3 of the most de-risked cannabis stocks

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It should come as no surprise that one of the most popular investment categories over the past couple of years has been marijuana stocks. With Canada giving the green light to recreational pot in October 2018, and two-thirds of all U.S. states legalizing medical marijuana, the outlook for cannabis stocks continues to point higher. Unfortunately, green arrows haven't been as common for the green rush of late.

While marijuana stocks were mostly unstoppable through the end of the first quarter, they've been nothing short of a disaster since then. Over the past 4 1/2 months, most cannabis stocks are down by a sizable double-digit percentage. Supply shortages in Canada, high tax rates in select U.S. states, and persistent operating losses for most big-name pot stocks have all been responsible for pushing marijuana valuations lower.

But there are three pot stocks for investors to consider that appear to be more de-risked than their peers. Mind you, that doesn't mean these three stocks are without risk. It merely means their downside risk is mitigated, relative to their competition.

An up-close view of a cannabis flower.

HEXO

I want to be clear that cannabis growers are the most exposed to the early-stage supply and/or tax concerns that have been encountered over the past year. However, cannabis grower HEXO (NYSE:HEXO) may have a leg up on its competition.

For starters, it landed the largest single supply deal to date in April 2018 with its home province of Quebec. The five-year agreement allows HEXO to supply Quebec with an aggregate of 200,000 kilos of cannabis over the next five years, with Quebec having the option to extend the deal for a sixth year. When the deal was announced, HEXO's roughly 1.3 million square feet of grow space was on track for 108,000 kilos of peak annual production. But with the acquisition of Newstrike Brands, HEXO is now on pace for 150,000 kilos of peak output a year. Taking into account its production ramp-up, the 200,000 kilos of aggregate supply between 2019 and 2023 should account for about 30% of HEXO's total production. That's more peak supply already spoken for than any other Canadian pot grower. 

The company is also devoting a lot of its effort to processing and producing derivatives. It has more than 600,000 square feet of facility space set aside for processing hemp or cannabis and creating alternative pot products. It also worked out a two-year extraction agreement with Valens GroWorks in April. The deal will see HEXO supplying Valens with 80,000 kilos-in-aggregate of hemp and cannabis biomass in return for resins and distillates that HEXO can use in derivative products. 

This deal with Valens, as well as its Quebec wholesale supply agreement, creates some level of certainty and cash flow that simply doesn't exist with other Canadian growers.

Four vials of cannabidiol oil lined up on a counter.

Neptune Wellness Solutions

Whereas cannabis growers carry a lot of risk for investors, extraction-service providers like Neptune Wellness Solutions (NASDAQ:NEPT) are on the opposite end of the spectrum. Extraction companies should benefit from the rise of cannabidiol (CBD) -- the cannabinoid best known for its perceived medical benefits that doesn't get users high -- and the expected launch of derivative products in Canada by mid-December. Plus, with the passage of the Farm Bill in the U.S. this past December, industrial hemp and hemp-derived CBD are now legal.

Neptune appears set to benefit throughout North America. Its acquisition of SugarLeaf will give it the ability to process up to 1.5 million kilos of hemp or cannabis biomass on an annual run-rate basis by the end of the year, while its wholly owned subsidiary, 9354-7537 Quebec Inc., should offer 200,000 kilos of annual extraction capacity.

In June, Neptune signed two major deals that pretty much guarantee its Canadian operations will see steady cash flow for the next three years. On June 7, it announced a three-year agreement with Tilray that'll involve a minimum of 125,000 kilos being extracted for cannabinoids. Just five days later, Neptune nabbed the largest extraction-services deal to date with The Green Organic Dutchman. It covers three years and features a minimum of 230,000 kilos of cannabis and hemp that Neptune will extract, formulate, and package for TGOD. 

With much of its Canadian extraction services contracted out through 2021, and its U.S. extraction plant set to see a surge in demand once complete, Neptune looks to be particularly de-risked.

An up-close view of flowering cannabis plants growing indoors.

Innovative Industrial Properties

A third cannabis stock that's done a very good job of de-risking its business is cannabis real estate investment trust (REIT) Innovative Industrial Properties (NYSE:IIPR).

As a REIT, Innovative Industrial's task is to acquire land and facilities that can be used to grow and process marijuana, then lease these facilities out for an extended period of time, thereby collecting rental income for a long-term profit. Further down the line, the company has the option of selling its owned properties for a profit, thereby starting the buy-and-lease cycle anew.

Since the beginning of the year, IIP, as the company is better known, has more than doubled the number of cannabis properties in its portfolio. As of last week, it owned 27 properties in 12 states, with $264.2 million invested in aggregate, and an additional $96.5 million set aside for reimbursement to certain tenants and sellers for construction and facility improvements. The weighted-average remaining lease term for these 27 properties was 15.5 years, with an average return on invested capital of 14.5%. This means it'll take less than five years for IIP to receive a complete payback on its aggregate investment. 

Furthermore, Innovative Industrial Properties also passes along a 3.25% annual rental increase, as well as charging a 1.5% management fee that's tied to the annual rental rate. In other words, IIP has built modest organic growth into its contracts.

Although it's common for REITs to dilute shareholders with stock offerings to raise capital for more property acquisitions, this is a relatively small risk compared with the guaranteed cash flow that IIP's diversified portfolio brings to the table.

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