Blood in the Streets: A Buy Signal for Pot Stocks

The time to buy is when there’s blood in the streets. Attributed to the 18th century financier Baron Rothschild, this often repeated phrase means that investors in the midst of a market panic should seek inherently strong stocks that have been unfairly driven down in price by the irrational fear of the crowd.

This truism amply applies to marijuana stocks right now. As the S&P 500 hovers at new highs, the cannabis sector has spilled a lot of blood.

The marijuana industry benchmark exchange-traded fund Horizons Marijuana Life Sciences Index ETF (HMMJ) year-to-date has fallen 35.4%, compared to a gain of 17.7% for the S&P 500 (see chart).

I’ve been predicting as much. The marijuana stock market had gotten frothy and was due for a pullback. Fact is, you should welcome corrections, because they put pricey but worthwhile stocks onto the bargain shelf.

If you’re holding marijuana stocks with solid prospects but they’ve recently taken a tumble, remain patient. The industry’s tailwinds are powerful and confer multi-year momentum.

From cheeseheads to potheads?

In the U.S., marijuana remains illegal on the federal level. Medical marijuana is currently legal in 33 states and the District of Columbia. Recreational use is legal in 11 states and DC.

More states are jumping onto the legalization bandwagon.

Under legislation that Democratic lawmakers introduced Wednesday in the Wisconsin legislature, possession of marijuana would be decriminalized. The bill faces Republican opposition but the state’s Democratic governor has pledged support and chances of eventual passage are good.

Wisconsin Gov. Tony Evers has put forth a bold vision to reform the state’s marijuana laws. He proposes removing all penalties from cannabis possession, expungement, and a comprehensive program to encourage the development of marijuana medicines.

As marijuana becomes increasingly legal across the country, the recreational and medical uses of this apparent wonder herb represent a huge investment opportunity.

In particular, cannabis-based medicines present some of the most intriguing plays in the entire biotechnology sector. For conditions ranging from epilepsy to multiple sclerosis, to glaucoma, to even cancer, compounds derived from the plant are achieving remarkable results when conventional therapies can’t.

Without a doubt, there’s money to be made in the medical marijuana industry. But you should steer clear of thinly capitalized marijuana penny stocks that lack significant products in the marketplace.

Investors are indiscriminately throwing their money at marijuana stocks with a lemming-like fervor that’s reminiscent of previous market frenzies — Dutch Tulip Mania and the Dot.Com bubble come to mind.

It’s precisely those weak players that have fallen the hardest in recent weeks. Driven by hype and increasingly populated by indebted and poorly managed microcaps, the marijuana industry was destined for a shake-out.

But that’s a good thing.

In the biotech sector, the marijuana winners will boast strong research and development, FDA-approved products, proprietary compounds, and partnerships with giant drug firms. In recreation, the winners will produce branded products, forge efficient national supply chains, strive for vertical integration, and target specific demographic groups (e.g., millennials).

Read This Story: Millennials and Marijuana: Agents of Change

A common denominator for all marijuana winners: earnings growth and solid balance sheets. As with any investment, tune out the hype and focus on the fundamentals.

The madness of crowds…

Ever since the legalization train left the station, the investment herd has been yabbering about the huge potential in marijuana stocks.

Let’s be clear: some cannabis stocks are indeed stellar investments. But many others are not. You need to conduct due diligence and remain selective.

The Achilles Heel for a lot of marijuana companies? Marijuana is simply a plant, which makes it a commodity.

When most companies in a single market are selling the same commodity, there’s little to distinguish their products. Price wars erupt; profit margins shrink. Many run-of-the-mill pot companies are highly vulnerable to the pressures of commoditization.

What’s more, the marijuana black market has actually increased in America, as criminals in some states grow marijuana legally, to sell weed illegally in other states. These illicit operators are able to evade taxes and sell pot at below-market rates.

But millions of consumers would be willing to pay a little extra, to avoid making shady back-alley deals for marijuana. Legalization is a permanent trend; it’s unlikely to get reversed. State governments are getting addicted to the tax revenue from marijuana sales. The industry also is a proven job generator.

Marijuana companies with a unique selling proposition will have staying power. That’s why I like small-cap marijuana biotechs that are working to patent their production methods, which could generate hundreds of billions a year in licensing fees. And that’s on top of the vast potential revenue from drug sales. A “gatekeeper” patent could push the stocks of these small companies into the stratosphere.

Some of these companies are pursuing the promising technique of cannabinoid biosynthesis, whereby marijuana compounds are created in the lab rather than extracted from the plant.

Biosynthesis eliminates the high costs and risks of growing marijuana plants. It also provides the opportunity to patent complex compounds, which ensures a steady profit stream and creates a high barrier to competitive entry.

The upshot: as many marijuana investors run away in fear, it’s time for you to show greed.

Questions or comments about pot stocks? Drop me a line:

John Persinos is the editor-in-chief of Marijuana Investing Daily.