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What You Need to Know Before Jumping into the MJ ETF Market

Tezcan Gecgil

If you are interested in investing in marijuana stocks but don’t know the best way to get started, you may want to take a closer look at the ETFMG Alternative Harvest ETF (NYSEARCA:MJ), a marijuana-themed exchange-traded fund (ETF) that has over a $1 billion in assets under management.

Investing in MJ may enable investors to take a long-term view on a growth industry that is likely to reach tens of billions globally in a decade or two. However, investors in the cannabis sector should also remember how choppy individual stock prices can be.

Therefore, long-term investors should buy into an ETF like the MJ only if they are comfortable with the fundamental drivers behind the industry, as well as the short-term volatility that comes with the territory.

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What You Need to Know Before Jumping into the MJ ETF Market

Canadian Cannabis Stocks Have Been Hot Yet Choppy

Over the past 100 years, marijuana has been illegal in most of the world. Canada stepped into the spotlight in 2018 when it passed the Cannabis Act and became the first Group of Seven (G7) country to decriminalize the use of marijuana for medical and recreational purposes.

Canada is also the second country in the world, after Uruguay, to legalize recreational marijuana at the federal level. Since then, a number of federally licensed Canadian cannabis producers have started trading on the Toronto Stock Exchange (TSE) as well as the New York Stock Exchange (NYSE).

Several of the Canada-headquartered companies that are listed in the U.S. include Aurora Cannabis (NYSE:ACB), Canopy Growth (NYSE:CGC), Cronos Group (NASDAQ:CRON) and Tilray (NASDAQ:TLRY).

The recent earnings reports from Canada-based cannabis stocks are important in gauging the health of the industry, as not everyone is convinced that Canadian recreational pot sales will remain strong. Many investors are concerned that the initial hype surrounding the industry could be decreasing.

Since legalization in October 2018, Canadian sales numbers have been muted without any signs of increasing. In 2019, the total cannabis market in Canada, including both legal and illegal recreational and medical sales, is expected to be around C$7.2 billion. About half of it is likely to come from legal sales.

The Canadian market may also be running the risk of being oversupplied. Is all this capacity truly needed, given that export volumes are not expected to meaningfully offset oversupply, either? If these marijuana companies harvest more than what they sell, there will be higher inventory balances.

And simple economics tells us that a supply glut would eventually drive down the price of marijuana along with the margins of these companies.

The developments in Canada over the past year has been reflected in the stock price of most of these Canada-based companies, moving investor sentiment from euphoria to greed to fear.

Legal Status in the U.S.

At the federal level, marijuana is illegal in the US. However, at the state level, its legal status depends on the laws of the individual state.

State-wide legalization in the U.S. allows for both individual marijuana possession as well as the legal production and sale of the drug. Legalization can happen in two categories: the legalization of recreational marijuana or of medical cannabis.

As both recreational and medicinal use is becoming more widely accepted, the number of U.S. states that have legalized it has increased. Medical cannabis is now legal in 33 states. Recreational marijuana is legal in 11 states, i.e., individuals require no prescription to use marijuana in these jurisdictions.

In other words, the legalized marijuana industry is still in its infancy, even in Canada, and it is almost non-existent globally. None of the Canadian marijuana stocks have so far done any business in these pot-friendly U.S. states, as the listing requirements at the NYSE or NASDAQ as well as at the Toronto Stock Exchange (TSE) bar companies from engaging in commercial activities in countries where they would be breaking the law.

On the other hand, in December 2018, the U.S. Congress passed the Farm Bill that President Trump later signed into law. The Bill legalized hemp and hemp-derived ingredient cannabidiol (CBD), especially popular among consumers seeking relief from physical pain. Because hemp is now an ordinary agricultural commodity in the U.S., farmers can apply for federal hemp cultivation permits.

Hemp production, as well as products that contain CBD, are likely to be growth areas in the US in the coming years.

Could Your Portfolio Benefit from the MJ ETF?

At InvestorPlace, my colleagues often cover how various ETFs can help investors construct a diversified portfolio. An ETF is an index-tracking fund that trades on a major stock exchange. Similarly, MJ seeks to provide investment results that correspond to the total return performance of the Prime Alternative Harvest Index, which tracks the performance of U.S. and global companies that are engaged exclusively in legal activities involving cannabis for medical or non-medical purposes.

In general, an ETF has an expense ratio — a percentage of the fund’s assets are used to cover management and other costs to run the fund. MJ’s expense ratio is 0.75% per year or $75 annually per $10,000 invested.

Depending on their brokerage accounts, investors can buy the MJ ETF on margin, trade options on it or even sell shares of it short. It currently pays dividends with a yield of 2.43%. In recent months, this marijuana ETF has become one of the most popular funds among millenial investors.

Which Stocks Are in the MJ ETF?

MJ ETF currently holds 38 stocks with about 70% allocation to pot companies and growers. Several of the major stocks in the MJ ETF include Aurora Cannabis, GW Pharmaceuticals (NASDAQ:GWPH), Cronos Group, Canopy Growth, Tilray and Green Organic Dutchman Holdings (OTCMKTS:TGODF) — companies that are becoming increasingly mainstream. It also has an allocation of tobacco stocks and fertilizer companies.

