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Why I Will (Probably) Never Invest in Marijuana Stocks

Chances are that you'd struggle to find an industry with faster, more consistent growth than the marijuana industry -- and that's a big reason why investors have flocked to marijuana stocks.

Legal pot sales are expected to skyrocket over the next five to 10 years. According to cannabis research firm ArcView, legal weed sales could top $22 billion in North America by 2021, while the Marijuana Business Factbook 2017, published by Marijuana Business Daily, calls for approximately $17 billion in legal U.S. sales by 2021. Investment firm Cowen & Co. went even further and is calling for $50 billion in legal U.S. sales by 2026.

Image source: Getty Images.

Rapidly changing public opinion has also fueled these bullish projections. According to Gallup and CBS News, the number of respondents who want to see recreational weed legalized nationally jumped to all-time highs of 60% and 61%, respectively.

The result has been triple-digit gains in a number of marijuana stocks.

However, this Fool has absolutely no desire at the moment to invest in marijuana, nor will I probably ever invest in marijuana stocks. Why? These six reasons sum it up pretty well.

1. Weed stocks face major financial disadvantages

The first issue I have with pot stocks is that businesses involved in the marijuana industry are set to face two notable disadvantages.

To begin with, weed-based businesses have a very difficult time gaining access to basic banking services, ranging from loans and lines of credit to something as simple as a bank account. Since most financial institutions report to the Federal Deposit Insurance Corporation (FDIC), and the FDIC is a federally created entity, providing banking services to marijuana businesses could be construed as money laundering and result in pretty hefty fines for participating banks. This leaves pot companies to deal in cash, which is a security concern and a growth inhibitor.

The second problem is that the Internal Revenue Service (IRS) puts the kibosh on what marijuana-based companies can deduct from their taxes. U.S. tax code 280E disallows businesses that sell a federally illegal substance from taking normal corporate income-tax deductions. This means cannabis businesses are stuck paying tax on their gross profits instead of net profits.

Image source: Getty Images.

2. Most are penny stocks (and thus should be avoided)

Another issue to consider is that most marijuana stocks trade on the over-the-counter exchanges, and are in many cases penny stocks.

The concern with over-the-counter stocks is financial reporting. Even though the OTC exchanges have done a better job of improving reporting standards in recent years, it can still be difficult for investors to get accurate and up-to-date financial information. And if you can't get accurate cash flow, cash balance, and debt figures, it's not a smart investment idea.

As for penny stocks (those with share prices of $5 or less), they tend to be highly volatile and potentially thinly traded. Avoiding penny stocks is almost always a good idea.

3. A majority of cannabis stocks are losing money, yet valuations are astronomical

A prime concern that's bound to scare away fundamentals-focused investors is that nearly all marijuana stocks are losing money. This is a function of the industry being highly fragmented (i.e., there are a lot of smaller mom-and-pop dispensaries, which means lots of competition), and the U.S. government holding firm on its stance of weed as an illicit substance.

There are a small handful of exceptions. For instance, Canadian grower and retailer for the medical cannabis industry Aphria (NASDAQOTH: APHQF) has generated a profit in five consecutive quarters. The company also has a fully funded $100 million project known as its Phase IV expansion that's more than tripling its growing capacity to 1 million square feet. Realistically, Aphria's profits could further expand.

However, Aphria is also valued at what could be a P/E of more than 100. Aprhia, along with its peers and other marijuana stocks, is trading at astronomical valuations. Investors appear to be succumbing to emotional investing, which could come back to haunt them if pot stocks continue to produce quarterly loss after quarterly loss.

Image source: President Donald J. Trump's official Facebook page. Photo by Benjamin D. Applebaum.

4. The DEA and federal government are unlikely to support change

A common sense reason to avoid investing in marijuana stocks is that it's illegal at the federal level, and that doesn't look as if it'll change anytime soon. Marijuana's schedule I categorization means it has no recognized medical benefits and is an illicit substance.

Last August, the U.S. Drug Enforcement Agency (DEA) had an opportunity to review two petitions to change cannabis from its schedule I status, but the DEA declined to change its scheduling. The regulatory agency found insufficient evidence that marijuana was safe or effective in the clinical setting, and believed that inadequate safety checks were in place for doctors to oversee administration of the drug. Since the DEA often takes years to tackle petitions, it could be years before it reviews pot again for rescheduling.

Furthermore, the Trump administration is unlikely to give the green light to the weed industry. Newly appointed Attorney General Jeff Sessions could accurately be described as marijuana's most ardent opponent in the Senate prior to this new role in the Trump administration. If Sessions had his way, he'd probably roll back marijuana's expansion in its entirety and reinstitute federal law.

5. Expansion may be more limited than you realize

Something you should also keep in mind is that the state-level expansions the industry has thrived on over the past couple of years may soon slow.

As of the end of 2016, 28 states had legalized medical cannabis and eight had approved recreational weed for adult use. There aren't too many states left where the legislature and/or governor supports legalizing medical marijuana.

Meanwhile, attempts to legalize recreational weed could be stymied by Sessions and other opponents in the Republican Party. With the federal government looking unlikely to legalize marijuana, the industry is reliant on state-level expansion for growth. If that growth slows, investors could be in for a world of hurt.

Image source: Getty Images.

6. Rescheduling may actually make things worse

Finally, marijuana stock investors have to understand that even rescheduling marijuana won't necessarily fix the industry's problems.

If marijuana were to be rescheduled by the DEA to schedule II (making it legal for physicians to prescribe), it would put cannabis under the strict oversight of the Food and Drug Administration (FDA). The FDA would have the power to control marketing and labeling of medical cannabis products, and it would almost certainly oversee the manufacturing of pot and pot-based products. Most notably, it could require that clinical trials be run to confirm the medically beneficial qualities that companies currently tout for cannabis products. Clinical trials could cost marijuana companies millions upon millions of dollars.

The only factor that could possibly change my view on pot stocks is the level to which the federal government changes its stance on marijuana, should that ever happen. Given the right amount of industry consolidation and a lessening of regulations surrounding marijuana businesses, they could be worth investing in many years down the road. In the meantime, this Fool would strongly recommend that investors keep their distance from marijuana stocks.

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Sean Williams has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.