Cannabis ‘legalization is inevitable,' says policy analyst—what to know before you invest

Cannabis stocks aren't the only ones that were riding high in early 2021. In the wake of a brief Covid-19-related bear market, investors were bidding up just about anything exciting, including cryptocurrency, nonfungible tokens and meme stocks.

Unlike some of the more speculative plays, though, cannabis seemed to be approaching a turning point in a promising long-term story. A slate of Democratic electoral victories, including in the White House, analysts thought, would be good news for cannabis. A more liberal government would, in theory, cut legislative and legal red tape that has kept the weed business from taking off nationwide.

Those changes have yet to come on a federal level, and dimming enthusiasm from investors, among other factors, has led to a major slide in pot stocks. The AdvisorShares Pure US Cannabis ETF, which holds U.S.-based cannabis companies, currently trades for $6.80 a share, down from nearly $52 in February 2021.

But for experts in the space, the question surrounding cannabis legalization (and a subsequent boom in the industry) isn't if, but when.

"Legalization of cannabis is inevitable," says Jaret Seiberg, a policy analyst at TD Cowen. "It's just a question of how bumpy the next several years are going to be."

Here's what potential investors need to know.

Roadblocks for cannabis firms

Medicinal marijuana use is legal in 38 states, and following a ballot initiative earlier in November in Ohio, 24 states now allow recreational use among adults. All told, more than half of Americans now reside in states where marijuana is legal, and even more — some 70% — are in favor of legalization, according to a recent Gallup poll.

So why isn't the marijuana business already booming? The drug is still federally illegal and listed among the world's deadliest substances as a Schedule I narcotic.

That means U.S.-based businesses can't transport their product across state lines, so any cannabis business looking to expand nationwide has to set up shop in multiple states. Similarly, pot's illicit status makes it difficult for cannabis firm to secure financing and investments from major financial institutions.

And thanks to tax rules aimed at crippling drug cartels, pot purveyors must file taxes but can't take normal business deductions.

"You basically get zero write-off. So the effective tax rate, depending on state and local tax, can be as high as 65%," says Brady Cobb, founder and CEO of Sunburn Cannabis.

3 potential pathways to marijuana legalization

Currently, cannabis advocates are pursuing three paths toward legalization, which could pave the way for an explosion in pot firm profitability.

1. Legislative

The so-called SAFER Banking Act has been in the works in Congress in one form or another since 2019. The legislation would bar federal regulators from penalizing banks for offering services, such as bank accounts, credit card transaction processing and payroll services, to cannabis firms.

The bill has enjoyed bipartisan support in the past, but looks to be in a precarious position thanks to Mike Johnson's ascendency to House speaker. Johnson opposes marijuana legalization and has called it a "gateway drug."

"We had this euphoric moment when it cleared the Senate committee — it felt like we had a path," says Cobb. "Then the Speaker of the House drama starts and the guy who gets elected is one of the few people who voted against it."

2. Judicial

A group of cannabis businesses in Massachusetts filed a lawsuit in October alleging that the federal Controlled Substances Act represents an unconstitutional infringement on the power of the states who have legalized pot.

A ruling in favor of cannabis operators wouldn't unravel problems surrounding interstate commerce, but would make life much easier for weed businesses as currently set up. Cannabis sellers would no longer have to do nearly all their business in cash, for instance.

3. Executive

In October 2022, President Joe Biden asked the Department of Health and Human Services to review marijuana's Schedule I status. The process is still ongoing, but in a letter obtained by Bloomberg dated Aug. 29, 2023, a top official at HHS recommended to the Drug Enforcement Agency that marijuana be rescheduled to Schedule III.

It remains to be seen how the process plays out, but a move to Schedule III "would be a huge positive — bigger than SAFER would be," says Jason Wild, founder of JW Asset Management, and investment advisor focused on health care. Wild is also the executive chairman of TerrAscend, a New Jersey-based cannabinoid company. The main reason, he says, is that it could spell the end of the rule prohibiting pot firms from taking business deductions.

Investors may have to wait for returns

For retail investors, investment in the cannabis industry is essentially a bet that a major catalyst — nationwide legalization — will launch prodigious growth for pot stocks. But as with any burgeoning industry, there are bound to be winners and losers, says Cobb.

"There's still time to get in, but not all companies and markets are created equal," he says. Some firms, he says, went into major debt hoping to grow across multiple states, leaving themselves in a financially precarious position, especially if there are delays to legalization.

"Take catalysts out of the equation. What companies are set up to succeed right now without any catalyst? Because they're likely gonna be the big winners when catalysts do happen," Cobb says.

That means potential investors would be wise to gravitate toward companies with savvy management teams, a deep understanding of the industry and strong balance sheets.

If that sounds like a difficult bit of research to delve into, you may be better off choosing a diversified exchange-traded fund that tracks a broad swath of cannabis stocks, which theoretically exposes you to a mix of winners and losers.

But be warned: Companies that are dependent on reform make up "the vast majority" of the industry, says Morgan Paxhia, founder of Poseidon Investment Management. "A lot of these things are not going to make it," he says.

And it may be a while before any true reform happens. "It won't be weeks or months," says Seiberg. "This is measured in years. Court cases take time. Legalization isn't close to advancing on Capitol Hill. And rescheduling is important, but creates new headaches that don't get to you to full legalization."

In other words, while cannabis stocks may eventually be a savvy bet, it's not one you should make with money you'll need any time soon.

Editor's note: This story has been updated to update Jason Wild's title.

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