The top 10 holdings represent about 60% of holdings in the MJ ETF. One fundamental point that investors need to keep in mind is that most of these cannabis producer stocks are not profitable yet. Analysts value them mostly based on the expectation of high revenue growth, which would lead to future profits. Therefore, whenever Wall Street fears the given company is failing to meet growth or expectations, that pot stock will get penalized.

Most of these Canada-based weed companies also have high operating expenses. And the red ink at the bottom of their income statements, quarter after quarter, is becoming a worry for shareholders. If the international cannabis market does not grow as expected, then MJ ETF’s price could also experience selling pressure.

From a fundamental perspective the next few years are likely to see important developments in the industry. There might be consolidation as well as partnerships between Canadian pot stocks and more established U.S. companies.

For example, in August 2018, the alcoholic beverages giant Constellation Brands (NYSE:STZ) announced a $4 billion investment into CGC, and STZ now holds a 38% stake in the company. The two are currently developing cannabis-infused beverages for Canada, where experts believe they will be legal by 2020.

Top Holding Stock to Note in the MJ ETF

Our readers may know that a wide range of products are made from cannabis, including CBD oils, edibles, cannabis-infused beverages, concentrates used in vaping, creams, and lotions. Thus the industry includes companies that operate throughout the supply chain involved in making, marketing, and distributing these products.

I’d like to highlight one stock in the MJ ETF that is quite different than the others which are mostly marijuana growers. This stock is GWPH, which tops the holding list with 8.87%.

A 2018-report by the United Nations (UN) revealed that Britain is the biggest producer and exporter of legal cannabis in the world. In 2016, the UK produced 95 tonnes of marijuana and exported 2.1 tonnes.

Virtually all of that is through exporting one drug, Sativex, produced by UK-based GW Pharmaceuticals, a leading cannabinoid-focused biotech company. In 1998, the company obtained a unique domestic licence in the UK to cultivate cannabis seeds.

GWPH now produces Sativex to treat spasms in multiple sclerosis patients. Last year the company obtained U.S. regulatory approval of its CBD drug Epidiolex for the treatment of epilepsy.

GW Pharmaceutical’s share price has gone from about $10 in 2013 to an all-time high of $196 in May 2019. Currently it is hovering around $163. In other words, a biotech company such as GWPH is a secondary way to invest in the CBD market.

Another example would be the companies that provide ancillary products and services, such as Scotts Miracle-Gro (NYSE:SMG). known by many consumers for its fertilizer products.

And the MJ ETF enables investors to invest in these businesses as well as several tobacco companies, too.

Where is MJ ETF Price Now?

In the past two years, marijuana stocks have been choppy and highly speculative. Their valuations can and do change suddenly and drastically, both as a result of event-driven company news or developments in the industry.

And the value of this particular marijuana ETF reflects this volatility. Year-to-date, the MJ ETF is up 22%. After seeing an intraday low of $23.3 on Dec. 24, 2018, it has rallied to a high of $39.25 on March 19. Its 52-week high remains at $45.4, reached on Sep. 19, 2018.

Those investors who pay attention to technical charts should note that due to the decline in price since April, MJ ETF has a not-so-pretty technical picture. In the long-run, MJ needs to build a base again before a long-term sustained leg up can occur.

From a price and time cycle perspective, the high reached on March 19, 2019, which came six months after the 52-week high of Sept. 19, 2018, is likely to be the highest price to be seen in the near-term.

And MJ price may see a new 52-week low in Sept. 2019, possibly around $22.5, about a year after the current 52-week high of $45.4.

Within the next two months, I expect MJ to mostly range-trade between $27.5 and $32.55. However, in case of a broader market selloff, similar to the one we have witnessed in the last quarter of 2018, the fund may easily go toward the mid-$20’s level.

The Bottom Line on the MJ ETF

Investors will need to follow developments in the industry closely to evaluate the appropriateness for marijuana stocks for their portfolio. It is important to note that unless legalization at the federal level in the U.S. happens, cannabis market is, for the most part, limited to the growth in Canada. And a limited Canadian market is not likely to help most of these pot stocks become profitable on an operating basis, a fact makes marijuana stock valuations even more difficult to justify.

Long-term investors should therefore have realistic expectation of the market fundamentals. They should also be ready for daily price fluctuations as well as high volatility around the earnings release dates of the marijuana stocks that mostly make up the MJ ETF.

If you already own this marijuana ETF, you might want to hold your position. However, within the parameters of your portfolio allocation and risk/return profile, you may consider placing a stop loss at about 5-7% below the current price point.

If you are an experienced investor in the options market, you may want to protect your portfolio or your recent gains in marijuana stocks with a covered call or possibly a put option spread with a three-month time horizon. If you do not yet hold a marijuana ETF like MJ, you may want to wait several weeks to buy into it at the next dip.

As of this writing, Tezcan Gecgil did not hold a position in any of the aforementioned securities.

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