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Marijuana stocks surged in the run-up to the legalization of Canadian recreational cannabis in October 2018.unknown/iStockPhoto / Getty Images

Cannabis stocks have been pummelled this year amid regulatory scandals, a shortage of provincial retail stores and stiff black-market competition.

Despite the recent relief rally, the North American Marijuana Medical Index was still down 58 per cent from its peak in mid-March to Nov. 27. While it’s tough for investors to pick winners in this emerging industry, exchange-traded funds (ETFs) can be an easier – albeit still a speculative bet – for a sector rebound.

Investors should have high-risk tolerance before buying cannabis ETFs given that they can also be “very volatile,” says Daniel Straus, vice-president of ETFs and financial products research at National Bank Financial Inc. Over five-to-10 years, they can wind up as “a very attractive growth opportunity, but it’s not a sure bet.”

Marijuana stocks surged in the run-up to the legalization of Canadian recreational cannabis in October 2018. But the industry had to wait another year for so-called Cannabis 2.0 – legalization of cannabis derivative products, including edibles, beverages and vapes, which can be sold as early as mid-December.

Pot stocks, meanwhile, suffered from a sharp sell-off due to a host of woes. The industry was recently rocked by revelations that CannTrust Holdings Inc. grew weed illegally at one of its greenhouses and had its licences suspended.

Canopy Growth Corp. and its peers blamed slow sales and losses on the slow retail-store rollout, particularly in Ontario. Aurora Cannabis Inc. halted construction at two production facilities, and Hexo Corp. began selling a cannabis brand at black-market prices to combat the illicit market.

Amid the negative news, some investors “capitulated and sold their marijuana stocks quite aggressively,” Mr. Straus says. “But we haven’t seen a rush out of the ETFs, although the buying frenzy has subsided.”

In 2018, Canadian-listed cannabis ETFs had net flows of $390-million. In the first 10 months of this year, there was $67-millon in net inflows despite the sector’s volatility, Mr. Straus says. “Remarkably, ETF investors are sticking with their initial decision to enter this industry in the hopes that it is going to pay off.”

Among the four largest Canadian-listed cannabis ETFs, the oldest is the Horizons Marijuana Life Sciences ETF (HMMJ-T), which tracks the North American Medical Marijuana Index and was down 32 per cent, including dividends, so far this year as of Nov. 27. The Horizons Emerging Marijuana Growers ETF (HMJR-T), which owns smaller names, was off 46 per cent and the actively managed Evolve Marijuana ETF (SEED-T) fell 30 per cent.

The Purpose Marijuana Opportunity ETF (MJJ-NEO), also actively managed, has been the best performer, despite losing 14 per cent in the same period. It “rarely makes the cut” when screening for ETFs that own stocks with the biggest declines, Mr. Straus says.

That because the ETF’s managers will raise cash to “to avoid falling knives,” and rely on technical signals – that is, share-price movements – as well as fundamental analysis to buy or sell stocks, Mr. Straus says.

Investors wanting to play a sector rebound might be better off in an active ETF where they let the manager try to time a recovery, Mr. Straus suggests. Those who prefer to make their own bet should invest in a passive ETF that is 100-per-cent invested. “But that is a difficult task to do right – even for professional managers,” Mr. Straus says.

In a Nov. 4 research report, New York-based Cantor Fitzgerald analyst Pablo Zuanic called a bottom on Canadian cannabis stocks.

Valuations are at two-year lows, and “we deem them attractive based on the long-term opportunity,” he wrote in a 264-page report. The sector should benefit from continued strong growth in recreational cannabis sales, more store openings in Canada, the roll-out of cannabis derivative products and industry consolidation, Mr. Zuanic says.

Potential partnerships between consumer-packaged-goods companies and cannabis firms – similar to Constellation Brands Inc.’s stake in Canopy Growth – also bode well for the space, he says.

Robert McWhirter, president of Selective Asset Management Inc., also believes the sector appears to have bottomed given that cannabis stocks received strong buy signals from his technical indicators just before last week’s rally.

“This is potentially the start of a new leg,” Mr. McWhirter says. “But it’s still a high-risk trade…Cannabis stocks have always been a speculative play.”

Cannabis stocks also got a lift last week after a U.S. congressional committee passed legislation to decriminalize marijuana federally, but it is expected to have a tough time getting the nod from the Republication-controlled Senate.

A key potential catalyst for boosting sales, however, stems from reports that Ontario is considering issuing new cannabis store-licences early next year that could raise retail outlets up to a thousand from the current two dozen, Mr. McWhirter says.

Because ETFs offer the benefit of owning many stocks, retail investors might play a sector rebound through Horizons Marijuana Life Sciences ETF because it is fully invested and is easily tradeable, or its harder-hit sister Horizons Emerging Marijuana Growers ETF, he says.

“If the weed space comes back, the ugliest [performer,] is probably going to be the highest-percentage performer,” Mr. McWhirter says, suggesting a similarity with junior gold stocks offering the best leverage to a rising gold price.

Still, he says the sector faces a lot of uncertainty because analysts have cut earnings estimates and target prices for cannabis stocks, and some players have postponed expansion plans to conserve cash.

Success in selling cannabis derivative products remains in question because of worries that pot-infused edibles will be consumed by children, Mr. McWhirter notes. Quebec has banned edibles in the form of chocolate, dessert or confectionery.

The U.S. Food and Drug Administration also just issued a warning that cannabidiol or CBD – a compound derived from the cannabis plant – can be potentially harmful to users. And there are concerns about vaping because of a rash of lung-related illnesses in the United States, Mr. McWhirter says.

“From a fundamental point of view, I think there are still an awful lot of challenges.”