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U.S. President Joe Biden’s move to review cannabis' Schedule 1 status has solidified expectations that it will eventually be taken off the list of illicit narcotics.PAUL BARBERA/The New York Times News Service

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The tantalizing prospect of cannabis becoming legal in the U.S. has sent euphoric waves through an otherwise depressing corner of the market in recent months.

Canadian and U.S. pot stocks soared by as much as 30 per cent in early October after U.S. President Joe Biden announced that marijuana’s status as a Schedule 1 narcotic would be reviewed and possibly downgraded. The sector experienced similar flourishes this year as U.S. lawmakers flirted with passing legislation that would allow banks and lenders to work more closely with pot producers and sellers without facing legal risks.

Yet, investors and advisors thinking about capitalizing on the sector’s low valuations ahead of a potential U.S. legalization should think twice, analysts say. Gains have been fleeting, and any upside momentum has reversed quickly.

“The stocks have not had a good run but I think everyone has to realize just how early this is,” says Greg Taylor, chief investment officer at Toronto-based Purpose Investments Inc., who manages Purpose Marijuana Opportunities Fund MJJ-NE.

“We’re still optimistic that the sector is in the early innings and some positive news around regulation could really kickstart interest.”

North American cannabis stocks are down more than 60 per cent on average, year-to-date, according to U.S. investment bank Stifel Financial Corp. While the regulated cannabis market has grown by double digits in Canada this year, it has contracted south of the border, and the industry overall isn’t expected to return to positive growth until the second quarter of 2023, the bank said.

“Economic reality always wins,” says Andrew Carter, vice president and senior analyst covering cannabis equities in St. Louis, Mo.

He points to a laundry list of operating pressures on producers – from oversupply and limited differentiation to uneven enforcement against the illicit market as well as regulatory risks.

“The headlines around policy are driving the day-to-day volatility. But at the end of the day, like all businesses, the economics and fundamentals are what really drive valuations,” Mr. Carter says.

One silver lining for the industry is odds are moving favourably toward U.S. lawmakers passing the SAFE Banking Act, and perhaps soon. Proponents say the legislation could deliver much-needed financial stability for the sector from top to bottom.

Currently, U.S.-based financial institutions that hold shares for investors won’t take custody of cannabis stocks because of marijuana’s federal status as an illegal substance, effectively prohibiting U.S. investors from investing in the space. The SAFE Banking Act would allow banks to take custody of pot shares.

“That’s why these companies are trading at discounted multiples. We know there’s [going to be] a lot of interest once the rules change,” Mr. Taylor of Purpose says.

The act would also grant access to cannabis retailers to use credit and debit payment networks – another catalyst that would boost sales and earnings, while the legislation may codify cannabis companies’ ability to go public in the U.S.

“It’ll bring down the cost of capital and make credit card payments a lot easier,” Mr. Taylor says. “It would make a lot of on-the-ground level [operations] much better but would also allow more institutions to buy the stocks.”

Analysts say President Biden’s announcement is a signal the U.S. Congress could proceed with passing the legislation before the current congressional session ends in early January.

“I would put the odds at better than a coin toss,” says Brian Madden, chief investment officer at First Avenue Investment Counsel Inc. in Toronto.

The boutique brokerage doesn’t hold any cannabis shares right now but is watching the sector closely. Mr. Madden says it will eventually “be a huge category,” and expects annual North American sales to top US$44-billion.

Reclassification in U.S. could be key

The bigger catalyst for the space, though, is the possible removal of a Schedule 1 classification, which would lift federal restrictions and enable the kind of growth opportunities early investors have envisioned, proponents say. President Biden’s move to review the Schedule 1 status has solidified expectations that cannabis will eventually be taken off the list of illicit narcotics.

But timelines are elusory and cannabis may not escape controlled-substance status altogether. It could instead be re-classified as a Schedule 2 substance in line with drugs like adderall and methadone. Drugs in that category can be legally sold but carry steep taxation requirements that the industry hopes it can lobby itself out of paying.

“If that goes away, then it’s a much better environment for operators,” Mr. Carter of Stifel says.

Meanwhile, the legal and political uncertainties combined with a challenging operating environment have led executives of major producers to temper near-term expectations. Announcements may momentarily stir the market but material developments remain in the future for now.

“It is important to recognize these initiatives for what they are,” said Irwin Simon, chief executive officer of Tilray Brands Inc., of President Biden’s remarks on an investor call in October. “Relatively modest.”

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