About a year ago, a client asked for my thoughts on marijuana. I blushed. He was not asking me if I wanted to light up — he wanted to know if he should invest. I pride myself in being abreast of current events in finance, but this question caught me flat-footed. So I decided to educate myself.

Marijuana popularity is growing like a weed (pun intended)! According to a recent Gallup poll, 64% of Americans favor some sort of legalization. In 1969 when the poll was first conducted, the approval rating was only 12%. If your clients haven’t asked you about investing in cannabis yet, they will very soon.

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Despite these red flags, I made a very small investment at the client’s request in a biotech company that was developing cannabinoid-based medicines.

First, I looked at publicly traded companies, and I was underwhelmed with what I found. Most public companies that earn revenue from cannabis are micro-caps and penny stocks that trade over the counter. The small sizes of these companies make the investment feel speculative. And as a practical matter many advisor platforms don’t allow penny-stock investing. Also, most of these companies are losing money. As a value investor, I find it hard to justify plowing investment dollars into companies that are bleeding money. Third, there aren’t a lot of pure-play marijuana companies. Most of the companies I found had ancillary exposure to marijuana.

Despite these red flags, I made a very small investment at the client’s request in a biotech company that was developing cannabinoid-based medicines. We held onto the positon for almost a year as I watched the investment lose money in the face of a smoking-hot equity market. It was time for some tax-loss harvesting!

MARIJUANA MARKET IS SET FOR EXPLOSIVE GROWTH
According to Arcview Market Research, the North American marijuana market recorded over $6.7 billion in legal sales in 2016, after notching sales of more than $5 billion the prior year. Separate analysis by Cowen and Company estimates the market for legal marijuana will grow 20% to 30% a year to $50 billion by 2026. And despite this backdrop, I found myself losing money on marijuana.

There are a number of unique challenges to investing in legal marijuana companies. First, you must understand that the federal government considers marijuana an illegal Schedule 1 drug alongside other substances with high potential for abuse like heroin, LSD and ecstasy. Although 29 states and Washington DC have passed varying legalization measures, this federal restriction creates several issues.

For example, the product cannot be transported across state lines. As a result of its taboo status, the banking and insurance industries have shunned the marijuana market. In 2016, only 301 of the nation’s 12,000 banks and credit unions worked with cannabis companies, according to Arcview. It is estimated that 70% of weed-based businesses do not have bank accounts. Additionally, insurance companies do not insure the marijuana plant itself, which caused huge losses for some weedpreneurs impacted by the California wildfires.

And then there’s taxes. IRS rule 280E prohibits companies that profit from Schedule 1 drugs from writing off operating expenses. That means a marijuana dispensary is effectively taxed on sales, because they cannot claim expenses like rent and wages. This proves to be a big disadvantage to the industry when compared with every other business. The marginal tax rate for cannabis companies can be as high as 70%, as opposed to 30% for other types of businesses, according to Arcview.

SHOULD YOU INVEST?
As with most investments, the answer is: it depends.

The current public equity market for marijuana is hit or miss. Perhaps the best opportunities in marijuana stocks will come from outside the U.S. Canada is taking steps to legalize recreational use nationwide by July 2018, which could be a game changer. Last month, Constellation Brands, the owner of Corona Beer, bought a 9.9% stake in Canopy Growth, a Canadian medical marijuana company. Perhaps other major beverage, tobacco and agricultural companies will soon jump into the fray.

With private companies, investors must apply the same process they would in evaluating any VC deal. You must look at the experience of the team. As I was told by Jacob Bell, co-founder of Patient Relief of Ohio and an early marijuana investor in California, “this is an industry that is run by former illegal drug dealers and users, so you have to be very careful.”

Additionally, you want to understand the licensure process for the state, and the legal status of the business you are evaluating. This is a highly regulated industry, and compliance is key.

Lastly, you want to understand the unique value proposition of the company. “Marijuana users are developing very sophisticated palettes,” says Rob Kurz, co-Founder of The Tribe Companies, which is pursuing cultivation and processing licenses in California. “They are beginning to acquire a taste for high-quality products and specific strains that they enjoy.”

In other words, weed is becoming the new wine.

Have fun conducting your research!

Allan Boomer

Allan Boomer

Allan Boomer is the Managing Partner and Chief Investment Officer at Momentum Advisors.