New U.S. cannabis markets are opening. A guide to what investors need to know

With new markets continuing to open, investors might want to give cannabis stocks another look. Here's a guide to making smart bets.

Published Sat, Apr 16 2022

Frank Holland @in/frank-holland @FrankCNBC

11 min read

Although the U.S. is unlikely to pass a federal law legalizing marijuana in the near future, cannabis sales are rising steadily as states continue to remove restrictions on its use. The majority of U.S. states allow some form of cannabis sales. This week, New Jersey took the final step to allow cannabis sales to adults , opening a new market on Thursday. Vermont will open its retail stores on May 1. With these additions, Bank of America projects about a third of the U.S. population lives in a state that allows cannabis sales to those over 21 years of age. While investors may be tempted by the growth potential of these new markets, the industry remains nascent, making its risks worth considering. Cannabis stocks have been volatile in the past and the industry will remain heavily regulated. The first cannabis stocks were listed on the New York Stock Exchange and Nasdaq in 2018. But since cannabis remains illegal under federal law, there are two main investment options: Invest in the stocks of U.S. multistate operators These are companies that have the right to sell cannabis at the state level. However, due to federal restrictions, these stocks do not trade on major exchanges like the NYSE or Nasdaq. Invest in Canadian cannabis stocks These companies, also called licensed producers, cannot sell products in the U.S., but can trade on major exchanges like the NYSE or Nasdaq. The restrictions mean U.S. and Canadian operators are facing two different sets of business conditions, each with their own benefits and challenges. Other investment options include owning the stocks of companies that provide services to cannabis growers or to invest in exchange traded funds. This last approach allows an investor's risk to be spread among a number of companies, rather than picking a single stock. This guide can help readers understand the basics of cannabis investments. How to read this guide This guide lays out various ways to invest in the cannabis industry. Follow along from start to finish, or jump to the section(s) you want to learn more about. How can I invest in the U.S. cannabis industry? Legal U.S. cannabis sales are expected to rise to $31 billion in 2022, up 29% from the prior year, as more states legalize adult use, according to cannabis data firm Headset. Thirty-six states have approved either medical or adult use of cannabis with a THC level above 0.8%, according to investment bank Stifel. THC, or tetrahydrocannabinol, is the psychoactive chemical in the cannabis plant that gives users a "high." The remaining states either allow sales of CBD — or cannabidiol, which is considered a "low THC" cannabis product — or do not permit sales of any form of cannabis. The growth of cannabis sales in the U.S. has come solely from state level legalization, which has ramped up in recent years due to increased acceptance and the potential for tax revenue. Currently, 18 states as well as Washington, D.C., and Guam permit adult recreational use of cannabis. States like New York, New Mexico, Connecticut and Virginia are among the states that have approved adult use, but sales are still pending. Once these four states are open for adult sales, 43% of the U.S. population will live in a state where those over 21 can buy cannabis, according to Bank of America. That amount could grow even further after the November elections. According to Norml, six states — with a combined population of 27.8 million — are looking to put adult use legalization on the ballot this year. The U.S. cannabis market is currently split, with about 60% of sales coming from medical use and 40% from recreational use, according to the latest estimates from Cannacord Genuity. It said the market is rapidly turning to a primarily recreational one as lower prices and increased availability boost sales. While cannabis sales are growing steadily, U.S. stocks have been highly volatile. Since cannabis remains illegal under federal law, institutional investors are not able to invest in U.S. cannabis companies. According to Cannacord analyst Matt Bottomley, retail investors make up about 70% of U.S. cannabis company shareholders. Analysts say these investors may trade for emotional reasons instead of fundamentals, which creates more risk in those names. For example, Cresco Labs , now the largest cannabis company in the U.S., reported revenue growth of 25% in fiscal 2021 from the prior year, but its stock fell 56% over the same time period. For other high growth stocks, that would likely be healthy sales growth that would be rewarded by shareholders. "First and foremost, the sector itself is very speculative in nature," Bottomley said. "So you have to keep in mind that what really you're paying for today is the longer-term growth profile and there are a lot of unknowns and risks that come with that." According to Bottomley, one of those risk is playing out. "A company can perform — or a group of companies can perform — very, very well for quarter over quarter over quarter, and — as we've seen in the last year — the stock prices can just be relentless in terms of the pressure that's on them," he said. Since the start of 2022, Cresco shares have continued to decline, and are down 19% year to date. Other U.S. cannabis stocks have posted bigger losses. Green Thumb Industries is down 25%, Curaleaf has lost 26%, and Trulieve Cannabis is off nearly 30% over the same period. How do I invest in Canadian cannabis companies? Federal legalization isn't a guarantee of big profits either. Although Canada is the world's largest federally legal cannabis market, it is considerably smaller than the U.S. Headset estimated it will rise to $5.5 billion in 2022, or about 38% growth year over year. Canadian cannabis companies are licensed producers, and as such can trade on U.S. exchanges. That gives these companies more access to capital and banking because the companies can sell cannabis legally under Canadian laws. The Canadian market is about 90% recreational and 10% medical, according to research from cannabis data firm BDSA. While cannabis companies in Canada can sell without concerns about federal laws, the landscape for their business has its own unique challenges, according to Bottomley. "Fifty percent or more of the Canadian market is a handful of companies, but there are thousands and thousands of licensed producers that they are competing with," he said. "That includes craft growers and undercapitalized players and people that are just selling