Investors looking for Canadian cannabis stocks to buy need to recognize these key risks

With the upcoming legalization of marijuana, and the resulting increase in marijuana production, there will be an even bigger increase in investor interest in Canadian cannabis stocks.

Is it a good idea to invest in Canadian cannabis stocks?

As you probably know, several U.S. states have decriminalized or legalized cannabis use and have begun authorizing legal production and sale of the plant. In Canada, marijuana has been legal for medical use for some time, and the government is moving ahead with its plan to allow for some legal form of recreational use. As a result, we are increasingly asked about Canadian cannabis stocks.

This change in the law is bound to lead to a shift in current and future cannabis production, from the underground economy to the legal economy, where it can be regulated, taxed and invested in.

High market caps leave many Canadian producers vulnerable

The speculative appeal of Canadian cannabis stocks continues to attract investors looking for a “ground-floor opportunity.” However, the pioneers in an industry are not always the ones who survive.

Longer term, the Canadian government’s plans to expand the marijuana market beyond medical use—with full legalization expected by July 1, 2018—remain a threat to today’s licensed producers. Right now, they depend on a heavily regulated market.

Small marijuana producers have to overcome all the usual obstacles that small and start-up companies face. As well, there are low barriers to entry for new marijuana producers. If demand grows large and profitable enough, major agricultural and drug companies, as well as tobacco firms, are likely to enter the field and take sales away from small growers.

Considering their current sales, many Canadian producers have very high “market caps” (the value of all shares outstanding). That means they need huge revenue growth even to justify their current stock prices. If revenues merely hold steady, their stock prices will be vulnerable.

All in all, despite the keen investor interest in marijuana stocks, we have yet to find any we are prepared to recommend as buys.

Bonus Tip: Ignoring market cap can lead to huge losses

If a company’s market cap is close to or less than its total yearly sales, this may indicate that it offers substantial value. However, companies in businesses with low profit margins, such as food retailers, ordinarily have a market cap that is a fraction of their sales. That’s because they earn modest profit margins, perhaps a few pennies on each dollar of sales.

When a stock trades at a high ratio of market-cap-to-sales—over 5.0, for instance—it usually means it’s in a highly profitable business, or else investors have bid up the price of its shares because they have high expectations for future growth. This introduces an element of risk.

A high market-cap-to-sales ratio makes a stock sharply vulnerable in a market setback. If its profit falls or if it fails to live up to investor expectations, its stock price can plummet. It’s best to avoid overloading your portfolio with stocks that have a high market-cap-to-sales ratio, and this includes marijuana stock.

Above all, avoid high-risk Canadian cannabis “pot of gold” stocks

While the cannabis industry now has a number of established producers, including Canopy Growth, in the early days of decriminalization we saw many highly speculative “pot-of-gold” penny stock promotions. These typically arise in new industries.

Stock promotion is a take-the-money-and-run type of business. Most successful entrepreneurs value their reputations, and want to build a profitable, sustainable business that can pay off for investors. So they generally go into some other line of work, and stay out of stock promotion. Right now, cannabis stock investing is a risky area.

We advise staying out of stock promotions of Canadian marijuana stocks businesses or anything else. They attract the wrong kind of people.

These days, it’s faster and easier than ever to launch a stock promotion, thanks to the Internet. One recent “penny pot” investing stock scam almost seems like an MBA-style case study on how to launch one of these frauds online. To avoid being taken in, it pays to read more, and to think before you invest.

A speculative stock is a higher-risk, more aggressive stock with uncertain prospects. Speculative stocks may offer significant returns to investors—but they will also have risk to match.

The odds are against you when you invest in speculative stocks and companies that are not yet making money. Some, if not many, of these companies will never make any money.

What do you find appealing about investing in the growing cannabis industry?

As exciting as it may be to think about investing early in Canadian cannabis stocks, it’s still a risky industry for investors. What do you think could change that and stabilize the industry enough to warrant investment?

This article was originally published in 2018 and is regularly updated.