Very few industries reach $5 billion in annual spending and then go on to grow another 25 percent each year for the next five years. It happened to broadband internet in the early 2000s, and earlier, in the late 1980s, when basic TV cable subscriptions boomed.
As an investor, you’d probably love to get in early on the next big thing, right?
That thing is marijuana, says Arcview Market Research, which calls it “arguably the fastest -growing industry in the world.” The firm, which specializes in cannabis market research, forecasts the industry will grow from $6.7 billion in North America in 2016 to $22.6 billion in 2021. If they’re right, that’s a whopping 27 percent compound annual growth rate.
But growth like that doesn’t come without enormous risks. And investors would be wise to act with caution, rather than jump right it. Here are five risks to investing in cannabis stocks and exchange-traded funds.
Uncertain regulatory environment. Although nine states and the District of Columbia have legalized marijuana for recreational purposes and 29 states have legalized it for medical use, the drug is still illegal on a federal level. The U.S. Drug Enforcement Administration classifies marijuana as a Schedule 1 drug, a category that also includes heroin, LSD and ecstasy.
[See: 11 Steps to Make a Million With Your 401(k).]
President Barack Obama’s administration relaxed federal enforcement on marijuana laws, but in January, Attorney General Jeff Sessions rescinded the measure, indicating the Trump administration is willing to take a harder stance on the issue.
The uncertain regulatory environment not only raises the specter of a federal crackdown on cannabis producers, but also presents capital constraints on businesses in the industry. As of 2016, only 301 — or less than 3 percent — of the nation’s roughly 12,000 banks and credit unions, worked with cannabis companies.
“Marijuana is still illegal nationally and business owners who deal directly with the plans and retail sales do not have a safe way to bank yet,” says Kristi Sullivan, a financial planner based in Denver.
High taxes. When deciding to invest in a company, one of the first places an investor should look is the company’s income statement — and taxes are a big part of that.
Cannabis producers are subject to IRS rule 280E, which prohibits companies that sell Schedule 1 drugs from deducting operating expenses from their income. As a result, cannabis businesses essentially pay taxes on their sales — rather than their profits — and face effective tax rates of up to 70 percent, according to Arcview.
This takes a big toll on profitability and cash flow.
Volatility. Because the market is still new and there are so many unknowns, publicly traded cannabis stocks and ETFs are notoriously volatile. On Jan. 4, the day that Sessions rescinded the Cole memo — the Obama-era policy that took a more hands-off approach to federal enforcement — marijuana stocks plunged. The world’s largest marijuana stock by market capitalization, Canopy Growth — a Canadian company — fell 17 percent, and ETFMG Alternative Harvest ETF (ticker: MJ), the first marijuana ETF listed in the U.S., lost 9 percent.
Even ancillary suppliers to the marijuana industry were hurt. Scotts Miracle-Gro Co. ( SMG), the fertilizer company, fell 5 percent that day.
Stephen Rischall, a financial advisor in Sherman Oaks, California, says several of his clients have approached him about investing in the cannabis industry, but he gives them this advice: “Expect volatility and I’d only recommend investing up to an amount that you’d be willing to lose completely.”
Even ETFs, which in theory, spread the risk around by tracking a broader basket of companies, are risky, he says.
“There is substantial political and regulatory risk with investing in the cannabis industry today,” Rischall says. “By using an ETF, at least you’re spreading that risk across several different cannabis-related stocks, but don’t kid yourself into thinking that makes it safe.”
[See: 7 of the Best Stocks to Buy for 2018.]
Bubble territory. The marijuana boom is often compared to other get-rich crazes like the dot-com boom and bitcoin.
“As with any new area of commerce, the first in the market are not always the ones that are the lasting players,” Sullivan says.
Some of the largest publicly-traded Canadian producers were valued at 100 times sales in 2017, reminiscent of the extreme valuations seen in the dot-com boom, which of course, ended in a bust.
“Without a doubt, right now what’s really hot seems to be a lot of the Canadian issues, but that said, they’re terribly overvalued. For those looking closely at this space, I would caution that euphoria should not dictate investment decisions,” says Robert Hunt, principal of Shingle Hill, a boutique consulting firm that advises cannabis investors.
Likewise, George Gagliardi, a financial planner based in Lexington, Massachusetts, also warns that speculators are driving up the value of cannabis investments, often based more on sheer greed and emotion, rather than knowledge of underlying fundamentals.
“Like the cryptocurrencies and their ETFs, much of the early activity will be purely by speculative buys by investors who know nothing about the underlying stocks other than their industry, only that it has gone up a lot in recent months,” Gagliardi says. “So quick gains might be possible by following the momentum of this sector. However, the losses may come even faster here.”
Piggybacking on the cannabis market. Early investors in the emerging cannabis industry are sometimes referred to as “green rushers,” harkening to the California gold rush in the late 1840s. And like Levi Strauss back then, there are investors who try to get in on the marijuana boom, not directly, but by investing in related products and services. Rather than invest in cannabis producers, they look for packaging firms, fertilizer producers and REITs that lease to marijuana growers.
“Are you willing to cross the green line? There’s definitely a true bifurcation between the two sides,” Hunt says. “On the ancillary side, the risk is significantly lower, but as a result, the reward is lower, too.”
But investing indirectly in the industry is not necessarily that much safer, he says. If the federal government ever were to crack down on cannabis producers, it’s possible their suppliers could also be seen as aiding and abetting a criminal act.
“Those that think playing the ancillary space is an easier, safer way to play cannabis, probably need to do a bit more research because it’s not that simple,” Hunt says.
Overall, experts tend to recommend that retail investors wait a bit longer before dipping their toe into marijuana stocks or ETFs.
Some of the best investments are private companies that are not listed on the exchanges, says Nic Easley, CEO of 3C: Comprehensive Cannabis Consulting.
[See: 9 Financial Stocks to Buy for the Dividends.]
“Unless you’re really well connected, it’s hard to know what those investments are,” he says. “Don’t just jump in. We’ve seen people make millions, but we’ve also seen people lose millions, sometimes in a day. Do your homework, do your due diligence and understand the market a little bit more.”
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5 Risks of Investing in Marijuana ETFs originally appeared on usnews.com
