How should investors evaluate marijuana stocks? 

Even as the sector racks up significant gains in the stock market, investor assessment of its stocks is still colored by past stereotypes. Here is a brief primer on the expected market for the stocks. 

Broadly the industry is divided into two markets: the market for medical marijuana and the one for recreational marijuana. As their names suggest, both have applications in different industries. Depending on an investor’s risk profile and time horizon, stocks for companies from both markets are attractive because they represent a growth opportunity, similar to the one that existed for tech stocks. 

According to a report released by research firm ArcView Market Research and BDS analytics, the overall share of the medical marijuana industry slid from 100% in 2013 to 71% in 2017. (It is important to note here that recreational marijuana was legalized in only two states back in 2013. As of this writing, nine states have completely legalized recreational marijuana.) By 2027, medical marijuana will be just 33% of the overall market states ArcView. Recreational marijuana is expected to account for the rest. 

How Should Investors Evaluate Medical Marijuana Stocks?      

Examples of companies involved in the use of marijuana for medical uses are GW Pharmaceuticals (GWPH), Tilray Inc. (TLRY), Corbus Pharmaceuticals (CRBP), Cara Therapeutics (CARA), and Zynerba Pharmaceuticals (ZYNE). 

Major pharmaceutical companies have yet to come into the market for drugs containing cannabinoid chemicals. But they have begun stacking up on the patents. Research last month stated that Sanofis Aventis (SNA) and Merck & Co. (MRK) are among the top cannabis-related patent holders.  

For the reductions to have a meaningful scale and market, however, pharmaceutical companies developing drugs with cannabis chemicals will have to spend extensively on research and contend with a phalanx of federal regulations before their products come to market. The balance sheet of GW Pharmaceuticals is a testament to this approach. In its latest earnings call, the company said its $1.1 million revenue increase was primarily driven by a sales bump in Sativex, a cannabis-based mouth spray. Its spending on research and development also increased by $8.1 million primarily due to expenses related to the program development related to Epidiolex, the first drug containing cannabis chemicals approved by the FDA. Finally, the company also increased its capital expenditures program by $6.6 million because of increased expenses related to the production of CBD.  

The medical marijuana industry will evolve in a manner similar to the pharmaceutical industry, according to NYU Professor Aswath Damodaran. He states that it is a “safe prediction” that medical marijuana will become legal in all states before recreational marijuana. 

The basic framework for evaluating medical marijuana stocks remains similar to that for the pharmaceutical industry, which means investors should focus on the company’s pipeline of drugs and spending on research. Because research in cannabis is relatively new, it is safe to assume that the payback for investors in this industry will be longer as compared to recreational marijuana. For context, consider that GW Pharmaceuticals spent 19 years researching cannabis chemicals before getting its first drug approval earlier this year. 

The medical marijuana industry primarily uses cannabinoid (CBD), a non-psychoactive chemical of the cannabis plant, which can be used to treat a variety of neurological disorders. For example, it is currently being used in tests to treat Post Traumatic Stress Disorders (PTSD) for soldiers returning from war. The Food and Drug Administration (FDA) has approved four drugs with chemicals from or similar to the ones found in the cannabis plant, including Epidiolex, a drug used to treat a rare and severe form of epilepsy in children. 

The agency has been fairly circumspect regarding inclusion and approval of drugs with cannabis. “The study of marijuana in clinical trial settings is needed to assess the safety and effectiveness of marijuana for the treatment of any disease or condition,” the agency writes on its website. However, a press release circulated by the agency after it approved the first CBD-infused drug cautions against “proliferation and marketing of unapproved CBD-containing products with unproven medical claims.” 

Medicines that incorporate marijuana might find significant applications in government healthcare. A 2016 research paper by Ashley Bradford and W. David Bradford from the University of Georgia found that prescription drug sales for painkillers “fell significantly” in states which legalized medical marijuana. “National overall reductions in Medicare program and enrollee spending when states implemented medical marijuana laws were estimated to be $165.2 million per year in 2013,” the authors wrote.

Meanwhile, other geographies might pick up the slack for medical marijuana from the American market. According to ArcView’s research, medical marijuana sales in Europe will dominate the marijuana market there. The research firm makes this claim based on the $1.3 trillion budget for the European healthcare market that is subsidized by governments. The South American medical cannabis market is also expected to grow from $125 million in 2018 to $227 million in 2027. 

How Should Investors Evaluate Recreational Marijuana Stocks?  

The most prominent example of recreational marijuana play is Canadian player Canopy Growth Corp. (CGC).  Even though medical marijuana was legalized first and already has a semblance of distribution infrastructure (in the form of medical dispensaries), recreational marijuana caters to a bigger audience and has greater recall in public memory. The head start translates into a potentially bigger market for this type of marijuana and is reflected in the exponential growth statistics for companies involved in this sector. However, federal legalization of recreational marijuana is essential before the market can reach its true potential. 

The recreational marijuana industry primarily uses THC (Tetrahydrocannabinol), a psychoactive agent that is responsible for the high which comes from smoking weed, for its products. It has multiple applications across products, from marijuana-infused beer to coffee and cigarettes. 

But the variety of products available for recreational marijuana comes with a catch in the form of hefty taxes charged by state governments. For example, Colorado charges 15 percent excise tax for sales from cultivators to retailers and another 15 percent sales tax. This makes the final marijuana product pretty expensive. Companies involved in recreational marijuana products will have to account for significant regulatory charges from governments on their balance sheets. 

Damodaran’s thesis states that illegal marijuana will still have a valid market due to high costs associated with its legal version. He states that the recreational marijuana industry “will grow with a wink and nod towards its side costs” and adds that it could also be a gateway to more potent and addictive substances. Social stigma against cannabis is also expected to play a role in overall sales for recreational marijuana products. Tobacco and alcohol, sectors which have to contend with similarly high taxes and reputation problems, have grown despite the problems. Bruce Linton, Canopy CEO, is optimistic about growth prospects for the cannabis market and told CNBC that recreational marijuana users will prefer to use the legal product instead of going back to street vendors.