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The Top 5 Marijuana Investing Mistakes to Avoid

Sean Williams, The Motley Fool

Over the past couple of years, few, if any, industries have beaten the returns offered by marijuana stocks. Some of the most popular pot stocks in the industry have delivered returns that, in some instances, have topped 2,000% since the beginning of 2016.

It's not hard to understand why investors are so bullish on the weed industry. After logging $12.2 billion in worldwide sales in 2018, according to Arcview Market Research and BDS Analytics, global sales are set to soar to between $50 billion and $75 billion by end of the next decade, based on various Wall Street estimates. This should, presumably, yield quite a few winners in the cannabis space.

But despite the relative ease of making money in pot stocks over the past few years, it's just as easy to fall victim to one of the top five marijuana investing mistakes, which are listed below in no particular order.

A gloved processor with scissors trimming a cannabis flower.

Image source: Getty Images.

1. Buying what's popular

Maybe the easiest way to lose money with cannabis stocks is by chasing the next-hottest intra-industry trend or purchasing a pot stock that everyone else considers to be "popular." The thing you'll have to remember is that popularity doesn't always mean profitability; and with cannabis now legal in Canada and throughout two-thirds of the U.S. (at least medically), profits actually matter.

For instance, when it became a public company last year, vertically integrated dispensary operator MedMen Enterprises (NASDAQOTH: MMNFF) was the bee's knees of U.S. pot stocks. MedMen's incredibly high sales per square foot rivaled that of Apple stores, and its normalization of the cannabis-buying experience led to significant sales growth in its oldest Southern Californian locations.

But just because MedMen has been a popular weed play, it doesn't mean it's been a smart one. Through the first nine months of fiscal 2019, the company has lost $178 million on an operating basis, and it's on track to be one of a very small number of brand-name pot stocks not to make money in fiscal 2020. Furthermore, its California stores slowed to a sequential sales growth rate of just 5% in the fiscal third quarter. Perhaps it's no surprise that MedMen's stock recently hit an all-time low. 

A person holding a magnifying glass over a potted cannabis plant.

Image source: Getty Images.

2. Focusing on price, not market cap

Another easy mistake to make is focusing too much on a marijuana stock's share price, rather than its market cap.

Although most Canadian pot stocks do have access to nondilutive forms of financing from banks, many are still raising money by issuing shares of stock or via convertible debt offerings. In doing so, the outstanding counts of these marijuana stocks are growing... rapidly. And if you're not careful, you could fall victim to what I refer to as "share-price bias."

Share-price bias is the idea that a stock with a low share price, say $0.75 or perhaps $2, has a better chance of doubling in value compared to a stock with a much higher share price. A real-world example would be comparing Innovative Industrial Properties (NYSE: IIPR), which goes for close to $95 a share, to the aforementioned MedMen at around $2 a share. Investors might look at MedMen and its $2 share price and think, nominally, that it'd be a lot easier for MedMen to hit $4 than see cannabis real estate investment trust Innovative Industrial Properties hit $190.

But, in reality, these two companies have nearly identical market caps. Also, Innovative Industrial Properties is very profitable and has seen its bottom line trend in the right direction as it has expanded its property portfolio to 11 states, whereas MedMen, as noted, has been losing money hand over fist. The point being to not be too swayed by the single-digit and penny-like share prices of pot stocks, and instead focus on a company's market cap.

A visibly frustrated stock trader grasping the top of his head while looking at losses on his computer monitor.

Image source: Getty Images.

3. Ignoring share-based dilution

A third cardinal sin as a marijuana stock investor, and one that builds on the previous point, would be to overlook the short- and long-term impact of share-based dilution.

Marijuana stocks have extensive capital needs when it comes to expanding capacity, building and diversifying their brands, pushing into overseas markets, and making acquisitions. This requires the regular issuance of common stock and/or convertible notes (which can be turned into common stock at a later date by noteholders), both of which wind up increasing a company's outstanding share count. When this share count increases, it has a negative impact on existing investors, and can also weigh down earnings per share if a company is profitable.

Easily the worst offender of the bunch is popular pot stock Aurora Cannabis (NYSE: ACB). Following 15 acquisitions in less than three years, nearly all of which were financed entirely by the company's common stock, Aurora's share count has ballooned from 16 million shares to just north of 1.01 billion. Not surprisingly, as the company's market cap has nearly tripled since the beginning of 2018, its share price has declined.

Dilution may be necessary in the early going, but it's an unmistakable evil for investors.

A magnifying glass being held over a company's balance sheet.

Image source: Getty Images.

4. Paying little heed to goodwill

A fourth mistake would be to ignore goodwill at your own peril.

Goodwill is essentially the premium that acquiring companies pay above and beyond the tangible assets they're purchasing. We'd certainly expect to see goodwill on the balance sheet of an acquiring company in most situations, but get worried if it becomes too large a percentage of total asset value. If it does, substantial writedowns could await.

Not to pick on Aurora Cannabis again, but its acquisition spree over the past three years has led to 3.18 billion Canadian dollars of goodwill being recognized on its balance sheet (much of which came from its MedReleaf acquisition in July 2018). All told, Aurora has CA$3.18 billion in goodwill and another CA$700 million in intangible assets out of CA$5.55 billion in total assets. This implies that a majority of Aurora's valuation is built on the hope and promise that things will simply work out, rather than tangible assets. As the shareholders of Kraft Heinz recently learned, that can be a dangerous bet.

Multiple clear jars packed with dried cannabis buds.

Image source: Getty Images.

5. Believing production is everything

Yet another way to potentially get yourself into trouble is by assuming that marijuana production is everything.

Right now, Canopy Growth (NYSE: CGC) is the largest pot stock in the world by market cap, and is forecast to be the second-largest grower by peak annual output. Canopy Growth has more than 4.4 million square feet of cultivation space already licensed by Health Canada, and it looks well on its way to having all 5.6 million square feet devoted to cannabis growing licensed before the end of the year. This should allow the company to produce between 500,000 kilos and 550,000 kilos per year.

But even as Canada's No. 2 producer, Canopy Growth could be one of the last of the major marijuana stocks to generate a recurring profit. Wall Street's consensus currently calls for a steep operating loss in 2019, and another substantial operating loss in 2020. Sure, Canopy is cash-rich and a top producer, but it has a long way to go before it's generating a recurring profit and earning its nearly $15 billion valuation.

There's no doubt that cannabis could be the investment opportunity of our generation, but it'll require that investors remain diligent if that's to happen.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Innovative Industrial Properties. The Motley Fool has a disclosure policy.