The buzz around pot stocks keeps growing, but should investors hold out for clarity amidst the haze?

Cannabis-related stocks have surged this year, driven by federal legalization of recreational marijuana in Canada, increasingly liberal laws in dozens of US states, and speculation that large beverage or tobacco companies may become acquirers. Investors—gripped by “fear of missing out”—have rushed into the handful of Canadian cannabis companies currently listed. Yet while the UN sizes the global illicit market at roughly $150 billion per year, we don’t know how large or profitable the legal market will ultimately be. It’s also far from clear which part of the industry value chain will capture the most profits—or which players will eventually ride highest.

While others debate the merits of broader legalization, our focus remains on the fundamentals of the investment case. As with any early-stage industry with high growth potential, the path to profitability matters. Sizing the legal market—including estimates for both usage and pricing—is just the first step. As the competitive landscape evolves, supply dynamics also matter. And industry structure will dictate whether growers, marketers, or retail distributers capture the bulk of value generated.

Dimensioning Demand

The bull case for cannabis stocks largely rests on demand growth. Currently, 29 countries and 34 US states sanction medicinal use, and marijuana remains fully legal in 10 other states plus the District of Columbia. While new medical uses may develop, industry boosters speculate most heavily about legal, broad-based recreational use in the US—the world’s largest illicit cannabis market.

How can we size that opportunity longer term? Much of it depends on migration from the black market to the legal one. That, in turn, revolves around how the legal, tax, and regulatory frameworks develop, three areas where uncertainty abounds. In the legal market, price differentials will need to account for taxes ranging from 25% to 40% of retail value. Currently, the after-tax price of legal marijuana in Canada remains higher than the illicit price, according to the government. That will likely slow migration. Several articles suggest that the black market continues to thrive in states like Colorado and Oregon well after legalization for recreational use there, too.

After studying states that have legalized cannabis, Bernstein Research forecasts the US retail market for recreational marijuana at around $40 billion per year, assuming legalization in all 50 states. But market size represents just part of the story.

Probing Supply

Today’s industry remains highly fractured with small start-ups driving progress. Given full legalization, Canadian producers have the advantage of raising capital on public markets and are focused on scaling up quickly. As the legal market matures, competition will surely increase. In Canada alone, about 100 companies have secured licenses and hundreds more have applications pending. Yet as more countries liberalize cannabis laws, will Canadian companies retain their first-mover advantage? Or, will producers from tropical climes with lower production costs displace them? Our research across industries suggests that first movers don’t always win, despite their profound impact on shaping their industries.

Forecasting Structure

The ultimate structure the overall industry takes represents another big unknown. Will it resemble the beer industry: highly concentrated and very profitable? Or, fragmented and less profitable like the wine industry? The latter seems more likely—certainly for the foreseeable future.

In the US, further legalization will likely occur at the state level, leading to a patchwork of regulatory requirements, and making it all but impossible to run the sort of properly integrated, national businesses required for optimal scale. This could depress margins and profitability for the overall industry long after first movers reach breakeven.

Perhaps most important for investors keen to select winners, profitability will somewhat depend on the role companies play in the supply chain. Growers, which have currently captured investors’ attention, may well end up holding the short end of the stick. For precedent, consider the agri-food value chain, where the bulk of profits have migrated to distributors and marketers rather than to growers.

Buzz Kill

The legal marijuana market remains in its infancy. Investors are waiting to see how legislative changes impact industry economics, how profitable the industry will be, and which players will thrive. Yet today’s excitement around cannabis stocks underscores investors’ tendency to overrate—both the impact of disruption in the short term and their own ability to pick winners.

With current valuations exceeding 40 times enterprise value-to-sales (a measure of how much investors are paying per unit of sales), cannabis stocks are pricing in both extraordinary growth and profitability. (Compare that to the broad US equity market which currently trades at around 2.2 times EV or the average of 7.7 times EV for more speculative biotech stocks.) As fundamental investors, we believe that current valuations grossly overestimate prospects for growth and profitability while underestimating the risks. To be blunt, this buzz appears overrated.

An information edge can mean the difference between getting ahead—or being left behind. That’s why many of our entrepreneurial clients look to us as a source of intellectual capital. For more insights on disruption, check out the related blogs here.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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