This Is the Biggest Mistake Cannabis Investors Make Over and Over Again

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This Is the Biggest Mistake Cannabis Investors Make Over and Over Again

Investors shouldn't assume the US government will legalize marijuana anytime soon, and investing based on those hopes can be risky.

The cannabis industry has a lot of potential upside. As new markets around the world open up and legalize cannabis for medicinal or recreational use, it can give a company with global aspirations more growth opportunities. The challenge, however, is that it can require a lot of patience from investors. Cannabis remains illegal in most parts of the world, and countries have been slow to make changes.

But some investors remain bullish on the industry's long-term prospects. And the catalyst doesn't have to be huge to get stocks moving. Last month, there was news that the German government was moving forward with marijuana legalization, which went into effect April 1. That, combined with the hopes that the U.S. might also follow suit and make serious changes, are key reasons shares of Canadian pot producers Tilray Brands (TLRY -1.62%) and Canopy Growth (CGC -12.75%) took off. Tilray's stock was up more than 40% in March, while shares of Canopy Growth soared by more than 160%.

Are cannabis investors falling back into old habits?

There's considerable volatility in the cannabis industry, and that can make these types of investments incredibly risky ones to hold. A lot of the excitement is based on hopes for reform.

Take November 2020 as an example. During that month, U.S. President Joe Biden was elected, and the prospects were strong that Democrats would control the House and Senate, potentially making it easy for them to pass marijuana reform. That month, shares of Canopy Growth and Tilray Brands jumped by more than 50%.

A few months later, in January 2021, Canopy Growth Chief Executive Officer David Klein said he was "pretty confident we'll be operating in the U.S. a year from now."

If you invested in the company at that time, bullish on the prospects for legalization, you would have incurred some incredibly deep losses. A $10,000 investment at the start of 2021 would be worth about $350 right now.

Betting on marijuana reform can lead investors down a dangerous path

The biggest mistake I've seen cannabis investors make over the years in writing about the industry is that they are too eager to believe that marijuana reform is coming soon. There are a couple of problems with that. The first is that even if there is reform, it may not mean the entire market opens up. It may just be that marijuana is decriminalized, but not that the entire recreational market is open for business. Plus, it could still take several years. Legalizing marijuana would be incredibly complex and involve considering tax, advertising rules, minimum ages, and many other issues.

That leads to the second issue: Legalization won't be a silver bullet that solves all of Canopy Growth's and Tilray Brands's problems. These are still cash-burning businesses that are deeply unprofitable. And that's the case for many of their rivals as well.

While the opening of a U.S. market will create new growth opportunities, that will also mean more spending and cash burn. These companies and other Canadian marijuana producers will be at a disadvantage, as there are already numerous multi-state operators in the U.S. that are just as eager for marijuana reform to take place. By aggressively pursuing opportunities, these businesses, which don't have sustainable operations today, could potentially put themselves into worse positions by stretching their operations too thin.

Tilray Brands and Canopy Growth are far from surefire growth stocks 

If your investment thesis relies on government reform, that may be a sign that you're taking on a bit too much risk. Government reform can be unpredictable and take a long time. There are no guarantees when it comes to reform, and while that may seem obvious, it's something cannabis investors should never forget.

A company also needs to be in strong financial shape to be able to execute on opportunities as they come up. Neither of these businesses checks those boxes, and until they do, investors may be better off staying away from them. If you want to invest in the cannabis industry because of a potentially strong market in the U.S., then the simpler option may be to just invest in multi-state operators that are already generating substantial revenue and that are in the U.S., rather than relying on the hope that marijuana legislation will pass in the future.

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