at a loss to try and survive. That's driving price down, making it even harder for the larger players to be successful." Despite legalization, these companies are operating under restrictions that make it difficult for them to develop a brand to make their products stand out in the market. "There's restrictions on what you're allowed to do with packaging and advertising," he said. "They also don't control the retail channel. It's a government-controlled wholesale operation in every market. Because of that, there's a lot of margin that's being left on the table." Canadian cannabis stocks also see wild swings based on sentiment. This year, the Alternative Harvest ETF , which tracks primarily Canadian LPs, has seen a weekly rise of as much as 15%, only to be followed by a decline of as much as 10%. I don't want to own shares of a cannabis grower. Can I still benefit from the industry's growth? Cannabis stocks can be volatile, but many experts say there are other ways to benefit from the growth of the industry without investing directly in the companies that grow the product. Companies that provide lights, hydroponic equipment and properties for growing facilities are not subject to the same federal restrictions as multistate operators, but are expected to be indirect beneficiaries of increased cannabis sales. That might make these industry suppliers a safer way to invest. Stifel cannabis analyst Andrew Carter said non-plant touching stocks are a lower risk way to play the growth of cannabis sales under the current regulatory structure even if reform or legalization happens. "They capitalize on a lot of the industry tailwinds for growth and also a number of the inefficiencies, starting with hydroponics. The fact that you have to create redundant capacity on a state by state basis is a long-term win for them in this environment," Carter said. "Structurally we believe in the cannabis industry there are going to be long term inefficient supply chain issues. If a state takes longer than expected to allow cannabis sales that can create large capital costs for an MSO. For a non-plant touching company, that's just a delayed sale pushed down the road," he said. New Jersey is a prime example of how there can be a substantial amount of time between legalization and actual sales. In the November 2020 election, 67% of voters supported legalizing adult use cannabis. However, actual retail sales at 13 locations were not approved until this week. Operators must also get local approval with each municipality permitted to establish its own guidelines or "opt out" of allowing cannabis businesses. Are there cannabis ETFs? Cannabis exchange traded funds give investors exposure to various companies in the cannabis industry using diversification to hedge for the volatility in the sector. There are ETFs that focus on the U.S. market, Canadian market or offer a combination of both in addition to non-plant touching stocks. Tim Seymour manages the Amplify Seymour Cannabis ETF , an actively managed thematic cannabis ETF designed to mitigate single-stock risk. "This is an industry that's moving rapidly," Seymour said. "Having exposure and an active ETF means you're going to be investing in the companies that are most relevant today or positioned for the ones that will be most relevant tomorrow." "A lot of the companies trade together but are not all created the same," he said, warning that investors should pick a fund that diversifies wisely and is responsive to changes in the competitive landscape. "Having exposure across the sector is ideal at this stage in the cannabis industry," he said. "I'm trading as I feel I need to in a sector that is moving on legislation, that is moving on new licenses and on new states. This is a sector and a consumer product class that's been evolving." As with all ETFs, it is also important to research what stocks are being invested in. For example, the MJ cannabis ETF includes investments in tobacco companies Phillip Morris , British American Tobacco and Swedish Match as well as several pharmaceutical companies in the cannabis space. It may not be an ideal fit for someone looking for a pure-play investment in cannabis. What's the outlook for industry reform and legalization? Cannabis legalization or reform that would allow access to major exchanges like the NYSE or Nasdaq and banking is often thought of as the catalyst for rapid growth in the industry. Currently, cannabis companies pay more to borrow money and pay higher taxes under the Internal Revenue Service's Section 280E. It bars cannabis businesses from taking most corporate deductions because cannabis is federally illegal. Federal legalization would eliminate these challenges and also allow companies to set up national operations instead of having separate structures for each licensed state. Hypothetically, this would create higher margins and enable bigger investments in growing facilities and retail stores. Developments with bills such as the MORE Act (The Marijuana Opportunity Reinvestment and Expungement Act), SAFE Banking Act (Secure and Fair Enforcement Act) and CAOA (Cannabis Administration and Opportunity Act) can cannabis stocks on investor enthusiasm. These are all being considered by Congress this year. The MORE Act passed in the House earlier this month, but is not expected to pass in the Senate. Even if a bill passes, it is not expected to have a dramatic impact immediately. According to Headset, the passage of the SAFE Banking Act would only boost sales 5% to 10% in the first 12 months after it takes effect. Carter said even if one of the pending cannabis bills pass at the federal level, the current regulatory structure, where the majority of control rests at the state level, would remain largely intact in the near term. "We've come to the conclusion a lot of this is still going to be in the hands of the local regulators," Carter said. "...They can control distribution. They can control retail. So the states are still going to be able to decide in a lot of ways what the cannabis companies can do and their ability to move cannabis across state lines, which would let the industry have its full scale advantages."

Josephine Flood | CNBC

Although the U.S. is unlikely to pass a federal law legalizing marijuana in the near future, cannabis sales are rising steadily as states continue to remove restrictions on its use.

The majority of U.S. states allow some form of cannabis sales. This week, New Jersey took the final step to allow cannabis sales to adults, opening a new market on Thursday. Vermont will open its retail stores on May 1. With these additions, Bank of America projects about a third of the U.S. population lives in a state that allows cannabis sales to those over 21 years of age.