The closest thing to a sure thing with investing in pot stocks

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There's absolutely, positively no such thing as a sure thing when it comes to investing. Period. Anything you invest in comes with some level of risk. And investing in marijuana stocks comes with a lot of risk.

The closest thing to a sure thing with investing in pot stocks is a far cry from a sure thing. Having said that, there is an anomaly that I think investors can exploit to improve their chances of success with investing in the cannabis industry. It's simple. It's data-driven. And it makes a lot of sense.

What is this closest thing to a sure thing related to investing in pot stocks? I can sum it up in two words: Buy American.

Hands holding $100 bills fanned out and a cannabis leaf on top of the money

 

Two compelling charts

Do I really think that buying the stocks of companies primarily focusing on the U.S. cannabis market gives investors an advantage? Yep. There are two charts that make a compelling case for the idea. The first chart underscores a big gap in the valuations of Canadian versus U.S. pot stocks.

Price-to-sales ratio comparisons chart for U.S. and Canadian pot stocks

DATA SOURCE: BLOOMBERG. CHART BY AUTHOR.

We can't use earnings-based valuation metrics for the simple reason that many cannabis stocks aren't generating positive earnings yet. But we can use another commonly used metric, the price-to-sales (P/S) ratio. The above chart clearly shows that Canadian pot stocks are valued much more highly than U.S. pot stocks are.

The average P/S ratio for Canadian cannabis stocks is nearly three times that of U.S. cannabis stocks. You can assign a lot of the blame for this big discrepancy to Cronos GroupThe Green Organic Dutchman, and Emerald Health Therapeutics. These three Canadian stocks have much higher P/S ratios than their peers do.

Using a median P/S ratio instead of the average P/S ratio gives us a better perspective. But even watering down the effect of outliers with this approach, U.S. pot stocks are much cheaper than their Canadian counterparts with a 27% lower median P/S.

There's also another compelling reason why U.S. cannabis stocks present a significant advantage to investors: the market opportunity. The following chart highlights just how much bigger the U.S. market opportunity is than in Canada or the rest of the world.

Estimated cannabis revenue chart showing Canada, rest of world, and U.S. revenue estimates for 2019 and 2022

DATA SOURCE: ARCVIEW MARKET RESEARCH AND BDS ANALYTICS. CHART BY AUTHOR.

Most of the largest Canadian cannabis stocks can't compete in the U.S. cannabis market as long as marijuana isn't legal at the federal level. This means that U.S. cannabis companies have a much larger addressable market than most Canadian companies do. 

Put aside for a moment that we're talking about cannabis stocks. If you knew that one type of technology stock had a much more attractive valuation and a much larger potential market than another type of technology stock, which would you be more likely to buy? 

The fly in the ointment

U.S. cannabis companies operate in states that have legalized either medical or recreational cannabis. But doing so doesn't change the fact that many of these companies are still violating federal marijuana laws. The ones that don't violate federal laws skirt the issue because they don't directly engage in the production or sale of cannabis. Innovative Industrial Properties (NYSE:IIPR), for example, is a cannabis-focused real estate investment trust (REIT)that leases properties to U.S. cannabis operators but doesn't run these properties itself.

This legal issue is the primary reason why U.S. pot stocks are so much cheaper than their Canadian counterparts. The issue causes several challenges for many U.S. cannabis companies. It limits their ability to access capital. It prevents them from listing their stocks on major U.S. stock exchanges. And it makes the companies susceptible to the risk that the U.S. federal government could crack down on their operations.

These challenges aren't as daunting as you might think, though. Quite a few of the pot stocks that focus primarily on the U.S. market have listed their shares on the Canadian Securities Exchange (CSE), which doesn't have restrictions on its members participating in the U.S. cannabis market. This approach, combined with listing on over-the-counter exchanges in the U.S., has allowed companies to raise the cash needed to fund operations and expansion.

Also, the risk of a federal crackdown appears to be pretty low at this point. Despite some worries early on in the Trump administration while Jeff Sessions was the U.S. attorney general, there haven't been any real measures taken by the federal government to interfere with businesses operating in states that have legalized cannabis. 

Two key assumptions

I really do think that the arguments for investing in U.S.-focused cannabis stocks are good ones. However, you should know that there are two key assumptions at the core of this approach:

  1. The U.S. cannabis industry will grow at least in the ballpark of what many project that it will.
  2. U.S. federal laws will be revised at some point in the not-too-distant future in a way that at minimum recognizes the rights of individual states to enforce their own laws related to cannabis.

My view is that the first assumption doesn't require too much of a leap of faith. We can look at the sales trajectory of states such as Colorado that have had established cannabis markets for several years to get a reasonable sense of how other state cannabis markets might grow in the future.

The second assumption is more iffy, though. Support for cannabis legalization at the federal level among the American public is higher than ever. The real question is exactly how intense that support is. I'm not so sure that most Americans will make voting decisions based largely on candidates' positions on cannabis legalization.

Also, because of the way the U.S. political system works, the leader of the Senate or the House of Representatives can effectively veto any bill he or she wants to by refusing to bring it to a vote. For example, the opposition of Senate Majority Leader Mitch McConnell to cannabis legalization makes the odds of anything happening much lower than you might think after looking at public opinion poll results. 

But will federal marijuana laws eventually change? I think so. In my view, it's a matter of when rather than if. 

A sure thing

If my two assumptions are correct, investing in U.S. pot stocks should pay off in a big way over the long run. My recommendation for anyone opting to take this approach is to buy multiple stocks of well-run companies that are either already profitable or have a clear pathway to profitability.

Including stocks of companies focused on the hemp market is also a good idea since hemp is already federally legal in the U.S. Keep in mind, though, that the U.S. Food and Drug Administration (FDA) hasn't finalized regulations for hemp-derived cannabidiol (CBD) products. Those regulations, when released, could change the prospects for some hemp CBD companies.

I've already mentioned one stock that I think would be a great core component of a U.S. pot stock strategy -- Innovative Industrial Properties. Not only is IIP profitable and growing, but it pays a solid dividend as well. I also like the prospects for Cresco Labs (OTC:CRLBF), a multistate cannabis operator that should close on its acquisition of California's leading cannabis distributor, Origin House, later this year.

My favorite U.S. hemp play is Charlotte's Web Holdings (OTC:CWBHF). It's another company that is consistently profitable and is growing fast. I also think new CEO Deanie Elsner's expertise in the consumer packaged goods industry will be a big plus to this CBD pioneer.

As I stated at the outset, though, buying U.S. pot stocks -- even a mix of winners like IIP, Cresco, Charlotte's Web, and others -- isn't a sure thing even though I do think it improves your chances of success over the long run. But there is one thing I'm completely sure about: If you don't invest in the cannabis industry, you won't profit from the boom in the cannabis industry. 

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