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Why Investors Should Add Cannabis Industry Stocks

The number of ancillary marijuana companies is rising as several states legalized the use of cannabis for either medicinal or recreational purposes in the past year. Several companies in the cannabis market focus on supply chain, software, packaging and industrial systems, among other aspects.

"For an industry that is growing at the current rate and employing more and more people, it only makes sense that it will need a massive amount of infrastructure to support the growth in cultivation and personnel," says Jason Spatafora, co-founder of MarijuanaStocks.com and head trader at True Trading Group.

Here are some things to keep in mind when considering marijuana stock investments:

-- Ancillary approach is key.

-- Growth in real estate.

-- Legislative changes.

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Ancillary Exposure Is Key

Any exchange-traded cannabis fund that is focused on a full spectrum investment approach to marijuana stocks must include ancillary exposure, says Tim Seymour, founder of Seymour Asset Management in New York and portfolio manager of the Amplify Seymour Cannabis ETF (ticker: CNBS).

There are several advantages to adding ancillary companies to a portfolio. Not only are ancillary companies able to list on U.S. exchanges in the current federally restricted environment, but they are also often the target for institutional investors who want to own cannabis-related themes.

"Many of these companies are leading players in subsectors that are an important part of the broader cannabis consumer packaged goods investment story," he says. "Investors want to be invested in cannabis just because it's an exciting social consumption growth story, but also because this massive market will also have the same exposures to software, technology, e-commerce, logistics, big data -- all trends that are a major part of investing in consumer trends outside of cannabis."

CNBS is an actively managed ETF and provides exposure to the entire marijuana market investment spectrum. The stocks in the fund include several ancillary companies, including special purpose acquisition company Silver Spike Acquisition Corp. ( SSPK) subsidiary Weedmaps, Hydrofarm Holdings Group ( HYFM), GrowGeneration Corp. ( GRWG) and AFC Gamma ( AFCG). Those stocks represent the growing subsector themes in the cannabis industry in addition to the vertically integrated cultivation stories, Seymour says.

"Part of the success we have had in the portfolio is rooted in our focus on these ancillary investments," he says. "A quick look at the performance of GRWG, HYFM, IIPR, SSPK and more recently AFCG, illustrates why this exposure has been an important part of our outperformance compared to other cannabis ETFs. We expect to find the next wave of these companies and have them expressed in the portfolio."

As plant-touching cannabis industry companies continue to scale their operations, major operators are finding it essential to work with best-in-class ancillary cannabis companies that provide innovative products that enhance efficiency and provide differentiated product lines, says Aaron Raub, senior equity analyst at Ambria Capital in Puerto Rico.

"After several states have legalized cannabis, ancillary companies are primed for exponential growth due to the high capital expenditure requirements for bringing large swaths of cultivation online to stock the shelves of new retail stores with a host of products," he says.

[See: Top Robinhood Stocks to Buy That Analysts Also Love]

Growth in Real Estate

One cannabis stock investors can add is GrowGeneration, which has had a specialized focus on the picks and shovels of the cannabis market for many years. The company now has 53 hydroponic stores across 12 states and estimates revenue of $415 million to $430 million for 2021.

A company that has produced a mixed bag for investors in 2021 after previously providing solid returns for long periods is cannabis real estate investment trust Innovative Industrial Properties ( IIPR).

Blue-chip cannabis operators such as Green Thumb Industries (GTIBF) and Ascend Wellness (AWH) have conducted multiple transactions with IIPR as the company's well-defined process of purchasing real estate in sale-leaseback deals has proven popular since it was formed in 2016, which has also invited additional competition to the space, Raub says. The company owns 68 properties containing a total of almost 6 million rentable square feet. IIPR recently increased its quarterly dividend by 6.5% to $1.32 per share.

The company recently reported earnings per share of $1.29, which missed the mark for most analysts with a 9% growth rate quarter over quarter. "This was a sharp pullback in growth after growth of 107%, 102% and 49% during the prior three quarters," he says. "The company historically trades at a forward P/E ratio that is at a premium to the industry average, and there was a large decline in price after earnings as a result of the weaker numbers."

[Read: Should You Buy Berkshire Hathaway (BRK.B) Stock?]

Legislative Changes

Many cannabis investors see 2021 as a pivotal year due to increased cannabis legislation as more states continue to legalize cannabis to help shore up budget deficits that rose due to the pandemic and as political pressure rises, Raub says.

"This increases the market opportunity for cannabis cultivation as more states come online and is seen by many as a positive sign for IIPR's business model," he says.

IIPR has a monopoly on financing for marijuana dispensaries in the U.S. due to current banking laws, says Michael Underhill, chief investment officer of Capital Innovations in Pewaukee, Wisconsin.

"Barring any federal banking law changes, we fully expect the stock will continue to experience high times despite price-to-sales valuation of 23 and a price-to-earnings valuation of 60," he says.

IIPR's 2020 rental income was $117 million, representing a 260% increase over the $45 million it had in the prior year. The average lease duration is 17 years.

"I think the stock is too expensive, but there are no comparable competitors and until banking laws change for cannabis, IIPR has a monopoly. So they are the only game in town for financing cannabis," Underhill says. "We would suggest holding the stock but not buying at these levels."

The ancillary names are popular investments since they allow investors or financial institutions unable to directly invest in cannabis businesses because of compliance reasons to still have exposure to the industry, says Rob Hunt, principal at San Diego-based Linnaea Holdings.

While this has attracted a great deal of capital to the ancillary companies, one of the problems with investing in the ancillary names rather than directly in cannabis businesses is that the "growth and profit potential in the actual plant-touching companies is far greater than it is in the ancillary plays," he says.

Most of the public ancillary names have been overbought, Hunt says. While they continue to perform well, there is little growth left in them.

"The EBITDA multiples simply do not make sense when compared to other hardware businesses or REITs away from cannabis," he says. "I would expect to see a retreat from the highs on almost all of them."