3 big changes could be coming for cannabis stocks before 2024

Legal barriers are falling, and the North American market is set to be in flux.

Cannabis from the earth in the hands

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This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Given that the industry-tracking AdvisorShares Pure US Cannabis ETF (NYSEMKT: MSOS) is down by more than 60% in the last 12 months, dramatically underperforming the broader market's slump of 14.5%, it's safe to say that marijuana stock investors are likely feeling a bit down on their luck lately.

But the industry is approaching three major shifts that could create new opportunities for investors -- not to mention a few new risks. Let's explore how cannabis companies are likely to change over the next couple of years, starting with the elephant in the room: legalization.    

1. Marijuana legalization will proceed in the U.S. and the E.U., and potentially by a lot

The biggest change coming to cannabis stocks in the next couple of years is the possible advance of marijuana legalization in the U.S. and in the E.U. While the jury is still out on whether the federal government will legalize adult-use cannabis anytime soon, enterprising state legislatures are already forging ahead. Maryland and Missouri both voted in the latest election to legalize cannabis for adult use, which means that new markets will soon open in both places.

Plus, legalization is advancing in major E.U. markets, specifically in Germany, where an estimated 4 million people consumed cannabis in 2021. While there's no timeline for when recreational sales will begin, Tilray Brands (NASDAQ: TLRY) is likely the best positioned to benefit since it's currently serving the country's medical cannabis market. But if other E.U. nations follow in Germany's footsteps to adjust their own laws, there will likely be room for other operators to flourish, too.

2. The cannabis glut will (painfully) end in Canada

Since late 2020 in Canada, there's been far more supply of marijuana than there has been demand at the average sales price. In the country's adult-use market, companies like Tilray and Canopy Growth (NASDAQ: CGC) are king.  

One major impact of the glut is that the average selling price per gram of legal cannabis faces downward pressure, which results in lower sales and compressed margins. Another impact is that under Canada's marijuana regulations, companies are only allowed to retain a certain amount of cannabis in their inventories, with any excess being marked for destruction.

And to make matters worse, any business that overbuilt its cultivation and manufacturing facilities will be burning money on overhead that isn't translating into earnings.

In the next couple of years, the glut will subside. It might continue to cause growers to shut down their extraneous operations, and sales are likely to be under pressure. But when the levels of demand and supply are more in equilibrium, there will be an opportunity to buy shares of the players that are the best positioned for consistent growth.

It's too early to say which Canadian company is going to fare the best in the coming shakeout, but betting on one of the market's top dogs, like Tilray, isn't an unreasonable approach. 

3. The seeds of a cannabis glut will begin to germinate in the U.S.

The conditions that made for a glut in Canada are already appearing in the U.S. recreational market, and it'll likely humble some of the better-performing businesses of recent times. 

As more states legalize recreational marijuana in the aftermath of the 2022 election, and as the chances of a change in federal policies remain high, competitors will be scrambling to cash in on fresh demand. To do so, they'll be cranking the dial on cannabis products to 11. It's also reasonable to expect them to open up a galaxy of new retail locations to distribute their goods. And for as long as demand seems hot, they'll probably keep scaling up their operations. 

Until there's a glut of marijuana in the U.S., that is. Investors are likely to be blindsided by the symptoms of oversupply, which will be the same as they were in the Canadian market. Top-line growth will slow, stall, and then decline, leaving companies with far too many cultivation facilities and storefronts to sustain. In that situation, vertically integrated pure-play competitors like Green Thumb Industries and Curaleaf Holdings will probably be hit the hardest, though timely interventions by management could easily head off major problems. 

In contrast, diversified companies like Tilray and Canopy Growth might not have as many problems with revenue growth, assuming that the pair are competing in the U.S. at all by that point. Being able to lean on beverage sales for growth, like Tilray and Canopy both can, could help to mitigate some of the shareholder risks from a glut of cannabis. Likewise, cannabis real estate investment trusts (REITs) like Innovative Industrial Properties will be somewhat insulated from problems with oversupply since they don't directly compete by selling cannabis. 

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Alex Carchidi has positions in Innovative Industrial Properties. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Innovative Industrial Properties. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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