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Top 3 Cannabis Stocks to Buy Ahead of Canada's 2.0 Legalization

Mark Prvulovic, The Motley Fool

Canada officially legalized dried cannabis flower, oils, and sprays for recreational use last year. However, there were many other marijuana products left off the table. Most notably excluded were cannabinoid-based edibles, beverages, topicals, and concentrates. By extracting CBD from cannabis and hemp, consumers can enjoy the health and other benefits of cannabis without the feeling of getting high, which is the result of another compound found in marijuana, tetrahydrocannabinol, known as THC.

What is important is that these CBD-derivative products have higher profit margins and are easier to sell to consumers who don't typically consume marijuana. With regular dried sales beginning to slow down in some states due to oversupply, CBD consumables are the next logical path for cannabis companies to expand into.

As investors eagerly anticipate October 17, the day when Canada will legalize these CBD products for recreational distribution, many companies have been preparing their own product lines for launch.

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The sheer potential of the CBD derivatives market

The CBD-derivatives market has been growing at an exponential rate over the past few years, growing from $200 million in 2016 to now being projected to hit $1 billion by the end of 2019. Many industry experts are predicting that the U.S. and Canadian CBD markets will be $3 billion by 2021, while more optimistic estimates suggest that the market could hit as much as $16 billion by 2022.

CBD edibles and beverages are more accessible to consumers who are curious about cannabis but might not have tried smoking dried flower yet, possibly due to the pre-existing stigma surrounding recreational use. These products are the perfect entry point for consumers and could easily transition into using other cannabis products in the future.

With this in mind, here are some companies that are well-positioned to take advantage of this coming second round of legalization in Canada.

1. HEXO Corp

The Quebec-based HEXO (NYSE: HEXO) has seen its shares fall by almost 50% since April, leading some investors to see a potential value investment at this low-price tag. When looking at industry benchmarks like the Horizons Marijuana Life Sciences ETF, which has fallen by 39.1% over the same time period, it seems that HEXO has been underperforming the market.

However, that's not necessarily HEXO's fault. Many Canadian producers have been hamstrung by ongoing supply problems with the local provinces despite strong production figures, leading to a buildup in inventory and a decline in sales. Once this issue clears up, sales are expected to rise, although its anyone's guess when the problem will resolve itself.

Even putting the supply glut to the side, HEXO still has a number of advantages over its competitors. Its enviable joint venture agreement with Molson Coors Brewing to produce CBD infused beverages could easily make it a leader in this market. When taking a deeper look into the company, HEXO has also devoted more than 600,000 square feet of its facilities to the cultivation and procession of CBD products. From a sheer output perspective, HEXO is at the forefront of CBD derivative production. Combined with the fact that it's is expected to see its sales spike from $59.7 million in 2019 to potentially almost $400 million in 2020, HEXO seems well poised to make a major comeback this fall.

2. OrganiGram Holdings

Another pot stock that lost much of its value recently is OrganiGram Holdings (NASDAQ: OGI), which fell by 30% in August alone. While Health Canada has been arduously slow in approving sales licenses for the company, there hasn't any major development that would have caused this decline besides the postponing the launch of its CBD derivative product line to December rather than October as previously planned.

OrganiGram is unique compared to other producers for a couple of reasons. While most growers are based in Ontario, Quebec, or British Colombia, OrganiGram is based out of Canada's Atlantic region in the province of New Brunswick. Although being the leader in a less populated region might not seem as advantageous, Canada's eastern-most provinces have seen the highest adult-use rates for cannabis in the entire country.

At the same time, OrganiGram is one of the few Canadian cultivators to boast supply agreements with all ten provinces in the country. This is a big deal as it puts OrganiGram in the same league with giants like Canopy Growth, Aphria, and the now floundering CannTrust Holdings, the only other companies with supply agreements in place with every province. As such, the comparatively smaller OrganiGram would be the leader in the high-use, less competitive Atlantic market while still having access to the other major provinces.

3. MediPharm Labs

Unlike the other two companies, MediPharm Labs (OTC: MEDIF) is an extraction-service provider rather than a cannabis producer. Extraction-based providers like MediPharm and Valens Groworks have been seen in a bullish light by experts as major producers are outsourcing extraction services to these third-party providers. If I had to choose between the two extractor stocks, however, I would pick MediPharm for a couple of reasons.

For one, MediPharm is already showing profits. It reported a CA$0.01 profit-per-share figure in its recent financials off a net income of CA$4.1 million. While seemingly insignificant, this is pretty impressive when one considers that MediPharm had virtually no sales the year before.

MediPharm also has secured major extraction contracts with giants such as Canopy Growth, TerrAscend, the Supreme Cannabis Company, and Cronos Group. These agreements are worth tens of millions of dollars in steady revenue for the company over the next two years. With CBD-derivative products offering a higher profit margin than dried flower, many more companies are lining up to secure the services of extraction-based companies like MediPharm. Once legalization 2.0 comes into effect, MediPharm could find itself swamped with many more highly lucrative extraction agreements.

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Mark Prvulovic has no position in any of the stocks mentioned. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends CannTrust Holdings Inc, HEXO., and OrganiGram Holdings. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com