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Be wary of this easy, diversified way to invest in pot stocks

This might sound laughably obvious, but cannabis stocks aren’t safe, profitable, dividend-generating holdings suited for the general investor.

Joe Mahoney/THE CANADIAN PRESS

Anyone betting on an individual cannabis stock is swinging for the fences. So is a diversified investment in the broader marijuana sector through an exchange-traded fund nothing but a bunt?

Given the lacklustre performance of the Horizons Marijuana Life Sciences Index ETF, which gives investors exposure to 20 marijuana-themed stocks, diversification is certainly raising some questions.

Since its debut in early April, the Horizons ETF has dipped more than 3 per cent, versus gains of about 24 per cent over the same period for one of its largest holdings, Canopy Growth Corp.

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Sure, Canopy has a cute ticker symbol (WEED) that might be more attractive to retail investors than the ETF's ticker (HMMJ). And yes, picking out one hot stock doesn't necessarily refute the benefits of diversification. You could do the same thing by picking one outperformer in the S&P/TSX composite index or the S&P 500.

But in the case of the marijuana sector, you do have to wonder if a couple of eccentricities are holding back the ETF and making individual stock picks the better approach for most investors. One of these quirks: A key holding in the ETF is a company that has actually backed opposition to marijuana legalization. More on this in a moment.

This might sound laughably obvious, but cannabis stocks aren't safe, profitable, dividend-generating holdings suited for the general investor. They're risky bets on the growing acceptance of medical marijuana use in North America and hopes for legalized recreational use in some markets.

And yet some observers are dreaming big. The North American legal marijuana market generated sales of $6.7-billion (U.S.) in 2016, up 30 per cent over 2015, according to Arcview Market Research. But that's just a fraction of the estimated overall cannabis sales of $56-billion, which suggests that there's a big market for legitimate enterprises to grab.

Numbers like these have been inspiring investors, who have driven a number of promising stocks to lofty heights over the past couple of years. Analysts are lending credibility to the sector with research and recommendations. And earlier this year, Horizons Exchange Traded Funds Inc. provided its stamp of approval when it launched HMMJ, a fund that gives investors one-stop exposure to a basket of stocks that are active in the legalized marijuana industry.

Diversification, broadly speaking, is a good idea for most investors because it reduces the chances of one of your stocks imploding, while giving you plenty of upside opportunity. And a marijuana-themed ETF, in particular, looks like a decent way to bet on a burgeoning trend that is shy on profits and long track records. Diversification may also protect you from occasional concerns, such as the announcement this week from stock exchange operator TMX Group that it could delist cannabis firms from the Toronto Stock Exchange or the TSX Venture Exchange if they are violating U.S. federal drug laws.

But HMMJ has a couple of features that have always been curiously misaligned with the goals of investors and are now looking increasingly odd given the fund's questionable performance.

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For one, Scotts Miracle-Gro Co. remains a top holding in the ETF with a weighting of more than 9 per cent. In some ways, it might look like a welcome addition: Scotts is profitable, it pays a dividend and it has a history of nearly 150 years.

Then again, the company isn't exactly a pure play on pot. This, after all, is a garden and lawn care company that has reached into the hydroponics business for growth. But that business accounted for just 18 per cent of sales in the third quarter, and it seems unlikely that all of those sales were tied to marijuana. Face it: You're investing in mulch and lawn seed.

There is also the strange back-story to another ETF holding: Insys Therapeutics Inc., a pharmaceutical company that has developed a synthetic marijuana drug. This is the company that gave $500,000 to a group opposing marijuana legalization in Arizona prior to a vote this year, according to The Washington Post. Legalization was defeated in the state.

Insys has a 6 per cent weighting in the ETF. Investors counting on marijuana legalization would probably prefer this weighting to be closer to zero.

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About the Author
Investing Reporter

David Berman has been writing about business and investing since 1995. He has written for a number of magazines, including Canadian Business and MoneySense. He worked at the Financial Post as an investing writer and daily columnist before moving to the Globe and Mail in 2008. More

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