Don't look now, but marijuana stocks are blazing hot, once again.
Pot stocks have been on fire since the beginning of November, which follows a roughly 19-month lull (April 2019 to October 2020) where they grossly underperformed. For instance, the ETFMG Alternative Harvest ETF, which holds stakes in dozens of direct and ancillary pot players, is up 129% since the end of October.
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If you're wondering what changed, look no further than the political makeup in the United States.
For years, the Senate has been under Republican control. Former Senate Majority Leader Mitch McConnell, who's openly against legalizing cannabis at the federal level, used his power in the upper house of Congress to ensure marijuana legislation didn't reach the floor for vote. With Democrats now in control of the Senate, House, and Oval Office, it's more likely than ever that we could see real cannabis reform at the federal level. This would open up capital markets to cannabis companies, allow interstate transport, and remove barriers to entry for Canadian pot stocks. In other words, the largest marijuana market in the world would be open for business.
But as the hype once again builds around cannabis, I can't help but point out three of the biggest mistakes marijuana stock investors keep making.
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1. They're counting their chickens before they've hatched
One of the most common mistakes made by pot stock investors (and I include myself in this crowd) is counting their chickens before they've hatched.
As an example, when Canada lifted the curtain on adult-use weed sales in October 2018, it was widely expected that our neighbor to the north would become a cannabis leader. It was the first industrialized nation to approve recreational marijuana, and many of its licensed producers had been expanding their production capacity to meet demand.
But when sales actually began, and in the months and quarters that followed, it became readily apparent that Canada was (pardon the pun) chronically unprepared for legalization. Federal regulators eventually delayed the launch of higher-margin derivatives by a couple of months, while select provincial regulators (ahem, Ontario) stymied the opening of new dispensaries. All the while, most Canadian licensed producers overextended themselves on the capacity front.
We may well be witnessing investors getting ahead of themselves on the legalization front in the United States. While there's no question that the likelihood of legalization is vastly improved with Democrats in control of the legislative branch of government, it's far from a lock. Without a filibuster, 10 Republicans would need to support the legalization of cannabis at the federal level. And even if that were to happen, President Joe Biden would have to sign the bill into law. Biden has previously campaigned on decriminalizing and rescheduling weed -- not legalizing it.
The "this time is different" ideology could come back to bite pot stock investors, once again.
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2. They're ignoring dilution
Another big mistake that could cost pot stock investors a lot of money is ignoring share-based dilution.
In Canada, banks aren't lending much given how poorly the Canadian pot industry has performed over the past two years. Meanwhile, in the U.S., some banks and credit unions have entirely avoided the cannabis industry for fear of facing criminal and/or financial penalties in the future. Providing basic banking services to U.S. pot stocks would technically constitute money laundering as long as cannabis is listed as a Schedule I drug at the federal level.
To some extent, it makes sense that unprofitable marijuana stocks regularly turn to selling their stock or issuing convertible debt as a way to raise capital. But the level to which some companies will drown their shareholders in at-the-market offerings and convertible debt issuances is astounding.
Aurora Cannabis (ACB -1.15%), which has long been one of the most popular pot stocks among millennial investors, is the perfect example of a cannabis company that continues to destroy shareholder value through dilution. Between June 2014 and the end of 2020, Aurora's outstanding share count ballooned from about 1.35 million to north of 186 million. That's an increase of almost 13,600%!
Aurora has used its stock to fund day-to-day operations, as well as finance more than a dozen acquisitions, nearly all of which it grossly overpaid for. Even with this rampant dilution, Aurora's long-term future remains in doubt, as evidenced by the $243 million Canadian in cash it burned through between July 1, 2020 and Dec. 31, 2020.
Long story short, ignore pot stock dilution at your own risk.
Image source: Getty Images.
3. They're chasing cannabis penny stocks
The third mistake, which could prove costliest of all, is that marijuana stock investors are suddenly obsessed with chasing penny stocks.
Over the past couple of weeks, retail investors on Reddit's WallStreetBets forum have been effectively banding together to pile into heavily shorted or low-priced stocks. This has sent the likes of Sundial Growers (SNDL 2.19%) and MedMen Enterprises (MMNFF) into the stratosphere.
The problem is penny stocks are usually priced low for a very good reason.
Sundial Growers, which might well be the most popular stock on Wall Street right now, has been issuing stock like water and converting debt to equity. Since the end of September, the company's outstanding share count has ballooned from just over 500 million to 1.56 billion. That's right -- the company has issued 1 billion shares in about four months. That level of dilution should absolutely terrify investors.
As for MedMen, its survival remains in doubt. It ended September with just over $10 million in cash and cash equivalents, although it did raise $25.7 million in early November. Nevertheless, that's a pittance compared to the $30.1 million net loss recorded in its September quarter. MedMen's overzealous expansion and unresponsive previous management team may have dug a hole so deep that the company can never recover.
There are great marijuana stocks that investors can buy. Chasing cannabis penny stocks, however, is not the way to get rich in this fast-growing industry.
This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
