No pun intended, but there seems to be a big “buzz” about the marijuana industry these days.
23 years ago, no state in the U.S., Canada or Mexico had legalized the use of marijuana in any capacity. Now in 2018, more than half of the states in the U.S. have legalized the use of medical cannabis - and nine of them allow recreational use. Mexico legalized medical marijuana in June of last year, and on June 19th of this year, Canada passed its own Cannabis Act, becoming the first industrialized nation in the world to legalize recreational pot. What a difference a few decades can make!
With such sweeping changes and continued growth in the marijuana industry, is it time to invest in marijuana stocks?
Investors should first remember that any "hot" stocks can burn a portfolio if they aren’t careful. It’s important to take time before investing to learn about the company, its products or services and the people running it. Just how viable is the business and what are its prospects for success?
In the case of the marijuana industry, which is relatively young in the U.S., there’s a lot of money being made, so viability is likely good. According to BDS Analytics, a cannabis market intelligence firm, this emerging industry generated $9 billion in sales in 2017 and is expected to hit $57 billion worldwide sales by 2027. However, how much of that drops to the bottom line in profits is up for debate, as the industry still faces significant challenges.
Despite being “legal” for certain uses in many states, marijuana remains classified as a Schedule I substance under the Controlled Substances Act (CSA). Therefore, the manufacturing, dispensing and use of marijuana remains federally prohibited, so any revenue these businesses generate and deposit into a federally-insured banking institution technically violates federal law. Furthermore, handling the proceeds of any marijuana transaction is considered to be money laundering. Very few large banks are willing to bear that risk. Because of this, the industry has largely had to operate in cash because they cannot accept credit cards or checks that require processing through a bank. As one would imagine, the risks of robbery from operating a cash business threaten not only the business, but all those working around the business.
While some state banks and credit unions have started offering banking services to the marijuana industry, they still don’t lend them money, because the federal authorities technically could seize whatever collateral backs the loan. So operating capital has had to come from investors (see below) and not lenders. it’s difficult to know if many of these businesses have bank accounts in their own name, because most banks refuse to publicly discuss this line of business, and they require clients to sign agreements promising not to discuss the relationship either.
As if that isn’t enough of a challenge, while Uncle Sam makes it hard for the marijuana industry to do banking, he sure doesn’t mind taxing it. Section 280E of the tax code specifies that businesses who are “trafficking in controlled substances” prohibited by federal law may not utilize many tax deductions and credits that are available to other businesses, like deducting rent and employee-related expenses. That means a marijuana business that doesn’t use a lot of “creative accounting” can pay effective tax rates as high as 70%, as opposed to the now more favorable tax rate of 21% for corporations, effective in 2018.
In spite of these challenges, investors who are considering investing in the marijuana industry need to realize that very few U.S.-based pot businesses are listed on the New York Stock Exchange or Nasdaq. Most of these companies trade in the OTC Markets, which have less stringent filing and disclosure requirements compared to the larger exchanges. It can be difficult to obtain sufficient information about these investments in order to make a wise investment choice.
And investors must beware that since the marijuana business has been getting a lot of attention lately, it has also caught the attention of scammers. With such a new “hot” industry, fraudsters love to lure potential investors with optimistic and potentially false or misleading statements designed to create high demand for a new company with very little history of financial success (aka “the pump”). Then, once share prices reach a peak, these con artists behind the scam will sell off their shares at a profit, leaving unsuspecting investors stuck with worthless stock (aka “the dump”).
It may sound like I am warning against investment in the marijuana industry. I’m not. I am merely advocating that, just as with any single stock investment, investors should go into such a transaction with “eyes wide open.” Here are some items to consider before making an investment like this:
- If you are solicited to make a purchase, consider the source of the solicitation. Is the source credible? A legitimate investment salesperson must be properly licensed with FINRA, the SEC or the state you are in. And… are they making claims that sound too good to be true?
- Do your research on the individuals running the company (seriously, have they served time in prison?) and understand the operations and financial information about the company as much as you can. There are quite a few new operators in the weed industry that are getting out of the black market; it’s not much of a “white collar” business – yet. And as a result, standard operating business practices are not as fully developed as in other industries.
- Consider where the stock trades: if it’s on the OTC market, understand that these markets are not as liquid, which means they do not trade frequently: it may be difficult to sell your investment later on, and prices can move up or down substantially from one trade to the next.
- Do not plan to invest more than you can afford to lose. We never recommend a single stock investment being more than 5% of a client’s portfolio – and preferably much less than that. Before investing, talk to your financial planner and make sure you are not taking on un-due risks to your retirement plan or other goals.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Stock investing involves risk including loss of principal. No strategy assures success or protects against loss.