Investing in high growth companies remain alluring to investors. These companies have the potential to outperform the broader equity markets and multiply your wealth significantly. In recent years, investing in cannabis companies have been extremely attractive for this very reason.
According to a report from Statista, worldwide spending on pot products is expected to reach $29 billion in 2020 and grow to $63.5 billion in 2020. This rapid expansion has provided opportunities for cannabis companies to develop products, technologies, and services that are not just limited to the cultivation and distribution of marijuana products.
However, all investments carry a certain amount of risk. The higher the potential return of an investment, the higher are the risks. Despite the massive growth potential of marijuana companies, there are several aspects to consider before investing in these companies.
A highly regulated industry
The cannabis sector is a regulated industry and several jurisdictions are in the process of exploring new laws and are establishing a framework to decide how cannabis should be sold. This has meant the rollout of retail stores in major Canadian provinces has been slower than expected resulting in oversupply issues for pot giants such as Canopy Growth (NYSE: CGC), Aurora Cannabis (NYSE: ACB), and others.
According to this report, “Cannabis companies must abide by all the laws and regulations of the jurisdictions in which they operate, which can vary from country to country. Should laws change, the company may be required to adjust its operations to comply with the law or risk having legal action taken against it. In some cases, this may mean ending its business.”
In the U.S. while several states have legalized sales of medical and recreational cannabis it remains illegal at the federal level. In case the country chooses to enforce this law at any -time, several cannabis companies will be at significant risk.
The cannabis products are also taxed at a higher rate which has meant the sales of recreational marijuana products in Canada are comparatively higher than the black market which has allowed the latter to thrive.
A capital-intensive business
The cannabis industry is at a nascent stage and as the sector continues to expand, companies will have to pump in billions to scale operations and meet demand. This includes the procurement of larger manufacturing facilities, increasing employee count, and purchasing machinery.
In case the company does not have enough liquidity to meet these capital and operational expenditures, it will have to raise additional funds via equity or debt capital. When companies fund their capex by equity capital, they do so by issuing additional shares which will dilute exiting shareholder wealth.
An unprofitable industry
Due to the high costs associated with developing and operating cannabis products, several pot companies are grappling with high operating costs and falling profit margins. Companies need specialized large-scale agriculture facilities to grow thousands of kilos of cannabis.
These costs will increase overhead expenses as licensed producers scale up production to meet consumer demand.
The key takeaways
The regulatory hurdles and a thriving black market have negatively impacted demand and top-line growth in the last few months. An investor should look at a company’s business model to understand how it generates sales and aims to improve profit margins.
You need to deep-dive into financials and look at the company’s balance sheet strength, cash burn, and several other metrics to gauge if they can beat the S&P 500 and if they remain a good bet to invest your savings for the long-term.
Disclaimer: The writer is an experienced financial consultant who writes for Finscreener.org. The observations he makes are his own and are not intended as investment or trading advice.
