Wall Street is crazy about it. Bloomberg, Forbes, and CNN cover it with increasing intensity, and the world holds its breath for the 17th of October. Not since the internet boom of the 2000's has an industry reached $5bn and then gone on to grow by up to 25% year on year from there. Now there's one. The Cannabis Industry.
The giant has awoken. Nations are starting to legalise it for adult recreational use (in essence lifting prohibition of the plant) and millions are being made in every area of the industry. From cultivation to extraction, 3rd party supply logistics and to the mother-of-all, retail, the growth is nothing short of hyperbolic.
But growth like that doesn't come without enormous risks. And investors would be wise to act with caution, rather than jump right it. Eyes wide open, and brain switched on. This is the best way to play it. So, in keeping with this theme, find below a few of the risks any investor and/or potential investor should be cognoscente of.
There is no guarantee of success. None
As a result of the fast-growing nature of cannabis sector companies, the prospects of their future profitability remains in the loop. A lot of cannabis companies build their company's success around future sale and distribution of cannabis products, even though a lot of rules and regulations on the sale and distribution of these products are still in the process of establishment. Similar to any normal investment, success, return, or income isn't guaranteed in cannabis sector investments.
The regulatory ground is shaky
Both the regulators and government in several jurisdictions exploring the newly instated cannabis laws still have to come up with a full establishment of the framework which clearly states where and how cannabis products can be sold.
For instance, there may exist some restrictions on stores permitted to carry out the sale of cannabis products and also the rules regarding the advertising and branding of these products. This could hamper the ability of a consumer to locate and buy such products. The above challenges may affect the company's ability to profitably sell its products which will then lead to a fall in the value of your investment in the company.
Even though the District of Columbia and nine other states have legalised marijuana only for recreational purposes while 29 other states have legalised it for medicinal purposes, it is still illegal at the federal level. Yet look how much money stands to be made by the Federal Government. Of course, it makes sense, that they should legalise it, but they still might not – and that's the point.
Marijuana is classified as a Schedule 1 drug by the U.S. Drug Enforcement Administration. Drugs such as ecstasy, LSD, and Heroin are also listed in this category. Yeah, that makes sense.
Under President Barack Obama, the administration loosened federal enforcement on the implementation of marijuana laws. The relaxation of this laws was rescinded by Attorney Jeff Sessions in January, which meant the Trump administration was bent on taking a harder stance regarding this issue. Although, to date, the administration has done nothing and Trump himself has promised his commitment to defending the individual states' rights on the issue.
Little Banking. Big Taxes
The mandated taxes and prices imposed by the government on cannabis products can also contribute to the risks affecting the success of cannabis companies. The prices of cannabis products should be set below their value on the black market so as to attract more clients. If the prices of these products are reduced only by black market dealers and the government also imposes a high price on these products, the companies which grow and sell these products might be affected negatively.
Before an investor invests in a company, they should always pay attention to a company's income statement (taxes make up a big part of this statement). Producers of cannabis are bound to respect the IRS rule 280E, which states that companies selling Schedule 1 drugs are prohibited from reducing operating expenses from their initial income. Because of this law, cannabis companies instead pay taxes on sales made, rather than on profits.
According to ArcView, these companies face tax rates which rise up to 70 percent. This affects both cash flow and profitability. This puts immense stress on the smaller cannabis companies. Will they have enough cash flow to survive?
Startup industry investments carry business-startup risks
Startup companies in new, growing industries always face inherent risks. Apart from the marijuana industry's rapidly changing dynamics, there is the need for new companies to make safe their funding, and compete for shares in the market, in the face of numerous competitors. And the competitor lists are growing at the same hyperbolic pace the market is.
The approval of cannabis for recreational purposes in other countries further complicates this and there is the possibility of added competition from outside. There is also the possibility of disruption of the market by the entry of larger companies. This is starting to play out with Big alcohol the first to join the party.
Strap yourself in. We're experiencing Volatility.
Due to the marijuana industry's evolving nature and relatively small size, price movements of its publicly traded companies are expected to be above average as a result of the numerous uncertainties in both the recreational and medical markets.
This gives us reason to believe that forecasting the future earnings and sales of these companies is a tough task as a result of the fact that there isn't a feasible recreational market. This means of course, that to do so requires significant assumptions. And you know what they say about assumptions?
Cannabis ETFs and stocks which are traded publicly are extremely volatile. On the 4th of January, which is the day Attorney General Jeff Sessions revoked the Cole Memo, marijuana stock prices fell off a cliff.
Canopy Growth (the world's largest marijuana market in terms of capitalisation) fell by 17%. Even the ancillary suppliers to the marijuana industry got hammered. The fertiliser company Scotts Miracle-Gro (SMG), fell by 5% on that day, just because they had a tiny division that supplied product to the cannabis industry.
People often compare the marijuana 'fad' to other get-riches crazes such as bitcoin and the dot-com boom. Some of the largest publicly-traded Canadian producers had valuations that were up to 100 times sales in 2017. Understand the dot-com reference better now?
Opportunities to make an investment in new cannabis enterprises or existing enterprises looking to incorporate the cannabis industry into their business has created a high level of interest among those investors who wish to be part of the new trend – expecting to experience quick growth.
Nevertheless, investments of this caliber can be highly speculative, and the investment cost in one of these marijuana companies may depend on the expectation of success in the long-run rather than the company's current performance.
So, in closing. Yes – there are massive gains to be made in this industry. We are right at the beginning of the greenrush and the next decade will see smart, informed investors make significant gains in their portfolio. But you have to go in eyes wide open.
It's risky business. You've been warned.