What to know if you're thinking about investing in the weed industry

As more states legalize marijuana and products containing CBD (a compound in cannabis that doesn't get you high) come onto the market, the financial impacts of the drug's popularity are becoming increasingly clear. A handful of cannabis companies are now trading on American stock exchanges, with many brands and individual people choosing to invest in weed as the industry grows.

According to Fortune, total investment in marijuana jumped to $14 billion in 2018 from about $3.5 billion the year before. Even major companies are taking part in the trend; Constellation Brands, the massive U.S. alcoholic beverage brand behind Corona and Modelo beers, invested $4 billion in Canadian cannabis company Canopy Growth in 2018. Altria, the tobacco giant that owns Marlboro, put $1.8 billion into Canada’s Cronos Group the same year (weed is legal throughout Canada).

It's clear why there's such interest. In June, Colorado governor Jared Polis announced that his state, where weed is legal, saw $1 billion in marijuana tax revenue over the past 65 months. Other states with recently legalized marijuana predict similar numbers in the future. Many entrepreneurs and business owners are quickly joining the industry, although the marijuana world is far from diverse — a 2017 Marijuana Business Daily study found that 81 percent of people who own cannabis businesses were white, and 73 percent were men.

In addition to inequality in who gets to invest, the cannabis industry also faces other issues due to its newness, which makes investing far from simple. For one thing, it's hard to predict what sub-sector (growers, retailers, recreational, etc.) will be the biggest, or which of the hundreds of new companies rapidly entering the market will survive, let alone dominate. Additionally, because the U.S. government considers marijuana an illegal substance even in states where it's allowed, there's uncertainty over the future of any company working in that sector.

So before putting any of your own hard-earned money into the marijuana world, consider some critical guidelines provided by financial and stock market experts below.

Understand the industry

There are three primary types of cannabis operators that you can invest in: growers, biotechs, and ancillary companies.

Growers: These are the “plant-touching” companies that cultivate cannabis. Many of them, like Canopy Growth, Tillray, and Aurora Cannabis, are either Canadian or operate primarily in Canada but trade on U.S. stock exchanges. Because growers are the most public-facing companies in the industry and their operations are easiest to understand (they grow weed), most early investors have gone this route.

Biotech: These companies focus on research and development of cannabis-based prescription drugs and products. Following the release of the first FDA-approved cannabis-based drug in 2018, the epilepsy medication Epidiolex, this area has received increased attention from investors.

Ancillary: These companies provide routine products and services used within the cannabis sector, ranging from fertilizers to lighting systems. Some investors just starting out in the industry choose this category, as the “traditional” businesses within it provide exposure to the weed industry but have brand portfolios that are only partly comprised of cannabis interests since the products can be used for many other types of operations.

Research the players

Regardless of sector, you should learn everything you can about a company before investing in it. Most analysts agree that with cannabis, retail investors should look for brands that list on major stock exchanges like NASDAQ or NYSE. These companies "have the market cap, the trading volume and most importantly the reporting requirements, so that you know they’re legitimate businesses," according to David Borun, stock strategist at investment research firm Zacks.

Some smaller cannabis companies trade via a separate process known as OTC (over-the-counter), where they don’t have to meet major exchange listing requirements. While some OTC users are legitimate businesses, others are little more than marketing schemes, according to experts. “A lot of these companies are bullshit, and retail investors need to do their homework to know what’s real or not real,” says Alan Brochstein, a cannabis industry analyst and founder of 420 Investor, an online community and research company.

But even if you're choosing companies on the big exchanges, Brochstein encourages investors to research what he calls the three Ps: people, pecuniary (money), and plan. Listen to conference calls and read reports — and if a company doesn’t issue reports or do conference calls with potential clients, ask yourself why that is. While you’re not necessarily looking to see profits, you do want to see the company’s ability to raise cash and grow, as well as a solid business plan.

