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Don't Invest In Legal Cannabis Until You've Read These 5 Tips

With massive industry growth predicted, it's tempting to want to pour money in the market. But that also comes with risks.

With legal cannabis expected to grow into a $21 billion dollar industry in the U.S. by 2021, it’s no surprise that investors are seeing an opportunity. Over the past year, the North American cannabis Index, which tracks the leading U.S. and Canadian stocks in the legal cannabis industry, has grown by over 106 percent, and in 2018 nearly $5 billion has been raised.  

There’s a lot to like from an investor’s perspective. The industry is growing rapidly, and much like alcohol and tobacco it’s consumption should not be materially impacted by a recession. Further, its legalization has spawned a slew of ancillary industries, including extraction, production and business services. And with many states still yet to legalize, there’s plenty of room for continued growth.

Related: Investment In Marijuana Industry Has Grown 600 Percent so Far in 2018

However, investing in the legal cannabis market is not without its risks. At a time when cannabis is still illegal under U.S. federal law, there’s a chance that the government could change the rules under which businesses currently operate. For this reason, it’s crucial to avoid jumping into a market you’re unfamiliar with just because it’s new and exciting. Legal cannabis is a complex space, and investors need to prepare themselves before they put their money on the line.

Here are five essential factors to consider before investing in the legal cannabis market:

1. Different investment markets offer different sets of risks and rewards

There are several channels you can use to invest in cannabis companies and you’ll want to think carefully about which path you choose.

Private markets tend to be illiquid, and it’s harder to find information about the firms you’re considering. While you can potentially earn larger returns by buying into companies at an earlier stage, your ability to succeed will hinge on your access to deal flow. If you’re planning to invest, you’ll want to think about whether you have industry connections or some other edge that will allow you to see better deals.

Meanwhile, public markets provide more transparency to the average investor, but the sector’s popularity means that some companies sport valuations that may already reflect their future growth potential and ultimate market size. You’ll need to do your homework in order to pick the winners and know when to buy or sell to realize your gains.

You’ll also have to decide whether you want to invest in Exchange-Traded Funds (ETFs) or single stocks. ETFs offer instant diversification, but they can be boom or bust as investor money flows in and out of cannabis sector.

2. Regulation might impact the company you’re about to invest in

Given the blurry legality of cannabis in the U.S. and Canada, it’s crucial to consider how an overnight change in regulations could negatively impact your holdings.

While Canada passed a law to legalize recreational cannabis in June, Canadian cannabis companies might be handcuffed by international treaties that restrict their ability to export cannabis products. In the United States, the federal prohibition on cannabis means the entire sector could be devastated by the stroke of a regulator’s pen.

Related: How Canada's Marijuana Legalization Changes the Game

In order to best protect yourself from regulatory impact, consider investing in U.S. firms that don’t handle cannabis themselves. These so-called “ancillary” businesses include companies that produce cannabis security technology, paraphernalia, and informational apps.

3. Successful companies have capable managers with the right incentives

Emerging industries typically produce their fair share of carnival barkers and charlatans. Cannabis is no different. Before investing, research a company’s management team to ensure that the people steering the ship have a proven track record of delivering shareholder value. It’s also worthwhile to review the company’s incentive plans. Managers should be material owners of the company.

4. Cannabis cultivators may be less valuable in the long run than companies that create consumer products from the commodity

Most of the big public cannabis companies right now are cannabis cultivators, meaning that investors are putting big money into firms that are essentially built around growing and selling a commodity. From an investment perspective, these businesses should be diligenced very closely. After all, how many major coffee or tobacco growers can you name off the top of your head?

Commodity businesses are notoriously cyclical, and they use a lot of leverage due to their low margins. As with any commodity, it’s all about supply and demand. When supply is low and demand is steady or rising the price of the commodity may be sufficiently high to produce solid returns.

But, as with what happened in the oil markets, when a tremendous amount of new supply comes online without a corresponding increase in demand prices can plummet. In most cases, they plummet faster than producers can reduce costs. The likelihood is that the winners in the cannabis industry will either be the lowest cost producers or those who can create branded products with the commodity.

5. Lab testing, extraction, and branding offer some of the market’s biggest opportunities

There’s an overinvestment in cannabis cultivation right now, but several areas of the industry have tremendous growth potential. Here are three places to consider investing:

  • Lab Testing: The legal cannabis sector is going to require an entire parallel industry focused on ensuring that cannabis products are healthy and safe. Lab testing will ensure the absence of pesticides, molds and other unwanted ingredients. Right now, this space is underbuilt and in need of significant investment. Keep an eye out for the right team with a quality strategy.

  • Extraction: Extracted products like edibles, vape pens, and cannabis beers will become the foundation of nearly all mass-market products. Instead of smoking the entire cannabis flower, people will consume goods like these that contain only cannabis’ active compounds. In much the same way that petroleum refiners have carved out a lucrative niche in the energy industry, cannabis extractors can create a strong foothold in the space, especially if they create proprietary formulations and new methods.

  • Brands: As noted earlier, branded products will become as ubiquitous as they are in alcohol and tobacco, offering consumers a range of options from low-end to luxury. The one thing to watch out for in the U.S. is that the restrictions on advertising and the state-by-state markets will require huge investments to overcome.

There’s no such thing as a sure thing when it comes to investing, but these tips can help you do the due diligence necessary to make an informed decision. You can also hire a professional with experience in the field if you need more information.

Related: Investing In Marijuana Businesses: Are Hedge Funds Coming To The Cannabis Industry?