Picking the right companies to back in a new and quickly-changing industry like cannabis is hard.
While there's no tried-and-true formula to picking winners in an industry that was fully illegal in the US and Canada less than ten years ago, top investors say you should look for companies affected by a wonky federal tax rule that prevents cannabis companies from deducting regular business expenses like any other company.
That rule — a section of the federal tax code known as 280E — is a vestige of former US President Ronald Reagan's war on drugs.
Cannabis is still considered illegal in the eyes of the federal government, so companies that cultivate or sell products that contain THC, the main psychoactive component of marijuana, can't deduct regular business expenses like office supplies, payroll, or health insurance premiums.
That forces them to pay unfairly high taxes compared to other industries, and puts pressure on profit margins across the industry, Insider reported last year.
Financial and strategic advisory firm Viridian Capital Advisors says that getting rid of 280E would save the 10 largest publicly traded US cannabis companies an estimated $279 million each year.
"If you want to find something interesting, invest in companies affected by 280E," Mitch Baruchowitz, a managing partner at the cannabis-focused investment firm Merida Capital Holdings told Insider in a panel last week. Merida has over $500 million in assets under management, Baruchowitz said.
Some companies are set to 'explode' if the 280E rule is removed
Any US company that sells THC in the US is affected by 280E. That includes better-known US cannabis companies, known as multistate operators or MSOs, like Green Thumb Industries, Curaleaf, and Trulieve, along with smaller industry players.
Emily Paxhia, a cofounder and managing partner of Poseidon Asset Management, agreed with Baruchowitz and says those companies are set to "explode" if the 280E rule is removed.
While it may seem counterintuitive to invest in companies affected by 280E, it's actually a smart way to take advantage of impending changes in federal policy.
The House passed the SAFE Banking Act, a modest cannabis reform bill, in April. While that bill does not explicitly remove the 280E penalty, many analysts and industry watchers say it's only a matter of time before the federal government takes action.
For his part, Sen. Majority Leader Chuck Schumer is pushing to introduce a full-scale legalization bill, which would remove cannabis from the list of federally controlled substances, thereby eliminating cannabis companies from being subject to 280E.
But the Senate's 50-50 split means there are slim prospects for full-scale legalization passing during this legislative session.
"There are a lot of people who think there's going to be this blinking green light that says 'now's the time to invest in cannabis,'" Baruchowitz said. "And I think people who keep waiting for this magic moment are missing the fact that every day more people buy cannabis who were illegal buyers. The market is enormous."
Watch the Insider webinar on investing in the cannabis industry with Paxhia and Baruchowitz here.
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