Shawn Cruz, manager of trader product & business strategy at AmeriTrade, also advises reading through a company's MD&A (management discussion and analysis) summary. “They take 10 minutes tops to read,” he explains. “It’s management giving their general high-level overview of the business as a whole, and that’d be a good place to start.”

In addition, stay "on top of industry news," says Cruz. Look at which cannabis operators other major companies are investing in, and why. For instance, Constellation decided to take a stake in Canopy once it became clear that beer sales were on the decline, while Altria got into the weed game through Cronos after seeing cigarette sales crumble due to changing attitudes on smoking tobacco.

“These are smart people who put their money where their mouths are,” says Mitchell Goldberg, president of ClientFirst Strategy, an investment advisory firm. “It’s hard to bet against these people, so these are the people I’d prefer to bet with if I [had] to get into the sector.”

Recognize the risks

All stocks are inherently risky, but because legal marijuana is so new, there's a greater level of volatility and unpredictability. As such, a good rule of thumb with cannabis investment—or any investment really—is to only put in what you can afford to lose.

“This is not your retirement fund or your kids’ college fund,” Borun says emphasizing that investors should be okay with the idea that they very well might not make money. While weed companies might be doing great now, he explains, there's no guarantee that'll last. "Some of them are going to hit — and some of them are going to suck," says Borun.

The industry also has specific regulatory risks that potential investors should keep in mind. For one, because weed is illegal at the federal level, banks are reluctant to service the sector, making it hard or sometimes impossible for cannabis companies to get loans or even checking accounts. Subsequently, most U.S.-based weed companies are forced to operate entirely with cash, which is both cumbersome and dangerous, as businesses can become targets for robberies. Marijuana's federal classification also makes it difficult for anyone in the U.S. to conduct clinical trials necessary for the pharmaceutical R&D that helps develop new products and improve ones already on the market.

Until marijuana's federal classification flips, U.S. cannabis companies will deal with numerous roadblocks, putting investors at risk. And it could get worse; if one day, an administration comes into power that decides to increase restrictions on weed and jail cannabis operators, even in legal states, the pot stock market would be decimated. On the other hand, an administration that decides to legalize weed nationwide would, of course, be a boon to the market, especially if some states had previously put limits on the number, type, or size of cannabis facilities allowed.

“The real watershed moment for this industry will be activity or regulatory changes at the national level,” says Cruz. “Right now, all we’re really seeing is a lot of movement at the state level. I would keep a close eye on the national discussion and to what extent you’re seeing this become a very talked-about topic in Congress.”

Spread out your investments

To protect yourself from the young cannabis industry’s volatility, diversify across companies and sub-sectors. No matter how strong a stock looks today, resist the temptation to go too heavily into a single company. If you're not sure where to start, ETFs (exchange-traded funds) are a relatively low-effort way to diversify. Similar to a mutual fund, an ETF pools together money from a group of investors and spreads it across companies. The two largest ETFs that invest solely in cannabis stocks are Horizons Marijuana Life Sciences Index ETF and ETFMG Alternative Harvest.

“An ETF is not a terrible way to go,” Borun says. “It’s going to be diversified enough that [you’re] not going to lose all the money on one dumb news item — you know, one company that has a drug in an FDA trial and it fails and it’s cut in half or worse in one day.” And while there are fees associated with maintaining ETFs, they're still good options if assembling and maintaining a full portfolio on your own seems like too much of a headache.

For young investors looking to get their feet wet in the stock market, cannabis can be a great opportunity, as long as you do your due diligence, comprehend the very real risks, and don’t overextend yourself financially. But if you feel more comfortable having someone else guide you through the process, there are investment advisors focused on the cannabis sector who can help steer you in the right direction (just make sure you do your research on them, as well). Once you have an advisor on-board, you'll be able to join the industry with ease.

“I’d never tell someone not to invest in pot stocks, especially a millennial,” Goldberg says. “It’s fun if you have a little skin in the game."