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Investment Outlook

As the cannabis industry goes through growing pains, many producers aim to speed their growth through acquisitions—which increases the risk for investors.

Early reports point to supply challenges for Canada’s legal recreational-cannabis market. Those shortages may be just a growing pain for the industry, but they explain why many cannabis producers relied on acquisitions in the months leading up to legalization on October 17, 2018.

Growth by acquisition is something we’re watching closely with many marijuana producers as they continue to grow quickly by purchasing other firms and operations.

Some are looking to diversify—either from medical marijuana into recreational cannabis, or into new areas like edibles. Most are simply looking to grab as much market share as possible in the first months following legalization on October 17, 2018. That’s because buying an existing grower is a much faster way to boost output than building a greenhouse from the ground up.

Canadian producers are also looking to expand internationally, including buying cannabis sellers overseas as medical marijuana becomes increasingly legal worldwide.

In general, growth by acquisition is riskier than internal growth for a variety of reasons, but especially because acquisitions carry an above-average chance of unpleasant surprises. The buyer of something rarely knows as much about it as the seller. If a company makes enough acquisitions, it is bound to buy something with hidden problems. Eventually, those problems come out in the open and hurt the buyer’s earnings. Growth by acquisition in unrelated areas is especially risky.

That kind of expansion also tends to load up a company’s balance sheet with goodwill. Generally speaking, “goodwill” is the total price a company has paid for all acquisitions it has made over the years, minus the value of tangible assets that it acquired as part of its acquisitions. Goodwill is an intangible asset whose value can drop overnight if it turns out that the company made a bad acquisition.

The purchases that marijuana producers are making are particularly risky. That’s because they are mostly buying firms with huge market values—but with limited revenues and little chance of making a profit anytime soon.