Are Marijuana Stocks Safe to Invest In?

Marijuana-stock-investBoom or Bust for Marijuana Stocks?

Many investors find it hard to distinguish between stock bubbles and booms. That can be discouraging, but don’t let it drive you away from the market. All you need are the right tools. Take the marijuana industry, for example. There is a simple set of tools that can tell us whether or not there is a marijuana stock bubble in 2017; we just need to apply them.

But, before I give you the tools for detecting bubbles, let me quickly explain what these tools are not:

  • They are not grounded in technical analysis.
  • They are not get-rich-quick schemes.
  • They are not an excuse for not doing your own research.

Don’t get me wrong; technical analysis can be useful. It’s especially good for timing your asset purchases or engaging in day trading. That said, I would never build a portfolio on it. There are just too many blind spots!

It’s inevitable that every tool in the technical analysis toolkit would be flawed. Why? Because reducing stock analysis to numbers means that technical analysts have to make decisions about which numbers to look at, and which ones to ignore.

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Here’s the problem: they don’t know which numbers are important.

Put another way, they don’t know what they don’t know. Yet they build models based on these technical indicators, models that spit out forecasts with “absolute certainty.” It’s all nonsense.

Don’t let the numbers give you a false sense of confidence. All statistical models fail sooner or later. If you don’t believe me, e-mail these “geniuses” and ask if their models predicted the 2008 financial crisis. You can hope for an answer, but I wouldn’t hold my breath if I were you.

In any case, let’s get back to the matter at hand: is the marijuana industry for real, or is there a marijuana stock bubble in 2017?

Short answer: there is no marijuana stock bubble. For the long answer, you’ll have to read below.

Is There a Marijuana Stock Bubble in 2017?

Most of us have an innate sense of business in our daily lives. If a friend or cousin asks us to invest in their business, we ask some reasonable questions, like:

  • How much do you expect to make in sales?
  • How much will it cost you to make those sales?
  • How quickly can you break even?
  • What are the risks involved?

And yet, many investors fail to ask these questions about the stock market. They don’t put publicly traded companies under the microscope, which is why some of them fall short.

Answering simple questions may not look as convincing as fancy numbers and a few charts, but you better believe that they perform better over the long haul.

Asking these questions is the only way to spot a bubble.

You’re disappointed…I can feel it. This isn’t the answer you were looking for. You wanted a metric or indicator that flashes red when stocks overheat. Sorry, but that metric doesn’t exist.

You have to ask the basic questions. Only then can you make informed decisions.

Some of the greatest investors in history use this tactic. Warren Buffett is famous for not having a computer in his office because it would over-complicate things. “There seems to be some perverse human characteristic that likes to make easy things difficult,” he once said.

He was talking about investing. Here’s another piece of advice from the Oracle of Omaha: “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.”

I could go on and on…

Considering that Buffett amassed $74.5 billion using these tools, you may want to give them a chance. I’ve been writing about the stock market for years, and I haven’t seen anything that works better.

So, let’s apply a bunch of common-sense questions to the marijuana industry. If the results are positive, it means that marijuana stocks are okay. If they are negative, well, there might be a marijuana stock bubble.

1. Are Marijuana Sales Growing?

This is the good news. Legal marijuana sales are growing pretty quickly in states that have legalized recreational use, meaning that just a handful of states—California, Nevada, Colorado, Oregon, Washington, Massachusetts, Maine, and the District of Columbia—are driving this trend.

legalweedsales

We can reasonably expect sales to continue on this upward path, because public opinion has shifted dramatically in favor of marijuana legalization. Around 60% of the general public are on board. And no wonder: legalizing weed creates jobs and additional tax revenue.

Everyone is happy about it. State officials love it because it gives an adrenaline shot to their tax revenues, entrepreneurs love it because they can get rich from it, and Cheech and Chong love it for obvious reasons. The rest of us can make a few bucks by investing in it.

It’s a win-win-win-win scenario.

There is also growing demand north of border. Canada has a solid medical marijuana market. But, even more importantly, the country is on the brink of full-scale legalization. Prime Minister Trudeau said himself that Canada will “go green” by July 1, 2018, which is incidentally Canada Day (their version of Independence Day).

That’s a pretty big market for marijuana companies to take advantage of. In terms of population, Canada is roughly equal to the 22 least populous states combined. So, selling marijuana in the Great White North is nothing to laugh at; it could be a cash cow by late next year.

