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It’s been a tough year for cannabis investors. After shares of pot stocks surged last year—with many of them more than doubling in 2020—returns this year have been a bust.
The S&P 500 has risen 17% so far this year, but pot stocks in aggregate (measured by the AdvisorShares Pure US Cannabis ETF (NASDAQ: MSOS)) have sunk 15%. In a year where the S&P 500 just keeps surging to record highs, pot stock investors are getting left behind.
Here’s what’s going on with pot stocks today and how you could profit from 3 “backdoor” investing ideas in the marijuana industry.
The promise of 2020 meets the legislative reality of 2021
This year started out with the most promise since 2014, the year Colorado officially began selling recreational marijuana, on account of the Democrats taking control of Washington.
The party’s 2020 platform called for decriminalizing marijuana at the federal level and leaving alone any local laws in states that had already legalized the substance. In July, the Senate released a draft bill called the Cannabis Administration and Opportunity Act.
But some are questioning the bill’s ability to pass, and the New York Times has noted that the bill is unlikely to become law soon. Increasingly, it’s looking like federal marijuana decriminalization is off the table for 2021.
But don’t let Washington take your eyes off pot stocks’ long-term potential
Regardless of what’s happening in Congress, the public trends on cannabis growth remain firmly in place:
- Broad public approval: Marijuana’s favorability has skyrocketed among the public. A recent Gallup poll found that nearly 70% of Americans favored legalization, the highest approval ever. Support for medical marijuana is even higher, with a recent Pew Research poll reporting that 91% of respondents approve of legalization.
- Bipartisan state adoption: Four states voted to legalize recreational marijuana in 2020, followed by four others in 2021 … so far. According to the National Conference of State Legislatures, 18 states—governed by both Democrats and Republicans—have legalized recreational marijuana, with another 18 allowing medical use. All told, nearly three-quarters of states have some form of marijuana legalization.
What does this mean for investors?
For long-term growth investors with a high-risk tolerance, getting into the marijuana industry is a no-brainer. Cannabis is well on its way to being a major consumer category, with products ranging from edibles to skincare products. At the same time, politicians on both sides of the aisle are warming to legalization (and taxation) as more states are legalizing it without significant issues.
At the same time, it’s understandable that many people would be hesitant to invest in an industry that’s still illegal at the federal level.
But there’s a way that even investors with a lower risk tolerance can take advantage of all the growth in the marijuana industry: by buying companies that provide ancillary services to cannabis growers and cultivators.
These “backdoor” companies are exposed to the upside of the cannabis industry but still have some protection in case regulations change.
› Learn more: Read our advice on how to invest with very little money.
Gardening company Scotts Miracle-Gro (NYSE: SMG) might fly below the radar of many cannabis investors, but the company has significant exposure to the pot industry. Most commercial growers use hydroponic growing methods to ensure product consistency and to increase yield.
The downside to hydroponic cultivation is that it’s relatively expensive. Not only does this method require a lot of money to build grow-houses, but it also requires ongoing costs like lighting and nutrients. Due to the complexity of growing a profitable cash crop, cultivators are willing to pay a premium to work with a company that has a legacy of quality and technical know-how.
With a history dating back to 1868, Scotts Miracle-Gro has become the go-to firm for cannabis growers. In 2015, Scotts acquired the General Hydroponics Company for $130 million and combined it with its Hawthorne brand of hydroponic products.
At the time, the company downplayed the connection, but General Hydroponics was heavily focused on providing solutions to marijuana growers. Now the company has 45 different brands under its Hawthorne segment and has expanded its host of services to include hydroponic consulting and technical services.
Hawthorne has been a true growth story for Scotts Miracle-Gro. In the recent third-quarter results, the company reported 8% overall year-over-year revenue growth, and the Hawthorne division was a big contributor, with year-over-year top-line growth of 48%. Through the first nine months of this fiscal year, Hawthorne has contributed 26% of total revenue, a 5-percentage point increase over the prior year.
Scotts continues to look for ways to return cash to shareholders. Last year it paid out a massive special dividend of $5 per share and announced a $750 share-buyback authorization; both were in addition to its regular dividend of $2.64 per year.
Like many stocks related to cannabis, shares of Scotts Miracle-Gro have cooled down following their blistering 88% return in 2020. Shares are down 25% so far this year. I think today’s price is an opportunity for you to pick up shares of this marijuana-adjacent stock on the cheap.
