dispensary shelves, they’re also spending the time and effort of enrolling patients in clinically controlled trials to see if they can prove out, that anecdotal evidence we were talking about earlier, the value of these medicines.

Harjes: Which suggests another way to play this trend, which is investing in the biotechs that are looking into uses of marijuana in a medicinal realm. One of them that we’ve mentioned on the show many times is GW Pharmaceuticals, ticker GWPH. We were just talking about them on July 18th of this year, talking about how Epidiolex was FDA approved for certain types of epilepsy.

Another big name out there that you might want to take a look at is called Insys. This stock has struggled quite a bit. They’re down 85% from their 2015 highs. They’re not a marijuana pure-play. Their primary drug is SUBSYS, which is a pain medication. There have been all sorts of allegations of illegal marketing and other struggles for the drug. They have a synthetic THC drug called SYNDROS, which is a treatment for chemotherapy-induced nausea and vomiting, and also anorexia associated with AIDS. That was approved in July and essentially has flopped commercially. They have another cannabidiol drug in Phase II.

There are some interesting marijuana-related things to watch with Insys, but personally, I’m not interested from an investment standpoint, just because of all of their struggles. It’s not really clear to me whether they’ll be able to right their ship anytime soon.

Campbell: There’s new management there, but there’s still an overhang of lawsuits and regulatory slaps on the wrist and stuff that we have to work our way through. I would say, of all the pure biotech plays, GW Pharmaceuticals would probably be the best one to approach that way.

Harjes: And then, there are less obvious ways of playing this market, as well. For example, Scotts Miracle-Gro, the fertilizer company. They actually have a tiny part of their business model that is related to marijuana, and that’s hydroponics, which they do through their Hawthorne brand. Growth has been kind of slow. If you back out acquisitions, their sales were actually down 30% in the last quarter year over year. But it’s not an insubstantial part of their business. They do a couple of hundred million in sales.

Campbell: They just reported their quarterly results last night, and I haven’t had a chance to go fully through them, but it looks like sales are clocking in at about $74 million last quarter. That gives you about a $300 million run rate. They were pretty early on in recognizing that momentum was building to legalize throughout the U.S., so they went, out, beginning about three years ago, and started acquiring all sorts of companies to put them together into this Hawthorne brand.

No word yet on whether or not they plan to IPO that or spin that off to investors someday, but I could see that happening down the road. While business is slowing right now — we’ll talk about overcapacity in a minute, I’m sure, and some of the risks — it’s certainly possible that we over-react the other way, and as more states start to ramp up, demand comes back for Hawthorne.

Harjes: One other less obvious way to play this industry that investors should consider is Constellation Brands. They’re an alcohol maker, but they actually own 10% of Canopy. The market for pot in Canada could already exceed the beer market. This is something that the alcohol makers are starting to see. Molson Coors is forming a joint venture with a Canadian cannabis producer. What both Constellation and Molson, with this new joint venture, are looking to do, is develop cannabis-infused beverages for the Canadian market. So, kind of an interesting, “who would have thought of that?” way to get involved.

Campbell: I believe Constellation is the brand behind Corona, correct me if I’m wrong. A massive company. They have a big beer and wine business, and looking out ahead and they’re saying, “Wow, CIBC World Markets is saying that pot sales could exceed beer sales at their peak in Canada. We should probably have some exposure to that, so we can take advantage of it.” Like you said, as a 10% owner of Canopy Growth, they’re able to share all their know-how as far as marketing is concerned and distribution, and hopefully, that helps Canopy Growth establish a foothold and maybe a leadership in the Canadian market.

Harjes: If you put together everything that we’ve just listed as a potential investment idea, and you think to yourself, “Huh, I see the tailwind, and I don’t want to pick an individual stock to play this market,” you can always go the ETF route. There’s an ETF called the ETFMG Alternative Harvest ETF, ticker MJ. They were the first marijuana-focused ETF listed on the New York Stock Exchange.

Campbell: Their expense ratio is higher than if you went out and bought the S&P 500. Obviously, over time, we’ve learned that lower-expense investments tend to generate greater wealth for investors. Still, at 0.75, it’s not ridiculous.

