Opinion: These are the new rules for investors who want to buy marijuana stocks

Rather than gloat — or cry because you own them — it’s always better to learn from market train wrecks. In this spirit, I rounded up seven key investing rules for everyone — cannabis bulls or not — from the marijuana meltdown.

Let’s jump in.

Rule #1: Don’t make the government your investment partner

This is a rule I have followed for years. Avoid any companies where a big part of the investment thesis depends on government action. There’s a simple reason: Governments are run by politicians, who are often irrational. That makes them unpredictable.

Obviously, there are exceptions. Biotechnology, pharma and energy companies routinely count on government approvals. But it’s possible to find companies in these sectors where only a small portion of overall growth depends on government action.

That’s not the case with cannabis stocks, whose future depends almost completely on legalization, tax reform and permission for companies to use banks.

Cannabis investors got burned by ignoring this rule in early 2021 when the outlook for cannabis seemed bright because Democrats took control of Washington, D.C.

That’s why cannabis stocks went to parabolic highs in February 2021, says Tim Seymour, portfolio manager of the Amplify Seymour Cannabis ETF
CNBS,
+1.89%.
“Everybody thought cannabis was going to be legal, bankable and taxable.”

It’s a bad move to put so much trust in politicians. If you bought the AdvisorShares Pure US Cannabis ETF
MSOS,
+1.39%
on these hopes in February 2021 at $50 to $55, you are now down over 60% vs gains of 16% for the S&P 500
SPX,
+2.47%.

Rule #2: If the government is your partner, expect it to take its sweet time

“The biggest mistake I made when I got into this industry was expecting federal regulation to change quickly,” says Emily Flippen, a cannabis analyst at The Motley Fool.

“Congress never moves that quickly, especially on something as big as prohibition,” says Mike Goral, Mike Goral, who runs the national cannabis and hemp practice at the accounting and consulting firm Armanino LLP.

And now, an all-encompassing cannabis-reform bill from Democratic Sen. Chuck Schumer of New York looks overly ambitious because it tries to do too much at once, says Goral. Incremental change is more realistic, starting with much-needed banking reform, says Goral. “We have clients that have to carry duffle bags of cash to pay their taxes. This is not safe.”

Jason Wilson, who follows the cannabis sector at the ETF firm ETFMG, also expects gradual progress in stages on banking reform, decriminalization and tax-law reform that allows cannabis companies to deduct expenses.

Rule #3: Avoid commodity products

A good, basic rule of investing is to own companies that have pricing power because they do something unique. That’s not the case with companies selling agricultural commodities such as corn, wheat and marijuana.

“What’s the sustainable competitive advantage of any of these companies?” asks Todd Lowenstein, the equity strategist with The Private Bank at Union Bank.

He’s avoided the group because cannabis is a commodity product with “negligible differentiation devoid of pricing power. For these to work, you’d have to count on a first-mover advantage to gain scale, cost and distribution efficiencies, and establish branding to build awareness, which is expensive.”

That is happening for some companies to some degree, meaning those approved to sell in limited-license states like New Jersey, says Seymour.

“Companies in New Jersey will print money for a few years,” he says. After that, wholesale prices will fall, as they have in states west of the Mississippi where cannabis has been legal for longer.

Publicly traded cannabis sellers face the additional challenge of a thriving illicit market, where prices can be far lower since legal sellers pay high taxes. Around 70% of cannabis sales in California are in the illicit market, says Goral.

The pushback to my “avoid commodities” rule from passionate cannabis investors is that Starbucks
SBUX,
+2.46%,
for example, sells a commodity, coffee, and it has been a fabulous investment. Which brings me to my next rule.

Rule #4: It’s hard to pick the “Starbucks of cannabis”

“While there are craft beers and fine wines of cannabis, it’s tough to figure out who will command this consumer attention in the long run,” says Goral, at Armanino. I think he’s right about this. How many people knew back in the 1990s that Starbucks would be the success that it is? I sure didn’t.

And if marijuana becomes fully legal, won’t an expert brand marketer such as Altria
MO,
+0.51%
or even Starbucks wind up being the “Starbucks of cannabis”? After all, they have a lot of expertise in brand development and probably more than cannabis companies taking a stab at it now, such as Tilray
TLRY,
+2.00%,
Curaleaf
CURLF,
+1.84%,
Green Thumb Industries
GTBIF,
+3.09%
and Canopy Growth
CGC,
+4.21%.

Rule #5: Be aware of media hype

Most investors, including me, have made the following mistake early on: You buy a stock because you hear about it on CNBC or some other financial media — only to watch it fade over time. Oops, you just got caught up in the media hype with a little bit of FOMO mixed in.

“If you are hearing about something in the financial media, it is probably the worst time to invest in it because it is probably in a cycle of hype,” says Flippen.

This pattern has played out regularly in the cannabis space whenever there was incremental progress on legislation in Washington, D.C. You can avoid this by ignoring what’s in the headlines and focusing on fundamentals, and by following the next rule.

Rule #6: Be diversified

To diversify, start by owning a mix of the best pureplay operators with high-quality cash flow, says Flippen. In her view, this means Green Thumb Industries, Cresco Labs
CRLBF,
-4.12%
and Canopy Growth. But she says you also must look beyond the growers to ancillary companies that don’t touch the plant. This is a variation on the old “picks and shovels” theme from the dot-com era.

In that regard, she cites Innovative Industrial Properties
IIPR,
+1.86%,
a real estate investment trust offering buildings used in the industry; Scotts Miracle-Gro
SMG,
+0.90%
; and Constellation Brands
STZ,
+0.35%,
which has an investment in Canopy.

Note the top holdings of the Cambria Cannabis ETF
TOKE,
+1.27%
are mostly companies that don’t grow, but have some connection to the cannabis industry. They include: Scotts Miracle-Gro, Constellation Brands, Innovative Industrial Properties, Jazz Pharmaceuticals
JAZZ,
-0.88%,
British American Tobacco
BTI,
-0.17%,
Altria, Philip Morris International
PM,
+0.71%,
Turning Point Brands
TPB,
+4.23%
and Imperial Brands
IMBBY,
-0.67%.

Rule #7: Have a long-term horizon

After Prohibition ended in the U.S. in 1933, alcohol stocks returned 20% per year in the next decade, nearly double the returns of the overall market, says Meb Faber, chief investment officer of Cambria Investment Management, which runs the TOKE ETF. “There’s a similar situation developing around the globe as legal restrictions on cannabis production and consumption are being lifted.”

But this decade-long timeline of performance tells me you can wait for politicians to actually act on legalization, banking and tax law reform, before getting exposure to the cannabis space.

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested SBUX, MO, PM and TPB in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.