When it comes to investing in cannabis stocks, it's easy to find a lemon when you're looking for a goose that lays golden eggs. Between the ever-present hype for questionable companies and the industry's struggles with efficiency, even savvy buyers can make mistakes -- and I know I've made a few!
The good news is that becoming a wiser investor is easier than it may seem. And today, I'll be sharing four of my best tricks for identifying the best marijuana stocks so that you'll be equipped to succeed.
1. Don't limit yourself to pure-plays
There's more to the cannabis industry than companies that grow cannabis and then sell it directly to consumers. In my view, some of the most lucrative marijuana stocks are those that don't ever handle any marijuana at all.
Take Scotts Miracle-Gro, (NYSE:SMG) Grow Generation, (NASDAQ:GRWG) and Innovative Industrial Properties (NYSE:IIPR) as examples. Scotts sells cultivation equipment and plant food, whereas Grow Generation sells hydroponic growing gear. Innovative Industrial doesn't sell anything at all, as its business model entails buying indoor cultivation space from marijuana companies and then leasing it back to them. All three feed directly into the cannabis industry's most basic needs, and all three are positioned to grow alongside the industry itself as a result.
The advantage of picking one of these stocks instead of a cannabis pure-play stock is that they're much more robust. If the market price of cannabis rises, it could seriously disrupt the margins of a retailer, but it wouldn't harm any of the three businesses I listed. Likewise, if the consumers in a given geographical market have a set of product preferences that a distributor isn't equipped to match, it won't be able to compete effectively. But the companies I listed won't have any issues.
So, don't limit your search for marijuana stocks to those whose business model are purely based on cannabis sales. You'll miss a few of the best options out there and potentially expose yourself to more risk if you do.
2. Profitable is preferable, but steadily improving margins are fine too
Because the cannabis industry is still immature and growing rapidly, profitability is hard to come by. Most companies are focused on growth rather than becoming more efficient or rewarding shareholders.
That means investors don't have many profitable companies to choose from, though they can probably expect to have more choices in the future. And investors might be able to find bargains with companies that are quite close to being profitable, like Cresco Labs.
If you can't find anything that suits your fancy that's as firmly profitable, don't be afraid to opt for a business which has been posting better margins each quarter for the last year or so.
3. Examine the revenue mix
As many marijuana aficionados will readily volunteer, not all cannabis products are created equal. Bulk cannabis flower grown outdoors and sold from a warehouse will cost the least to produce, but it won't command a high selling price, so it tends to be a category with thin margins for sellers.
On the other hand, high-value-added products like tinctures, vaporizers, and lotions are often more profitable. Because the value of these items lies in the considerable amount of processing of the raw materials that the manufacturer performs for the sake of the customer, they can be sold for much higher prices. And the profit that manufacturers make per unit doesn't vary as much with the prevailing market price of cannabis as it does with simpler, less processed goods like pre-rolled cannabis or dried flower.
So, when you're evaluating a marijuana company, take a close look at its revenue mix as well as management's plans for developing new products and brands. Prefer companies that focus on complex cannabis products rather than those that require minimal manufacturing before hitting the retail shelf.
4. Look for licensing moats
Because cannabis isn't federally legalized, there are a plethora of different licensing requirements for businesses to operate, which vary by state.
In most of the states where there is a regulatory framework for the industry to operate legally, there are a finite number of licenses for growers and distributors.
A large market share is assured for the companies that hold a significant proportion of the available licenses to operate dispensaries in a state. As an example, consider Trulieve Cannabis and its impressive share of 46% of the market in Florida, where it owns a large number of the state's dispensary licenses.
In contrast, a competitor without any state licenses to its name isn't much of a competitor at all, as it almost certainly lacks a legal way to generate revenue. As licenses are often tradeable, it's important to remember that entering a new market may be quite expensive as a result.
Therefore, my final trick for identifying a winning cannabis stock is to look for the companies that are favorably positioned with regard to their possession of state-level licenses to grow, process, and sell marijuana. Late entrants to a market will struggle to catch up, so it's often better to bet on the local favorite.