With less than a month left before the Federal legalization of Cannabis becomes the law of the land in Canada, investor optimism appears to be sky high (get it?). Yet, it is exactly in these situations of speculative frenzies and overly optimistic projections where investors should take a toke of fresh air and consider the real risks of entering the marijuana markets; I promise that I will attempt to keep puns at a minimum for the rest of this article. Before I go any further, please take note of the following: I am not recommending the purchase or sale of any stock, in marijuana or any other industry. Rather, I would like to point out some fairly obvious facts about the cannabis industry in general, which will hopefully help you make better investments with the long-run in mind. Personally, while I am not a user of any cannabis product and I believe its consumption is generally harmful to otherwise healthy people, my stance on its general availability through retail sales is that aside from a warning label and restricting its sales to adults only, cannabis should be regulated no more than cheeseburgers – a food article that is already over-regulated in my opinion. That said, here are 3 things that would keep me awake, had I been invested in cannabis stocks.

The “Green Rush” Is Eerily Reminiscent of The Dot-Com Bubble

I have been following the industry since attending the GreenRush Financial Conference in 2014 and have watched it grow into a multi-billion dollar industry. At the time of writing, according to the Canadian Marijuana Index, it’s two largest companies, Canopy Growth Corporation ($WEED.TO) and Aurora Cannabis ($ACB.TO) have a combined market cap of CAD$ 22.5 Billion dollars – approximately CAD$ Billion dollars each. If we were to take a step back and look at the overall marijuana market, it’s clear to me that both companies will have a hard time living up to these market evaluations. For instance, Deloitte projects marijuana sales in Canada during the first year of legalization to be roughly CAD$ 6 Billion dollars, while the Canadian Parliamentary Budget Office (PBO) expects marijuana sales to be range between CAD$ 4 and 6 Billion dollars. Neither figure is the sort of sales estimates to be ashamed of, yet both figures fall quite short of the current marijuana valuation – currently at CAD$ 32 Billion dollars.

Don’t get me wrong, I am not bashing any company on the Canadian Marijuana index. I am quite aware that the companies I have named above, as well as plenty of other companies, are producing and selling a real product, many have real business plans and some actually have a revenue stream and customers. What I am suggesting will happen though, is much like the dot-com bust, it’s not entirely beyond the realm of possibility for any company to lose 80 or 90 percent of its value as investors weed-out the bad players, and the market finds equilibrium with the remaining assets.

Lack Of Barriers To Entry Will Lead To Constant Disruption

Who owns the patent on marijuana? The answer is painfully obvious – nobody. Literally, anyone with enough capital and desire can enter the marijuana industry. As a matter of fact, according to my knowledge of Canadian law, marijuana users could grow their own marijuana for personal use (up to 4 plants I believe). Given that the industry is not mature enough, I find it quite hard for any brand to establish itself as an absolute authority in this sector. It took Apple, Nike, Ikea and a whole range of other companies to become consumers first choice when they think about electronics, sporting apparel and furniture – the same applies here. One thing I learned during my little time in entrepreneurship is that it’s rarely a good idea to be the first in any industry. As a matter of fact, the most successful companies in history, speaking in terms of longevity, often come after the initial innovation was made; after the initial company or inventor dealt with the pain of educating the market, establishing the consumer base, provide training on proper use of the product and its benefits to society. I would expect the same thing to happen in the Cannabis sector, especially following the federal legalization in Canada.

Consider this? What stops the Tobacco industry from entering the marijuana market? Why would they not consider using their massive economies of scale and resources to produce, distribute and market marijuana, following legalization? I would be immensely surprised if this isn’t already being discussed in boardrooms across Canada. Which brings us to the final point this article is trying to make.

Legalization Will Increase Supply (And Supply Always Brings Prices Down)

There’s not much to add to this really. It is the simplest yet hardest economic argument to get across sometimes, but when shelves are well stocked, businesses always have a sale. Given that the profit margins on existing sales are thin as things stand, how will the increase of supply impact the bottom line of marijuana producers, distributors, and sellers? Well, the answer is pretty obvious to me – there will be a period of adjustment industry-wide as competitive pricing will hit its peak. So the first 12 months of legal marijuana sales is a period of time I would be watching very closely as these titans of industry struggle to maintain their piece of the pie.

Why do I say struggle? According to research by the Canada Project, 84% percent of Canadian adults have never smoked marijuana. Findings from the same survey show that of the Canadian adults who do smoke marijuana, it’s daily users amounts to a paltry 5%. That’s less than daily tobacco smokers (roughly 16% cough-cough). There’s also the matter of travel to the US, where Canadians could be denied entry if they admit to a border agent that they have used marijuana – ever! While I couldn’t find data on B-1 visitors – that’s a visa granted to Canadians entering the US for business, I would think this might impact certain professional’s “social habits”, should they encounter a circumstance where their career could be in jeopardy.

Final Thoughts

So we have a market that is trading at about 4.5x times it’s expected earnings, a young retail sector with a small number of users, with quite literally no barriers to entry. What could go wrong? To be blunt with you, quite many things could go wrong for cannabis investors. Just going back to what was discussed about the dot-com bubble, Google was created after the dot-com bubble collapsed. I wouldn’t be surprised if 10-15 years down the line a company called “Doople” be established after the existing marijuana index collapses, and proceeds to dominate the industry. I will say this though; it isn’t all doom-and-gloom for the marijuana industry. As a matter of fact, I find the legalization of cannabis products to be positive overall. It’s just that as an investor, you must respond to real circumstances and make pragmatic investment decisions based on the data. Right now, many of these companies are trading on expectations – much of these expectations are simply going to fall short based on the data I have seen. If you are looking to invest in marijuana, I would have a chat with your financial advisor sometime in the 3rd quarter of 2019 – that’s after a full year of real revenue and real cost in an environment where the product is sold like cheeseburgers. I just wouldn’t be duped into an investment in the cannabis sector at this time. I think the profits have already been made, and what we have been seeing in the past 30 days is those initial investors selling into that optimism as the official date of legalization becomes reality.

I like to keep an open mind about everything, so I am open to having my mind changed. What are your thoughts on investing in Cannabis? I’d love to read them in the comments below.