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What are the different ways to invest in marijuana stocks?

There are several ways to invest in marijuana stocks. The following chart shows six major categories for investing in marijuana stocks, along with an example of a leading publicly traded company for each category.

Data sources: Yahoo! Finance and Bloomberg. Market caps as of Oct. 26, 2018.

Marijuana growers: Probably the most straightforward way of investing in marijuana stocks is to buy shares of a marijuana grower. Canopy Growth ranks as one of the top Canadian marijuana growers. The company is a licensed producer for the medical and recreational marijuana markets in Canada. In addition, Canopy has operations in several other countries that allow medical marijuana, notably including Germany, which claims the largest marijuana market outside North America.

Marijuana royalty streaming: An intriguing twist to investing directly in marijuana growers is to instead buy a position in a royalty streaming company that provides financing to marijuana growers in exchange for a percentage of their production. This approach helps smaller growers obtain financing and helps the royalty streaming company develop diverse sources of revenue. Auxly Cannabis Group is a leader in this niche market, with 13 streaming partners.

Marijuana distributors: Distribution is a key part of the cannabis industry supply chain. It involves transportation from growers, warehousing, and transportation to retail or dispensary locations. Origin House, formerly known as CannaRoyalty, is the largest recreational marijuana distributor in California, which claims the largest marijuana market in the world.

Marijuana retailers/dispensaries: Marijuana retailers and dispensaries put marijuana products in the hands of end customers and patients. MedMen Enterprises ranks as the largest marijuana retailer in the U.S., with operations in California, Nevada, and New York. The company is also expanding into Florida and has a partnership with Cronos Group (NASDAQ: CRON) to launch retail stores in Canada. MedMen recently announced the acquisition of PharmaCann, a deal that will make the combined entity the largest cannabis company in the United States.

Ancillary services/supplies providers: Any industry requires a host of providers of ancillary services and supplies. The cannabis industry is no exception. Thanks to a series of acquisitions, including the buyout of Sunlight Supply in April 2018, Scotts Miracle-Gro stands as the largest supplier of hydroponics products (which help grow crops in liquid without soil) to U.S. marijuana growers. The company is also a major supplier of other key products for the cannabis industry, including fertilizers and lighting systems.

Cannabinoid-focused biotechs: Cannabinoid-focused biotechs develop drugs based on chemical ingredients derived from marijuana plants or synthetic versions of these ingredients. GW Pharmaceuticals has become a leading cannabinoid-focused biotech. The company won U.S. regulatory approval of CBD drug Epidiolex in June 2018 as a treatment for Dravet syndrome and Lennox-Gastaut syndrome, both of which are rare forms of epilepsy.

Risks of investing in marijuana stocks

There are three major risks associated with investing in marijuana stocks.

Valuation risks: Probably the greatest risk with buying any marijuana stock is that valuations of these stocks have increased so rapidly that share prices more than reflect the stocks' growth prospects. A stock's valuation can be assessed in several ways, including using the stock price in relation to earnings, revenue, and cash flow. Investors should note that many marijuana stocks aren't yet profitable, which makes assessing stock valuations more challenging.

Using historical sales is also problematic. Canadian marijuana companies such as Canopy Growth, for example, generated revenue only from the country's medical marijuana market before Oct. 17, 2018. As a result, any valuation metrics based on trailing sales -- for example, price-to-trailing-12-month-sales or enterprise-value-to-trailing-12-month-sales -- make the stocks appear to be priced ridiculously high. It's a similar story for GW Pharmaceuticals. The biotech's historical revenue doesn't include any sales for Epidiolex.

Because using historical data is so unwieldy, investors must rely on forward-looking projections of growth such as the price-to-earnings-to-growth (PEG) ratio or price-to-projected-future-sales ratio to determine if stocks are valued reasonably. And that opens up another can of worms.

CEOs of marijuana growers sometimes mention global market sizes of $150 billion or higher. With a potential market that large, a stock with a market cap (the total market value of a company's outstanding shares of stock) of around $10 billion doesn't seem too expensive. However, it's important to understand that the $150 billion figure is based on a United Nations estimate of the global marijuana market including sales of illegal marijuana. Most of this illegal use is for recreational purposes, which remains illegal at the national level in all but two countries.

It's possible that someday recreational marijuana will be legalized throughout much of the world. In the meantime, investors should be careful in which projections they use in determining the attractiveness of marijuana stocks. How big will the marijuana market realistically be? Arcview Market Research and BDS Analytics conducted an extensive analysis and estimate that the global marijuana market will increase from $9.7 billion in 2017 to $32 billion by 2022.

