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3 Hard Facts Behind the Hype About Marijuana Stocks

A green rush is under way. 

Over the past couple of years, many investors have flocked to marijuana stocks in anticipation of the biggest growth story since the internet began to be widely used. And many marijuana stocks have soared as a result.

Their success is enough to tempt even investors who aren't fans of marijuana legalization. But should you give in to this temptation? Before jumping in, here are three hard facts behind the hype about marijuana stocks that you need to know.

Image source: Getty Images.

1. Most marijuana stocks are tiny 

The reality is that most marijuana stocks are so tiny that they only trade over the counter and not on a stock exchange. Many are what are referred to commonly as "penny stocks." In the past, this term meant stocks that traded for less than $1, but now penny stocks can include stocks with share prices of up to $5.

Some investors might see the cheap share prices and think a gain of only a few cents could generate huge returns. While that's true, remember also that a loss of only a few cents could wipe out much of your initial investment.

There are more serious issues with penny stocks, though. One is that the companies don't have to report their financial information as stocks on public exchanges are required to do. The information that is available doesn't undergo the same level of scrutiny, either. This limits how much you can know about what's going on with the company.

Tiny stocks also tend to have low liquidity. Not only can this make it difficult for investors to sell when desired, but it also opens up the potential for unscrupulous individuals to manipulate the price of the stock.

2. Valuations are ridiculously high

You might be thinking, "OK, I'll just stick to stocks that at least have small-cap valuations of $200 million or more." That's usually a less risky proposition than buying stocks of much smaller companies. However, even some of these marijuana stocks can be penny stocks. For example, Medical Marijuana Inc. (NASDAQOTH: MJNA) claims a market cap of over $260 million, but its share price is currently less than $0.10. The stock is also traded over the counter, with some of the inherent disadvantages.

Beyond that, though, most marijuana stocks have ridiculously high valuations. Medical Marijuana Inc. shares trade at 33 times sales (not earnings, because the company continues to lose money). What about a marijuana stock of a company that isn't a penny stock? Most of them have sky-high valuations, too.

Canadian medical-marijuana grower Canopy Growth (NASDAQOTH: TWMJF), for example, has a market cap of $1.3 billion. Its share price is well above anyone's definition of a penny stock. While the stock is available over the counter in the U.S., Canopy Growth is listed on the Toronto stock exchange. The company is seeing tremendous revenue growth. However, Canopy Growth shares trade at 34 times sales. To put that into perspective, chipmaker NVIDIA, one of the fastest-growing stocks on the market, trades at 12 times sales.

3. Growth prospects are real but risky

One aspect of the hype around marijuana stocks is real: the prospects for growth. More U.S. states are considering legalization of medical and/or recreational marijuana. Canada plans to allow recreational use of marijuana throughout the nation by next summer, a move that Deloitte projects will open up a market of up to $8.7 billion annually. 

However, while growth prospects are real, they're also risky. The use and sale of marijuana remains illegal at the federal level in the United States. There is a significant possibility that the U.S. Department of Justice will crack down on the marijuana industry in states that have legalized the drug. And even though Canada appears to be moving forward with its efforts to legalize recreational marijuana, there are several obstacles that remain to be overcome.

One major risk is that more and more players will enter the marijuana market to the point that prices drop dramatically. Commoditization could be the greatest enemy to marijuana stocks over the long run.

What about a marijuana stock like GW Pharmaceuticals (NASDAQ: GWPH)? It's a biotech that doesn't have to worry about running afoul of U.S. federal anti-marijuana laws. The company is seeking approval for its epilepsy drug Epidiolex from the U.S. Food and Drug Administration. However, even growth prospects for GW Pharmaceuticals are risky.

The biotech faces the possibility that Epidiolex won't win approval. A bigger issue for GW Pharmaceuticals, though, is meeting the high level of expectations for sales of Epidiolex. It's entirely possible that the company is successful in the clinical and regulatory process but flops when it comes to commercialization.

Caveat emptor

The hype over marijuana stocks isn't without some degree of merit. There's a good possibility the marijuana market in the U.S. and Canada will explode and make many investors wealthy. For biotechs like GW Pharma, there's a solid chance of success with cannabinoid drugs.

On the other hand, it's critical to understand the hard facts behind the hype. That's especially true with penny stocks in the marijuana industry. Any investor contemplating putting his or her hard-earned money into marijuana stocks should remember the old Latin phrase caveat emptor: Let the buyer beware.

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Keith Speights has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Nvidia. The Motley Fool has a disclosure policy.