- Value tip: Scotts Miracle-Gro currently trades at 16.5 times forward estimated earnings, compared with the S&P 500’s valuation of 22 times.
Innovative Industrial Properties
Shares of Innovative Industrial Properties (NYSE: IIPR) have avoided the poor performance that has plagued many weed stocks in 2021. The stock is up 34% year to date, even outpacing the S&P 500. Still, the long-term opportunity here is just beginning.
Innovative Industrial Properties is a real estate investment trust, or REIT. The company is a landlord to marijuana growers; it buys their facilities and leases them back to the growers in a transaction it calls a “sale/leaseback.”
This might not sound like a big deal, but it’s a lifesaver for many growers. Currently, federal legislation makes it difficult for growers to access traditional banking services like loans and even checking accounts, so IIPR’s sale/leaseback model lets growers invest in higher-return efforts, like marketing and R&D, instead of saving up cash to buy a facility.
The service is catching on in a major way. Last year the company reported $117 million in revenue, which is more than 1,700% greater than in 2017—its first full year as a public company. Shares are now going for 1,100% more than their IPO price, and the company’s quarterly dividend payout is now 10 times larger than in 2017.
The company went public to buy a single property with 127,000 square feet of rentable space. As of last quarter, Innovative Industrial Properties owned 73 total properties with 6.8 million rentable square feet.
As with all stocks, there are risks in investing in Innovative Industrial Properties. A harsh crackdown on marijuana would understandably be a negative event, but full legalization might not be in its best interests, either.
So far, the company has been able to negotiate favorable deals because traditional financing institutions have avoided the marijuana industry for fear of running afoul of federal legislation. But if the federal law changes, that could pit Innovative Industrial Properties against competitors that have access to capital at lower rates.
This might happen sooner rather than later. Even though it looks like the Cannabis Administration and Opportunity Act faces an uphill battle, the Secure and Fair Enforcement Banking Act that would protect banks from being punished for lending to cannabis companies appears to be on firmer footing for legalization.
Still, I’m not worried. Banking legalization might lead to significantly more venture funding and entrants coming into the sector, which could provide Innovative Industrial Properties ample opportunity to close more deals.
The Valens Company
As Americans have become increasingly accepting of marijuana, the tobacco smoking rate for adults has continued to fall, dropping to 14% as of 2019.
So companies have been leaning into other forms of cannabis products, including edibles and beverages, to entice non-smokers. According to cannabis analytics firm BDSA, edibles are growing faster than overall cannabis products as users migrate away from smokable products to “lifestyle” products.
Large companies are forming joint ventures with cannabis brands for infused products in hopes of winning this market. So the rise of CBD oil and edibles might be a boon for Canada’s The Valens Company (OTC: VLNCF), which extracts CBD from hemp flowers.
Valens estimates that 75% of the future cannabis market will require the type of CBD extracts that the company manufactures (a figure that includes materials for vaping), up from approximately half in 2020.
In its home market of Canada, Valens projects that extracts will be a $4 billion market by 2024, and it’s positioning itself to benefit—regardless of whose name is on the product package. It offers white label services (manufacturing the product for others to market and sell) along with providing related services, including formulation, testing, and processing.
Most major companies are taking a collaborative approach with CBD companies, but some could eventually pursue a white-label approach to keep a higher percentage of the profit.
In June, Valens completed its acquisition of Green Roads, which at the time was the largest privately owned CBD company in the United States. This gave Valens a foothold in the U.S. market and a presence in more than 7,000 stores, along with the ability to bring the well-known Green Roads brand to Canada.
The Valens Company is a riskier stock than the others I’ve discussed here. With a market cap of about $333 million, it’s still a small-cap stock even after posting gains so far this year. Because of its small size, investors could profit greatly if the company is able to grow—whether that’s by expanding Green Roads in the U.S. or Canada or signing a major white label deal. In any case, Valens has a significant opportunity to profit from the growth of edibles and CBD-infused products. And as an upside, Valens is exposed less to the whims of U.S. regulators since most of its operating presence is in Canada, a country that has already legalized cannabis.
The bottom line
As cannabis use becomes even more accepted and prevalent, investors in well-run pot companies should benefit. Even if you’re hesitant to invest in an industry whose future legality is unclear, there are more cautious ways to get in on the growth today: Scotts Miracle-Gro, Innovative Industrial Properties, and the Valens Company. Consider making a small investment in each.