2. What Are the Expenses in the Marijuana Industry?

This part can be a little tricky to evaluate, only because companies vary in their strategies and business models. A biotech company looking to harvest medical marijuana as a painkiller is not remotely similar to your standard weed dispensary. The two are worlds apart.

But let’s take the generic example: a marijuana dispensary. A dispensary can be a brick-and-mortar store or, in the digital era we live in, an e-commerce company. If it is the former, the dispensary will need to lease or buy physical locations for growing the marijuana, and other locations s for distributing it to customers. That is pricey, depending on the city.

But, as a general rule of thumb, investors should write off two-thirds of revenue. According to some estimates I’ve seen, that is the average “cost of goods sold” in the marijuana industry.

Then you have to subtract another 20%-or-so for operating expenses. Staff wages and marketing costs are bundled into this part of the expense sheet, so it’s an unavoidable blow to the profitability of marijuana stocks in 2017. But it’s not a fatal blow.

Here’s what the expenses would like for $1.0 million in revenue.

Marijuana Profitability

Sales Revenue

$1,000,000 100%

Cost of Goods Sold

-$680,000 (68%)
Gross Profit $320,000

32%

Operating Expenses $200,000

(20%)

Earnings Before Interest, Tax, Depreciation and Amortization $120,000

12%

3. What Is the Outlook for the Marijuana Industry?

As it stands, the marijuana industry has a decent outlook. They are making a pre-tax profit even before the industry weeds out (pardon the pun) bad companies, which is not always the case in emerging sectors. Very often, it takes a while to settle on the right business model.

I’m sure this will happen in the marijuana industry as well.

Some enterprising young company will start selling weed via the Internet, making it an at-home delivery service. Or else they’ll create a line of products around their marijuana brand. Whatever it is, the best business models have yet to emerge in the marijuana investing space.

Despite this fact, the marijuana industry is still above water. That’s pretty significant, especially since I’ve seen Silicon Valley green-light far more questionable companies with weaker revenues. So don’t be fooled by the excessive pessimism on marijuana stocks.

The fundamentals are decent, and they will likely improve as a few companies work out the best business model, achieve scale, and consolidate market share.

4. What Are the Risks in Marijuana Investing?

Marijuana stocks suffer from “political risk.” This is the idea that a handful of people in government can control the fate of the marijuana industry. By continuing to classify marijuana as an illicit substance, they can prevent it from becoming a legitimate business.

This is the big fear that holds back marijuana stock. Any time you see marijuana stock prices falter, it’s probably because of bad regulatory news.

For instance, earlier this year, the Attorney General of the United States, Jeff Sessions, suggested that a federal crackdown of marijuana was in the works. Investors panicked.

Weed stocks took a pounding thereafter, but nothing happened. The heavy hand of the government did not come crashing down on cannabis-related companies, and I think I know why.

The public doesn’t care about marijuana as an issue anymore.

Ten years ago there would have been a political backlash to marijuana legalization, but things have changed. We went through a financial crisis! People are far more concerned with jobs and the economy than they are about who “sparks up” from time to time.

If marijuana companies will add jobs and money to their states, then most people are on board with legalization. That’s the political reality. So Jeff Sessions should tread lightly here, because there may actually be a political cost to hurting the marijuana industry.

Should I Buy Marijuana Stocks in 2017?

I continue to be bullish on marijuana stocks, though not all of them. There is a handful of companies that I think will outperform, but you’ll have to subscribe to my newsletter to view those picks.

What I can tell you here is that marijuana stocks are not getting a fair shake. Investors tremble and flee at the smallest tremor. They abandon pot stocks even when nothing has changed in the fundamentals, which is usually a sign of mispricing.

It’s like when shares of Tesla Inc (NASDAQ:TSLA) fell to $143.00 last year. I couldn’t understand what had materially changed from when the stock was trading at $238.00. The only difference was how people perceived the stock, because nothing had changed in the company itself.

Eventually, TSLA stock shrugged off that pessimism and rose to $318.00.

I think there could be a similar bounce in marijuana stocks, so my conclusion is actually pretty far away from the question.

Judging by the answers to my fundamental questions, there is no marijuana stock bubble in 2017. Quite the opposite, actually. There might even be an opportunity to make triple-digit gains.