It tracks an index called the Prime Alternative Harvest Index. It comprises 30 different stocks. It uses what’s called a modified market cap weight. It will look at the quarterly rebalance of the underlying index, and maybe make some adjustments to make sure that it’s not too overweight in any one particular stock.

That being said, despite 30 stocks being in the index, 10 of them represent about 43% of the fund’s assets. So, you’re a little bit consolidated in the biggest players.

Harjes: If you thought that we were generous in what we considered marijuana stocks, these guys had to work to come up with 30 stocks that are even tangentially related to marijuana. In addition to Scott’s being in the index, they also have Philip Morris, which doesn’t drive any revenue from marijuana that I know of. But, because they make cigarette filters, I think, that’s what qualifies them for the index.

Just an interesting index to look into, even if that 0.75% expense ratio makes you nervous — and it should. They’re heavily exposed to Canada. They also have a lot of American companies. They even have 9% in U.K. companies. So, take a look at what’s in that basket, it might give you some more stock ideas.

Campbell: It has about $300 million of assets in that. Again, we’re laying out a bullish theme for this, but there are some threats and risks that people should be aware of. Mainly, we don’t know what’s going to happen in Washington D.C. We could see some sort of a crackdown of what’s going on in the individual states that could hamper the growth of this market. I think a little bit of caution is warranted.

Harjes: Absolutely. If you look at the sentiment in Washington, it’s certainly not terribly positive for the marijuana industry. Attorney General Jeff Sessions has been very actively opposed to marijuana, as indicated by many words and also some actions, such as rescinding the Cole Memo, which meant that the federal government would be hands-off when it came to the states’ decisions to regulate marijuana. Rescinding that opened the door for state-level prosecutors to use their discretion, whether they wanted to levy charges against marijuana businesses. In practice, this is not a huge change for anything, but it does indicate sentiment. That is a bit of an overhanging question mark, particularly in the United States markets.

There are plenty of other risks that apply internationally, as well, such as the threat from the black market. We mentioned earlier that marijuana sales are a great way to generate tax revenue. Well, that does end up making marijuana more expensive than it would be on the black market, where it’s not taxed.

Campbell: Absolutely. Over time … I mean, I don’t buy mason jars off the back of a truck for my weekend beer. I go to the store, even though I’m paying a little bit more than I might be able to get otherwise. Maybe that’ll happen with marijuana as it evolves, as well.

The other risk to mention is the risk of price compression, or a price war, between some of these producers and distributors. It’s called weed for a reason. [laughs] It grows really easily. What we’ve seen is a lot of investment in production that’s boosting capacity. As a result, we’re seeing a lot of price compression in the per-pound rates. If that trickles through and creates some price cuts at the consumer level, that’s great for weed consumers, but it might not be so great for the companies that are actually manufacturing and selling the stuff.

Harjes: Right, there’s a lot of competition here. Each of these major growers in Canada is racing to try to expand their production capabilities. Currently, if you add up the numbers, their ability to produce will be pretty significantly higher than what the projected demand in Canada is going to be anytime soon.

But, if you think about that big picture, I don’t see that as much of a problem. We’re long-term investors, we know that this industry is only expanding. Plus, as a Canadian producer, you’re able to supply countries outside of Canada. Once you add in the expected demand, based on all of the other countries that have active medical marijuana laws, add in all of the countries that are on track to legalize medical marijuana soon, you end up with very sizable demand that shouldn’t be any sort of concern for those that look at the supply numbers and note that they’re much higher than the current demand for Canadian marijuana.

Campbell: Yeah. That’s another reason to not be so concerned about the crazy valuation of these stocks. This is not an industry that a value investor is going to approach. These companies are still generating very inconsistent financial results. The revenue is growing gangbusters, but the profitability is all over the map. I would expect losses for most of these companies as the continue to invest, until they reach that sweet spot of demand. Who knows how quickly that happens in Canada. We should have more insight in the next 12 to 18 months.

Harjes: This industry is so nascent that it’s hard to even come up with a valuation for a lot of these companies.

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