A Pivotal Moment for the Cannabis Stock: Exploring Investment Prospects and Risks

Last week marked a historic day for the cannabis industry as the U.S. Drug Enforcement Administration (DEA) unveiled plans to reevaluate marijuana's classification as a less dangerous drug. In response to this significant development, cannabis stocks surged. What impacts will this have on the industry? What new avenues for investment and risks are poised to emerge?

Marijuana has been classified as heroin, methamphetamines, and LSD since 1971. All the substances under the Schedule I classification are defined as a drug with no accepted medical use and a high potential for abuse.

Sources confirmed that the DEA will recommend to the White House Office of Management and Budget (OMB) that marijuana will be moved to Schedule 3, which is considered medical value and can be legally used only with a prescription. Schedule 3 drugs are a lower-risk classification, opening the door for pharmaceutical companies to get involved with the sale and distribution of medical marijuana in the U.S. states that have legalized its use.

Even though the market anticipates that the rescheduling will be successful, a few steps and roadblocks remain before reclassification.

After the White House reviews the proposal, the rescheduling will go back to the Justice Department, which will publish a proposed rule in the Federal Register. Public consultation and hearings with an administrative law judge will follow. The public review period could lead to a challenge, and Congress has the power to overturn the decision made by the Federal Register.

The White House confirmed that a review of marijuana is part of fulfilling the pledge President Joe Biden made to voters in the 2020 election. However, the influential House Republican Policy Committee declared that "there is nothing 'recreational' about the use of marijuana" while arguing that the drug was associated with violent crime and declines in worker productivity.

Currently, cannabis companies have been operating in states that have legalized marijuana, even though it remains illegal at the federal level. These companies are bound by Section 280e of the IRS tax code, which prohibits companies selling Schedule 1 and 2 drugs from deducting any operating expenses for tax purposes.

Additionally, most banks in the U.S. don't serve cannabis companies because marijuana remains illegal at the federal level. Therefore, cannabis companies rely heavily on cash and seek alternatives to mainstream banks, ultimately increasing operating costs. Some U.S. cannabis companies have been prevented from listing on major U.S. stock exchanges and instead have been trading over the counter.

Rescheduling would eliminate significant tax burdens and allow cannabis companies to access banking and financial services, lowering operating costs, facilitating business expansion, and even enabling listing on major stock markets.

Looking back at Canada's path to cannabis legalization, publicly listed Canadian cannabis companies saw a remarkable six-fold increase in value over a decade, reaching CA$40 billion. Consequently, with recent news hinting at the potential rescheduling of cannabis, the stocks in this sector experienced a significant surge. One contributing factor to this surge is the market's anticipation of an increase in cannabis demand.

BDSA, the leading provider of market intelligence for the cannabis industry, projected that global cannabis sales would soar from $36 billion in 2023 to $58 billion by 2028. Another research firm, ACE Equity Research, also forecasts the same, indicating that the global legal cannabis industry (including medical and recreational use) will grow at a CAGR of 19.65%.

Adult-use sales in the U.S. play an important role, accounting for 56% of global sales. Total U.S. sales are forecast to grow by 10% in 2024.

While there may be potential investment opportunities, it's crucial for investors to understand that cannabis stocks are highly volatile. They face different risks, including regulatory challenges, oversupply, and profitability concerns. These factors can significantly impact the performance of cannabis stocks, making it a risky investment.

Regulatory challenges: While marijuana is legal in some global markets, it remains restricted in most countries worldwide. This factor could impact companies' long-term growth and profitability.

Low-profit margins: The marijuana industry is a low-entry-barrier market. Besides, historically, the agricultural sector has usually had low margins (half of all farming businesses generate operating profit margins of less than 5%). Despite the legalization of marijuana in more countries and states, many cannabis stocks have underperformed due to slim profit margins and high valuations. Due to possible margin pressures for the industry, it is also not guaranteed that they will become profitable.

Political influence: The legislation of cannabis is strongly influenced by the country's political and progressive stance. Investors must understand that these stocks can be volatile and impacted by regulatory changes and political sentiment.