Should You Invest in Cryptocurrencies or Cannabis?
While both have significant upside potential, they also face serious investing pitfalls, including participation in new industries with unknown futures, highly uncertain or no cash flows, and extreme price volatility.
Cases to Be Made for Upside Potential
To date, the story behind investing in cryptocurrencies and marijuana stocks should look familiar. The investment thesis for both centers on high growth potential in nascent industries.
A favorable argument for cryptos (of which bitcoin is the most widely recognized) begins with the tailwinds of an increasingly digital world. Proponents of digital currencies point to several advantages over paper currencies and other forms of electronic payments that they believe will drive further demand for the cryptos:
Potentially lower transaction fees
Use of cryptography for security that makes cryptos difficult to counterfeit
Privacy of users and anonymity of transactions
Meanwhile, investors in pot stocks look to cash in on the increasing movement in a growing number of jurisdictions for the legalization of various uses of marijuana. In North America alone, Canada legalized marijuana for recreational use nationwide in 2018, and at the time of this writing, medical use of cannabis is legal in more than 30 states and Washington, D.C., while recreation use is legal in 10 states plus the District of Columbia. (In Kansas, cannabis is illegal for all purposes, but CBD oil containing 0% THC is allowed for medical use because it’s exempted from the definition of marijuana.)
While marijuana is still illegal at the federal level in the United States (preventing U.S. cannabis companies from listing stocks on U.S. exchanges), hemp—a plant similar to marijuana but doesn’t contain THC—was federally legalized in 2018.
Efforts to legalize various uses of marijuana are gaining traction in multiple states. This is helping to open up a market that RBC Capital Markets opined last year could reach legal annual sales of $47 billion in the U.S. in a decade.
Participation in Highly Uncertain Industries
The consideration of investment in any opportunity should include not only the analysis of the upside potential but also the risks associated with achieving less-desirable outcomes or investment loss. Investing in cryptos or cannabis stocks certainly involves participating in highly uncertain industries and should not be pursued without careful review of several potential barriers.
Regulation: Practically every company in every industry is regulated to some degree. Said differently, in order to play, companies must agree to follow certain rules created by various governing bodies. These rules are created for several reasons, including protecting participants or those otherwise affected, and in some cases, as a means to generate tax revenue. Navigating regulation is difficult enough even for mature companies in mature industries; regulations involve a lot of gray areas, and the rules of the game can sometimes change mid-game. Navigating regulation is even tougher for start-ups in fledgling industries.
For digital currency, there’s hardly any regulation at the moment. But if and when the masses embrace cryptos, it’s hard to imagine that regulation won’t increase. What that will look like is anyone’s guess.
Pot companies already have a challenge with regulation given the patchwork-like environment of acceptance and enforcement they face. Additionally, if the taxation of sales of alcohol and tobacco is any indication, the marijuana industry is a prime target for high levies, especially at the state level, given so many states have fiscal issues.
Competition: In a capitalist system, great fortunes can be made. Great fortunes can also be lost, in part because under capitalism, opportunity and profitability invite competition. Increased competition means there will be losers, even in attractive growth markets.
Consider all of the failed automobile companies in the U.S. through the years (anyone remember Studebaker, Packard, Tucker or Plymouth?), or the number of bankrupt airlines in America (Pan-American, Eastern, Braniff, among many others). From the dot-com era, for every Amazon.com, there’s a Pets.com. While social media today is dominated by Facebook, Instagram, and Twitter, does anyone still use predecessors Friendster or Myspace?
The competitive landscape for digital currencies and the cannabis industry will almost certainly look different than it does today. There will be new players, and some current players will probably vanish—first-mover advantage isn’t everything.
Consider that while bitcoin is the most dominant of the cryptocurrency market as of this writing, its market share had fallen to about 51% as of March 19, 2019, down from consistently over 70% before 2017 (per CoinDesk). Bitcoin is losing share, in part, because a new cryptocurrency can be created at any time. According to CoinMarketCap, there are 2,171 different cryptocurrencies as of this writing.
Cash Flows Highly Uncertain, at Best
By our definition, investing is acquiring an asset that provides the investor the right to future cash flows (or potential cash flows) generated by its normal business operations or intended purpose.
The intrinsic value of such an investment is the sum of all future estimated net cash flows discounted to their present value by an appropriate risk-adjusted rate. Over time, an investment’s return is largely determined by fundamentals and can include price appreciation and investment income (largely coupon payments or dividends).
In contrast, speculating is acquiring an asset with no clear income potential, where a speculator’s return is determined primarily by selling the asset to another party willing to purchase it at a higher price. In most speculation, there are little, if any, periodic income streams for the holder.
With that as a framework, we think allocating capital to either cryptos or cannabis is more akin to speculating than investing. For digital currencies, the argument is clear. Currencies of any kind do not generate cash flows, and the price of currencies is determined solely by what the next party is willing to pay for it.
Meanwhile, even if you were able to correctly predict who the long-term winners were in the marijuana industry, unknowable factors will have a significant influence on the timing and magnitude of their future cash flows: Which states will legalize marijuana? Will it ever be legal at the federal level? To what degree? When? Such a wide range of future outcomes makes it extremely difficult to determine a company’s intrinsic worth.
Extreme Price Volatility
All this uncertainty can lead to wild price swings. Look no further than the price action for bitcoin. In the five years to December 17, 2017 (the date bitcoin’s price hit its all-time high), bitcoin surged from around $13 to $19,871—a total gain of 149,303%, or an average of 331% a year! But those poor souls who didn’t take profits or bought at the top lost more than 80% of their stake as bitcoin plummeted over the next year.
So … should you “invest” in cryptocurrencies or cannabis?
To answer this, it may be helpful to think of such “investments” in either industry as gambling. If you’re OK with losing your stake at the craps table in Vegas, then go ahead.
Just make sure first that you’re on track to meet your financial goals with an appropriately diversified portfolio consisting of traditional asset classes.
Posted in Clayton Wealth Partners Blog
James Walden, CFA
As Chief Investment Officer, James Walden strives to maximize our clients’ long-term, risk-adjusted portfolio returns. This includes determining strategic and tactical asset allocations, as well as specific investment analysis and prudent rebalancing. Jim is also a partner and management team member. His expertise includes advanced investment research and valuation, and he is passionate about his role in helping clients reach and exceed their financial goals.