4 Quick Tricks for Picking Winning Cannabis Stocks

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Investing in cannabis stocks can be like looking for a goose that lays golden eggs -- but finding only lemons much of the time. Between the ever-present hype about questionable companies and the industry's struggles with efficiency, even savvy buyers can make mistakes; 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 never handle the substance at all. 

Take Scotts Miracle-Gro (NYSE:SMG), GrowGeneration (NASDAQ:GRWG), and Innovative Industrial Properties (NYSE:IIPR) as examples. Scotts sells cultivation equipment and plant food, whereas GrowGeneration sells hydroponic growing gear. Innovative Industrial doesn't sell anything at all; its business model entails buying indoor cultivation space from marijuana companies and then leasing it back to them. All three businesses 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 pure-play marijuana company is that they're much more robust. If the market price of cannabis rises, it could seriously disrupt margins for 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, that distributor 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 models are purely based on cannabis sales. Doing so could lead you to miss a few of the best options out there -- and potentially expose yourself to more risk.

 

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. In the meantime, bargains might be found in companies that are quite close to being profitable, like Cresco Labs.

If you can't find anything that suits your fancy that's firmly profitable, don't be afraid to opt for a business that has been posting better margins while still growing revenue during each quarter for the past year or so.

But if you're looking at a pure-play company, be sure that its profits are increasing as a result of increasing operational efficiency rather than fluctuations in the market price of cannabis. Many marijuana businesses are tenuously profitable when prices are low, but only the cream of the crop can keep expanding their margins in the face of strong price pressure. A good rule of thumb is that if a company reports "adjusted" earnings that compensate for the market price of cannabis rather than using non-adjusted figures, its margins probably aren't stable enough to consistently improve.

 

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 with these products, the profit that manufacturers make per unit doesn't vary as much with the prevailing market price of cannabis, compared with 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. Seek out companies that focus on complex cannabis products rather than those whose offerings require minimal manufacturing before hitting the retail shelf. 

 

4. Look for licensing moats

Because cannabis isn't federally legal, 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. 

This means that for the companies that hold a significant proportion of the available licenses to operate dispensaries in a state, a large market share is assured. 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. It's often possible to buy licenses or apply for new ones, but both of those options tend to be pricey and time-consuming.

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.

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