The United States and Canada have moved in different directions when it comes to the legalization of marijuana for years. As of November 2020, 35 states have legalized cannabis for medical or recreational purposes—or both—and Canada moved to legalize recreational cannabis use for adults in October 2018. Unsurprisingly, companies in the legal marijuana space and investors alike have been clamoring to take part in what many believe is a promising and fast-growing new industry. The result is that marijuana stocks have seen incredible gains over the past two years and in recent months in particular. However, there are reasons why investors should be cautious before diving into the legal cannabis market.

Overly Ambitious?

Canada's legalization of cannabis for recreational use has been seen as a game-changing move for the industry. Medical marijuana remains a larger market than legal recreational cannabis. However, the dramatically larger potential consumer pool for recreational sales suggests to many investors that Canada's industry could develop into a major market in just a few years. Investors predicting a multi-billion-dollar space in the Canadian market that promises to develop over a relatively short period of time have jumped in eagerly.

At the same time, marijuana companies have made aggressive plays to win dominance over competitors in a growing and complicated field. One of the ways that many companies have done this is through rapid expansion via acquisitions, according to a report by The Motley Fool. One reason for this approach is that these companies aim to set themselves apart from their competitors and to strengthen their long-term outlook. Companies such as Aurora Cannabis (ACB), Canopy Growth (CGC), and Aphria (APHA) all purchased other companies for hundreds of millions of Canadian dollars this year.

The Motley Fool report suggests by rapidly acquiring other businesses, these companies may inadvertently be priming their eager investors for failure.

Common Stock Deals

In November 2018, BNN Bloomberg reported that 69% of all cannabis sector deals with a change of control were financed entirely with stock. Compare this to more than 50% of deals conducted using all cash in 2018 across the global mergers and acquisitions space,

Many of these acquisitions involve companies that may or may not emerge as victors as the legal cannabis space grows. The field is crowded, and it's likely that there will be many failures as certain companies win dominance over their peers. That some of the largest companies of today are buying up unproven and untested competitors for lots of money, and that they're using common shares to do it, could be disastrous for unwitting investors.

For each new share-based deal, the total outstanding share count for each of the acquiring companies gets larger. The process means that these stocks then have a more difficult time creating per-share profit. If some of the companies that have been acquired in these deals end up failing, the buyers of these major players may struggle to generate net incomes high enough to deliver strong price-to-earnings (P/E) ratios.

The Bottom Line

The legal cannabis space is new, rapidly expanding, and facing a great deal of hype (and pressure) from investors around the world. It's clear that there will be many changes as the industry continues to grow. However, investors thinking that they are playing it relatively safe by buying into companies that have already emerged as big names in the nascent space may reconsider these moves—particularly when faced with the prospect of a major player getting overeager with its acquisitions—may end up setting themselves up for failure. But just like any market move, these bets could pay off in a significant way—but only time will tell.