Everything You Need to Know About Investing in Pot Stocks

Cannabis became legal in Canada less than a month ago, and already, the industry has become the darling of the investing world. It’s kind of a big deal: Canada is only the second country in the world to legalize the possession and use of recreational cannabis. But if other countries follow suit, this industry that has operated on the fringe for decades could be worth $194 billion in seven years, according to a BMO report.

To say that there has been enthusiasm around investing in cannabis stocks would be an understatement. Countless articles have been written about the best marijuana stocks to invest in Canada, and early investors are already getting caught up in the hype. While the current federal government had noble intentions of increasing public safety and de-funding the black market when they passed The Cannabis Act in June 2018, the move kicked off an unintended investing frenzy as thousands of Canadians jostle to capitalize on this burgeoning industry.

What’s Happening in the Pot Stock World?

Call it what you want – a bubble, a bull market, a runaway train, the pot stock world is currently characterized by expensive, high-growth stocks that are on a roller coaster of daily value gain and loss, and their performance is mostly based on hype at this point.

But over the next 12 months, Canadians can expect some big changes in the cannabis investing world.

First will be the introduction of additional cannabis products in July of 2019. Right now, edibles, oils, and cannabis-infused beverages are not legal, but several companies are already funding the development of products infused with THC (tetrahydrocannabinol) including both alcoholized and non-alcoholized shakes, teas, and energy drinks. U.S. alcohol giant Constellation Brands Inc. is getting in on the action by purchasing a 10 percent stake in the Canadian company Canopy Growth for $245 million. Other rumours swirl related to a collaboration between Coca-Cola and Canadian producer Aurora Cannabis to develop a cannabis-infused beverage, although both companies have publicly denied the reports.

Beyond recreational cannabis use, we expect to see more research funding into the medical benefits of cannabis consumption. Cannabis has long been used to treat health problems like pain, anxiety, depression, and insomnia, but now that it is legal in Canada, we expect a more targeted expansion of cannabis-related drugs. This development is already begun, with British Columbia-based company Tilray announcing plans to work with the University of California San Diego on a clinical trial to test CBD’s (cannabidiol) effectiveness against essential tremor, which is a brain disorder that can cause part of your body to shake uncontrollably. The announcement of this collaboration caused Tilray’s shares to surge by 15 percent.

Finally, we can expect some significant consolidation of the cannabis industry over the next several years. As a fledgling industry, the cannabis market in Canada is comprised of upwards of 250 companies, many of them being relatively smaller players. As the industry matures, we’ll see consolidation into a handful of major players. That makes investing in one specific company risky, as competition is fierce while start-ups race to grab market share and larger organizations muscle out or absorb smaller companies.

Should Investors Put Their Money in Marijuana Stocks?

Right now, investing in marijuana stocks presents a lucrative opportunity. But like all investment opportunities with significant upside, there is also a significant downside.

Investing in marijuana stocks is risky right now because the markets are fairly volatile, but also because cannabis is still illegal in most countries. While consuming recreational cannabis in Canada is government-sanctioned, the rest of the world is not so welcoming, which means the industry is still vulnerable to government intervention. For example, last year Jeff Sessions implied that federal prosecutors could and should go after the cannabis trade wherever federal and state laws collide. Canadian cannabis stocks took a tumble in reaction to this statement, even though cannabis continues to be legal in Canada.

Investors also have extremely high expectations for the marijuana industry, which makes investing in cannabis stocks inherently risky. The market is in flux, with new, small companies entering a market that is fueled more by hype than earnings.

These sky-high stock prices are unlikely to be sustainable over the long term. Andrew Hallam, personal finance expert and acclaimed author of the best-selling book, Millionaire Teacher, agrees.

“Assume a group of marijuana stocks is expected to increase their business earnings by 30 percent per year over the next 12 months,” says Hallam. “If they increased their business earnings by 25 percent instead, their stocks would likely drop, despite the strong annual earning gain of 25 percent.”

This type of investing frenzy is bad news for green investors, who may not have the strong stomach required to ride out market fluctuations. If you’re confident you can weather the storm, Hallam recommends a measured approach of dollar-cost averaging into a marijuana index. Keep the investment portion small (less than 5 percent) relative to your overall portfolio, and be prepared for a wild ride.

What to Know Before Investing in Marijuana Stocks

At the risk of sounding like a broken record – before taking the plunge and investing in cannabis, you’ll need to prepare yourself for some serious market fluctuations. Hallam cautions new investors to take the time to understand how stock prices work before taking the plunge.

“Stock price appreciation over time is the result of business earnings and investor expectations,” says Hallam. “Right now, expectations are extremely high, which makes cannabis stocks risky, because the likelihood of not meeting expectations is high.”

Don’t underestimate how much stocks can gain based on hype alone. As stocks soar, more Canadians will flock to purchase them, which will push prices up even further. Conversely, a massive flight from a particular stock will cause a precipitous fall. Timing these types of fluctuations is nearly impossible.

Instead of trying to time the market, consider investing in index ETFs instead.

How to Invest in Pot Stocks

In the next several years we’ll see more cannabis companies go public and the market should settle out, but for now, you should hold off before investing in individual companies because of the volatility cited above. Instead, consider purchasing an exchange-traded index fund. These funds focus on the whole industry and are less risky than purchasing individual stocks.

You can purchase the Horizons Marijuana Life Sciences Index ETF yourself directly through a discount brokerage like Questrade, but you may be hard-pressed to find a robo advisor that invests in this ETF. Instead, your robo advisor likely invests in cannabis in a roundabout way by holding an ETF with some exposure to cannabis stocks. This is actually a good thing since we rely on our robo advisors to manage a diversified portfolio on our behalf. A large exposure to cannabis stocks is not diverse.

Wealthsimple, for example, has this to say on the subject: “Some of our underlying ETFs may have periodic exposure to cannabis and marijuana stocks, however, none of our ETFs are specific to the cannabis sector. By investing in a diversified portfolio, you will be exposed to various different sectors and geographies, which can include marijuana.”

A good option is the Horizons Marijuana Life Sciences Index ETF (HMMJ). This index ETF is designed to provide you with exposure to a basket of North American publicly traded companies with “significant business activities in the marijuana industry.” This ETF is a good alternative to attempting to pick the winners and losers yourself – a strategy that could go up in smoke.

Currently, cannabis stocks are included in the iShares Core S&P/TSX Capped Composite Index ETF (TSE: XIC), which is an ETF that is commonly held by Canadian robo advisors including Wealthsimple, Nest Wealth, and ModernAdvisor.

As the market matures we’ll see more mutual funds and ETFs jumping on the cannabis wagon, but for now, you can further increase your exposure to the cannabis market by investing in iShares Core S&P/TSX Capped Composite Index ETF (TSE: XIC), Vanguard FTSE Canada All-Cap ETF (TSE: VCN), and BMO S&P/TSX Capped Composite ETF (ZCN: TO) either directly through a discount brokerage like Questrade or through a robo advisor.