Beginner's guide to investing in marijuana stocks and the booming cannabis industry

• As the legal cannabis market grows in the US, there are several ways for investors to gain exposure to the marijuana industry.
• In addition to investing in individual stocks, marijuana ETFs allow you to invest in a range of companies across the industry.
• Due to legal uncertainties on the federal level, marijuana investments remain risky and volatile.

When it comes to investing in the legal marijuana industry, they dont call it the "green rush" for nothing.

Many analysts are projecting massive growth for the cannabis industry. New Frontier, a Washington DC-based cannabis research firm, expects total US legal cannabis sales to exceed $35 billion by 2025.

In light of such tremendous growth potential, many see marijuana as a golden investment opportunity - but not without risk. It's important to remember that the use and sale of marijuana, despite state laws, is still illegal under federal law.

Here's what you need to know about investing in the legal cannabis industry, including the risks and challenges, the biggest companies to watch, and why ETFs could be the safest way to add marijuana stocks to your portfolio.

Basics of the cannabis industry

With each election, more states are voting to legalize some form of marijuana use. A total of 36 states have legalized medical marijuana, with 15 states and Washington DC legalizing cannabis for recreational adult use.

Broadly speaking, there are two markets in the marijuana industry: recreational and medical. While each cater to different markets, both represent growth potential. Whereas medical marijuana stocks involve companies dedicated to the medicinal and therapeutic benefits of the drug, recreational cannabis companies cover products for personal enjoyment.

On the medical side, there's also a growing market for CBD products. CBD, short for cannabidiol, is the legal, non-psychoactive compound found in cannabis plants that's taken to ease chronic pain, anxiety, and other ailments.

The growing acceptance of cannabis is not just happening in the US, but all over the world. Grandview Research projects that the global market size for the cannabis industry will reach $73.6 billion by 2027.

Important: In December 2020, the House passed the MORE Act, a bill to federally decriminalize cannabis. If passed in the Senate, the MORE Act would remove cannabis from the list of controlled substances and allow states to decide how to regulate the drug.

"Investors have the opportunity to get in on the ground floor of an emerging industry," says Michael Shea, CFP at Applied Capital, adding that by getting in early, investors could "capture outsized returns as the industry grows and develops."

Types of marijuana investments

Currently, the medical marijuana market offers strong short-term income potential. But the recreational side continues to attract investors as more states pass legislation.

There are four major categories of marijuana stocks related to different facets of the cannabis industry:

• Growers: Companies that own marijuana farms and actively cultivate the plant.
• Retailers: This includes dispensaries in states where residents can purchase marijuana and cannabis-related products such as edibles, oils, and more.
• Manufacturers: Companies that provide ancillary support to the industry and are involved in cannabis extraction, product preparation, packaging, and labeling.
• Drugmakers: Pharmaceutical companies that use biotech to create drugs derived from the cannabis plant.

It should be noted that some companies that are tangentially connected to the marijuana industry may still benefit from its growth. An example would be companies that develop hydroponic technologies, such as GrowGeneration (GRWG).

Risks of investing in marijuana

One of the biggest risks of marijuana investing is that it's rising popularity makes it a prime target for scam artists. In fact, the SEC has issued a warning that lists several various marijuana-related fraudulent investment schemes including unlicensed sellers, unsolicited investment offers, and market manipulation.

Quick tip: Before you agree to work with a seller of investments, use the SEC's Investment Advisor Search tool to make sure they're properly registered and licensed.

Other risks of investing in marijuana to consider:

• Business risk: As long as marijuana is federally illegal, it will continue to be difficult for marijuana companies to open US bank accounts. Sean van der Wal, Managing Partner at Drawing Capital, explains that this not only makes it more difficult to secure funding, but also means that "many marijuana producers rely on cash," which "poses a significant risk from a liability and accounting perspective."
• Legislative risk: The industry's growth is tied to legislation. Surprisingly, there's even some risk involved with the legalization of marijuana. Kenny Polcari, founder and Managing Partner of Kace Capital Advisors, says future taxation is a big question mark. "Right now you can buy marijuana and pay no sales tax." But "taxes will increase the price of marijuana for the end user." And, if too high, those added costs could push some consumers away.
• Valuation risk: Many of the companies that are involved in producing or selling marijuana are young. What should their valuations be? It's hard to tell. Polcari warns that "if valuations end up too high as the excitement builds, the potential exists that the market will correct and prices will decline."
• Demand risk: As more companies enter the market, supply could outpace demand for cannabis products. Van der Wal also says that "enthusiasts may be compelled to produce their own product in small batches for personal consumption" as legalization spreads. This could especially be true if high excise taxes are applied to marijuana sales. And, in these ways, he says "analysts may overstate the total addressable market."
• Volatility risk: Marijuana stock prices often swing wildly up and down in short periods of time. This is less likely to be a concern if you plan to hold onto your investments for 10-30 years or more. But if you have a shorter investment horizon, you may want to stay away from volatile investments like marijuana stocks.

How to invest in marijuana

Much like investing in any stock, you'll need a broker to invest in marijuana. You'll also want to do your due diligence before choosing investments, which means taking the time to research each company and staying up to date with the latest regulations.

There are two main types of marijuana investments: individual stocks and marijuana ETFs. ETFs allow you to spread your investment among companies across the entire marijuana industry.

If you're a trader looking to take advantage of short-term price shifts, Polcari says that individual stocks may be the way to go. Otherwise, he prefers ETFs since they don't require you to pick and choose and run the risk of picking the wrong company.

Marijuana ETFs

Some ETFs seek to provide investment results that correspond to an underlying index while others are actively managed. The advantage of index ETFs is that they tend to have lower expense ratios. But actively managed funds may be able respond faster to marijuana stock news - both positive and negative.

The list below of popular marijuana ETFs includes a mixture of actively managed and index options:

Marijuana stocks

Because US marijuana companies are engaged in activities that are illegal on the federal level, there aren't many publicly-listed US cannabis stocks on major exchanges. By contrast, Canadian cannabis companies - where recreational use of cannabis was legalized in 2018 - are able to list on major stock US exchanges like the Nasdaq and the New York Stock Exchange.

The distinction is important to know because US cannabis companies looking to raise capital are forced to list on the secondary market, or trade over-the-counter (OTC). OTC stocks can be dangerous as they lack public financial records and are often more susceptible to price manipulation.

The good news is that the number of publicly-listed marijuana stocks is growing. As you're evaluating your options, the first thing to consider is the company's market cap. The larger the market cap, the better the chance that the company will have the financial stability to survive over the long haul.

Here's a list marijuana stocks that have a market cap of at least $1 billion:

The financial takeaway

Marijuana investing isn't for everyone, especially for retail investors who prefer to minimize risk. But investors with a higher risk tolerance may find that the growth promise of marijuana stocks and ETFs make them a worthy addition to their portfolios.

From ETFs to over-the-counter stocks, here's how to invest in the booming cannabis industry, according to 2 expert investorsHow to invest in healthcare, a massive market sector that offers unparalleled diversification for portfoliosAll the states where marijuana is legal - and 5 more that voted to legalize it in NovemberVolatility measures how dramatically stock prices change, and it can influence when, where, and how you invest