So will all marijuana stocks compete in a $32 billion market within a few years? No. The U.S. accounts for $23.4 billion of the total. Canadian marijuana stocks that are listed on the Toronto Stock Exchange can't maintain their listing and conduct significant operations in any area where marijuana is illegal at the federal level -- which, for now, includes the United States. That means determining valuations of Canadian marijuana stocks based on growth projections should focus on the Canadian market and markets outside the United States.

It's also important to understand the potential impact of future supply-demand imbalances. A supply glut, a situation in which supply far exceeds demand, is predicted for the Canadian marijuana market by 2021 -- and perhaps earlier -- based on the rapid expansion of production capacity many Canadian marijuana growers are undertaking.

Valuation risks exist for cannabinoid-focused biotech stocks also. For example, estimates of peak annual sales for Epidiolex vary widely. Some pessimistic analysts think that the CBD drug could generate less than $300 million per year. Other highly optimistic analysts project peak annual sales for Epidiolex of more than $2 billion. Which estimate you use makes a huge difference in determining how attractively priced GW Pharmaceuticals stock is right now.

Dilution risks: Dilution occurs when a company issues new shares to generate additional capital for funding operations or expanding the business. The value of existing shares decreases as a result of the higher number of outstanding shares -- the total number of shares investors own, including those held by company insiders. .

Why is dilution often bad for current shareholders? Suppose a company has 10 million outstanding shares trading at $10 per share, giving the company a market cap of $100 million. If you own 1 million shares, your investment is worth $10 million. Now suppose the company issues 10 million new shares. Assuming the market cap remains constant, each share is now worth $5 rather than $10 because of the impact of dilution. Your investment that was worth $10 million would now be worth only $5 million.

While dilution is a risk for many kinds of stocks, it's especially problematic for a lot of marijuana stocks. Because of legal barriers that prevented access to borrowing from banks, Canadian marijuana businesses had limited choices available for generating capital for funding operations and growth.

Many of these companies used an approach referred to as bought deal financing, whereby an investment bank or syndicate agrees to buy all of the securities a company issues at a predetermined price. While this approach allowed marijuana companies to raise much-needed cash, it also dramatically increased their numbers of outstanding shares and diluted the value of existing shares.

It's possible that the dilution risks for at least some marijuana businesses could diminish as they become consistently profitable. Until that happens, though, dilution remains a serious threat for investors to take into consideration.

Commoditization risks: One risk that especially applies to marijuana growers and to royalty streaming companies is the potential for commoditization -- when a product becomes indistinguishable from other products. Marijuana is an agricultural crop. And all agricultural crops are commodities.

It's not just agricultural crops that are commodities, though. Precious metals such as gold and silver are commodities, too. So are resources including crude oil and natural gas. Other types of products can be commoditized as well, such as memory chips, hard-disk drives, and laptop components. Any product for which price is the only or dominant differentiating factor among multiple vendors is a commodity.

Commoditization weakens the pricing power for producers. In other words, companies can't raise prices for their products without causing demand to fall. For example, if one gas station raises the price of fuel significantly higher than its competitors, it will lose business as customers choose to fill up at other gas stations with lower prices.

When demand is greater than supply, commoditization isn't a big problem. But when supply exceeds demand, as will eventually happen in Canada, commoditization could hurt marijuana growers, particularly smaller ones that don't have the same economies of scale -- cost savings that result from increased size and scope of operations -- that larger producers have.

Risks specific to U.S. marijuana stocks

Some investing risks are specific to U.S. marijuana stocks:

Prosecution risks: Although many states have legalized medical marijuana, recreational marijuana, or both, their laws are in direct violation of federal marijuana laws. During the Obama administration, the official federal policy was to avoid interfering in states that had legalized marijuana.

However, in January 2018, U.S. Attorney General Jeff Sessions rescinded the Obama-era policies. His move cleared the way for U.S. federal attorneys to prosecute anyone who possesses or sells marijuana -- including medical marijuana. Sessions had a long history of opposition to marijuana before becoming attorney general. His opposition continued after taking the top spot in the U.S. Department of Justice (DOJ).

Could Sessions instruct the DOJ to target marijuana businesses operating in the United States? Theoretically, yes. And that means a dark cloud hangs over the U.S. cannabis industry. There are a couple of obstacles, though, that hinder Sessions from taking action.

First, the Rohrabacher–Farr amendment has been part of each spending bill passed to keep the federal government running since 2014. This amendment prohibits the DOJ from using money to interfere with state laws legalizing medical marijuana.

Second, President Trump has expressed support for medical marijuana and a willingness to leave laws pertaining to recreational marijuana to the states. In April, Sen. Cory Gardner (R.-Colo.) announced that the president pledged to support "a federalism-based legislative solution to fix this states' rights issue once and for all" -- apparently thwarting any plans that Sessions might have had to target marijuana businesses.

