Among many experienced investors, the consensus appears to be that marijuana stocks are uninvestable. It isn't too surprising. During the past three years, despite the market's gain of 23%, many major marijuana stocks are down by 65% or more.
But the industry's leaders will eventually overcome this stigma. Here's what you should be looking for to know which companies to buy so that you can benefit when that eventually happens.
Understand why many investors avoid the industry
Despite the recent trajectory of cannabis stocks, it's probably not the root cause driving investors away.
In short, the North American cannabis industry is relatively new, as marijuana legalization in Canada is less than a decade old, and the U.S. is still using a patchwork of state-level legalization policies rather than a unified set of federal regulations. New markets tend to follow the same sequence of development, the early phases of which tend to be difficult for most investors.
First, players enter the market by securing the relevant regulatory permissions from the government and attempt to stake out as much market share as possible. In the case of cannabis companies, that process involves scaling up cultivation capacity and manufacturing facilities, as well as distribution and retail networks, with a focus on areas that are expected to be sources of demand. As an example, Tilray Brands(NASDAQ: TLRY) is currently pursuing growth in soon-to-open or newly opening markets in the EU, like Germany and Portugal.
Then, at some point the aggregate output exceeds demand, and growth becomes a harder to come by -- unless it's at the expense of one competitor to the benefit of another. A dead ringer for this phase is when key prices start to drop significantly, like the price per gram of cannabis in the U.S. did in late 2023.
Next comes the shakeout, which is where the industry is right now.
During the shakeout, weaker competitors start to lose market share. Their stocks tend to fall by quite a bit as well. Inevitably, the stronger competitors are those with wider margins, and they're typically positioned to buy up the remains of the others, even if they aren't consistently profitable themselves. And because the strong tend to be better-capitalized, they can afford to take a bit more time with becoming efficient in the new and somewhat more hostile environment.
SNDL (NASDAQ: SNDL) is one player that's likely to survive this period. After lending significant sums of cash to smaller operators during the past couple of years, it's now acquiring some of its debtors at a discount. At the same time, it's trimming some of its overhead to become more efficient.
The final phase is when the market stabilizes, and the maturing competitors find their footing, with industry leaders being both profitable and growing despite the prior upheaval. Here, companies with competitive advantages will start to peel apart from the pack and show their strength over the long term.
And the cannabis industry is going to get there eventually. When it does, its reputation will rebound. The only alternative to a recovery would be for it to wither away over time, which won't happen so long as there's demand.
Take a conservative approach
It could take years before cannabis companies are considered worthwhile investments on par with other consumer recreational product industries, like the alcoholic beverage industry. There is likely to be a gap, perhaps a lengthy one, between when financials start to look better and when investors recognize that the turbulence of the start-up period and the subsequent shakeout has given way to a more stable set of companies that are investable.
It's entirely possible to experience solid returns by investing before then. Focus your efforts on the businesses that are making the most headway toward profitability while continuing to grow, like SNDL. Just be aware that it'll be a risky endeavor until there's been a year or two of stability.
Until that happens, these stocks aren't suitable for risk-averse investors, even if they might be in the future.
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Alex Carchidi has no position in any of the stocks mentioned. The Motley Fool recommends SNDL and Tilray Brands. The Motley Fool has a disclosure policy.
