Buy Marijuana Stocks Now? You'd Have to Be Stoned.

Marijuana stocks have become the “next big thing.” Thirty-three states have legalized medical marijuana, including 10 (and the District of Columbia) that have greenlighted it for recreational use. In Maryland, where I live, medical marijuana dispensaries are opening apace, and several clients have asked me to recommend a marijuana stock.

My advice: Stay away. It’s almost certainly less risky to inhale than to invest.

Marijuana exhibits the classic hallmarks of an investment bubble. As with Internet stocks in the late 1990s and Bitcoin and other cryptocurrencies a year or so ago, marijuana stocks (and related investments) are almost certain to crash and burn.

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Investment bubbles, of course, are marked by rapid price gains based on sketchy facts, grand dreams … and no regard for stock valuation. Marijuana stocks are soaring into bubble territory. ETFMG Alternative Harvest ETF (MJ, $37.35), a marijuana-focused exchange-traded fund, has returned an annualized 20.3% over the past three years, including a 49.8% gain in just the first two-and-a-half months of 2019. (Data is as of March 15.)

Alas, investment bubbles all end the same way: with stocks cratering, costing their investors most (if not all) of their investment.

The Problem(s) With Marijuana Stocks

Will marijuana turn out to be a wonder drug? The scientific evidence on its potential benefits and harm is limited because the drug remains illegal under federal law, making it extremely difficult to conduct research in the U.S.

Being illegal presents numerous other obstacles. If you’re producing or selling marijuana in the U.S., you’re violating federal law. Consequently, American marijuana companies can’t list on Nasdaq or the New York Stock Exchange. So they list on the Canadian Stock Exchange in Toronto and the OTC Markets Group in the U.S. where disclosure requirements aren’t nearly as strict as on the major U.S. exchanges. That presents significant challenges for investors who want to find reliable data on American marijuana companies.

Funnily, only companies that produce marijuana outside the U.S. – such as Canada’s Cronos Group (CRON) and Canopy Growth (CGC) – can trade on the major U.S. exchanges.

Banks, likewise, give marijuana companies a wide berth for fear of raising the ire of the federal government. There are some workarounds, but generally, marijuana is an all-cash business. Customers at marijuana stores (called dispensaries) often pay hundreds of dollars, in cash, for marijuana each time they visit.

The trouble with all-cash businesses: They tend to attract unsavory characters. The marijuana industry is already seeing federal probes and allegations of self-dealing.

Another problem for companies producing and selling marijuana in the U.S.: The companies must grow, process and sell their products all within the confines of a single state. Taking it across state lines would violate federal law. Imagine a beer company that had to build a brewery in each state where it wanted to sell beer.

Despite this, marijuana is a fast-growing startup industry … but unsurprisingly, few companies are actually turning a profit. Most are losing money hand over fist as they build out their businesses. That makes it incredibly difficult to tell which of these companies could eventually grow into well-run, profitable firms that enrich stock holders like you. Remember: During the Internet stock bubble, people legitimately wondered whether Amazon.com (AMZN) would be more successful than Pets.com. Similarly, there were dozens of Internet search engines at the time, but today, Alphabet’s (GOOGL) Google is the only one that truly matters.

None of that has deterred marijuana investors. The market capitalization of U.S. companies (those listed in Canada or with the OTC Markets Group) was $14 billion U.S. in mid-February, according to Barron’s. Insiders, who are eager to dump their shares as soon as lockups expire, hold a large percentage of the stock. Insider selling, of course, can crush stock prices.

What about the Canadian marijuana companies that are listed on the major U.S. exchanges? They do have the advantage of Canada allowing marijuana sales nationwide, but these stocks are wildly inflated. Again, citing Barron’s, in mid-February, these stocks were trading at an average of about 30 times sales! (U.S. companies listed in Canada are even pricier.) The Standard & Poor’s 500-stock index currently trades at 2.1 sales, and that is about as pricey as the index has been in at least the past two decades.

The One Play for When the Smoke Clears

None of this is to downplay the potential of the marijuana industry. Almost all investment bubbles are based on a real opportunity. Many Internet stocks (such as Amazon.com) recovered from their massive losses in the early 2000s to grow into highly profitable companies.

But it’s way too early to tell if or how the marijuana industry will develop, much less which stocks are attractive.

Still want to invest? The ETFMG Alternative Harvest ETF might be the least-bad way. It owns about 30 marijuana stocks involved in the industry in one way or another, whether it’s crop cultivation, marijuana distribution or even companies that distribute things such as plant food and fertilizers that may be used in the cannabis business.

Thus, holdings include the likes of Cronos Group, Canopy Growth and grower Aurora Cannabis (ACB). But it also holds GW Pharmaceuticals (GWPH), a biotech firm studying medical uses for marijuana, and Altria Group (MO), the tobacco giant that recently bought a big chunk of Cronos.

With the ETF, at least you spread your bets.

Finally, remember that the legal marijuana companies not only compete with each other; they also compete with long-established black-market dealers who don’t pay state taxes, which are high and rising. These dealers won’t go away easily, and growing marijuana isn’t all that difficult. After all, they don’t call it “weed” for nothing.

Steve Goldberg is an investment adviser in the Washington, D.C., area.