Sen. Gardner is co-sponsoring legislation with Sen. Elizabeth Warren (D.-Mass.) to prevent the federal government from interfering in states that have legalized marijuana. Both of the senators' home states, Colorado and Massachusetts, respectively, have legalized medical and recreational marijuana.

The Rohrabacher–Farr amendment is only effective temporarily, though. It's possible that a budget bill could be passed without the amendment, which would then allow the DOJ to use funds to prosecute medical marijuana businesses. Also, the amendment doesn't prevent the DOJ from going after businesses involved in the recreational marijuana market.

There's no guarantee that Gardner and Warren's legislation will pass Congress. Until U.S. federal laws are revised, the potential for the government to prosecute marijuana-related businesses remains a possibility.

Risks associated with obtaining banking and financial services: Even if businesses operating in the U.S. cannabis industry aren't prosecuted, they face another risk on an ongoing basis -- obtaining banking and financial services. Because selling marijuana is illegal at the federal level, banks or other financial institutions that handle money made from marijuana-related businesses could be accused of money laundering (that is, concealing the origin of money made illegally).

Many banks have opted to steer clear of dealing with marijuana businesses because of the risks of running afoul of federal laws. That has resulted in marijuana businesses being forced to operate on a cash-only basis. One downside is that it makes companies more susceptible to robbery. An even greater problem, though, is that it limits their ability to obtain capital needed for expansion.

Some banks and credit unions have chosen to do business with U.S. companies operating in the cannabis industry. As a result, the risks for marijuana-related businesses in obtaining banking and financial services aren't as great as they used to be.

In addition, some U.S. companies have attempted to sidestep the issue of raising capital by listing on Canadian stock exchanges. MedMen, for example, is based in California, but its stock is listed on the Canadian Securities Exchange (CSE). Unlike the Toronto Stock Exchange, the CSE doesn't prohibit marijuana businesses with U.S. operations from listing.

Alternatives for lowering your risk level

Can investors lower the risks associated with investing in marijuana stocks? Possibly. Here are three alternatives that could potentially decrease the risks of investing in marijuana stocks.

Buy only marijuana stocks with lower levels of known risks: One obvious way to reduce your risk associated with buying a marijuana stock is to choose only stocks with lower levels of the known risks. For example, Canadian marijuana stocks don't face the risks specific to the U.S. cannabis industry. Within the universe of Canadian marijuana stocks, some are more attractively valued than others. Some are also either already profitable or are on track to be profitable soon, which should decrease their dilution risk.

There is a major drawback to this approach, however: All marijuana stocks will probably face at least one of the key risks. Still, buying only marijuana stocks with lower risk levels should improve your chances of long-term success.

2. Buy exchange-traded funds: Another approach to potentially reduce your risks is to buy a marijuana-focused exchange-traded fund. ETFs are investment funds containing a basket of securities that can be traded like a single stock. There are currently two marijuana ETFs available:

• Horizons Marijuana Life Sciences ETF (NASDAQOTH: HMLSF)

• ETFMG Alternative Harvest ETF (NYSEMKT: MJ)

The key advantage of ETFs is that they provide more diversification than buying only one or a few stocks does. However, marijuana ETFs have some disadvantages as well:

1. They have relatively high expense ratios (the costs charged to investors for management of the fund as a percentage of the fund's total assets).

2. They're heavily weighted with marijuana stocks that have very high valuations.

3. Their holdings primarily include stocks that don't focus on the U.S. market -- the largest marijuana market in the world.

Buy stocks of companies with a core business outside the cannabis industry: Can you gain exposure to the cannabis industry in a limited way? Yes -- by buying stocks of companies that participate in the medical or recreational marijuana markets but have core businesses outside the cannabis industry.

Scotts Miracle-Gro is one example of this approach. Although Scotts is the top supplier to U.S. marijuana growers, the company still makes more than 90% of its total revenue from its consumer lawn and garden business.

Another example is Constellation Brands (NYSE: STZ). The company is a major alcoholic beverage maker, with nearly $7.6 billion in revenue in its last fiscal year from products including Corona and Modelo beer. However, Constellation also has a presence in the cannabis industry, thanks to its 38% ownership of Canopy Growth.

Risk vs. reward

The risks associated with investing in marijuana stocks are real and can't be ignored. At the same time, though, these risks should be balanced with the potential rewards that marijuana stocks offer.

The global cannabis industry continues to grow by leaps and bounds. There will be both winners and losers over the long run, just as in any other industry. Being aware of the risks and finding ways to limit them can help improve your prospects of picking the winners.

More From The Motley Fool

• The Best Marijuana Stocks to Buy in 2018

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• Your 2018 Guide to Investing in Marijuana Stocks

Keith Speights has no position in any of the stocks mentioned. The Motley Fool recommends Auxly Cannabis Group, Origin House, and Constellation Brands. The Motley Fool has a disclosure policy.