California's Gigantic Medical-Marijuana Industry Could Be Devastated by an Unlikely Source

Marijuana Cannabis Buds Stacked In Jars Getty

If you support the legalization of marijuana, 2016 didn't give you much to complain about. Last year, residents in four states approved recreational-marijuana ballot initiatives, doubling the total from the end of 2015, while five new states put medical-cannabis laws on their books. By year's end, 28 states and Washington, D.C., had legalized medical pot.

And there's more where that came from. We saw two battleground states -- Pennsylvania and Ohio -- introduce and pass medical-marijuana legislation without sending it to a public vote. We also saw a continued softening in the public's opinion toward marijuana, which remains an illegal drug at the federal level. Gallup's 2016 poll found that 60% of Americans now want to see the substance legalized nationwide, up from just 25% when California passed the first compassionate-use law in 1996. Legal weed sales have also soared. Cannabis research firm ArcView sees sales reaching nearly $22 billion by the end of the decade, while investment firm Cowen & Co. projects a better-than-23% annualized growth rate leading to $50 billion in legal sales by 2026.

California is a medical-marijuana juggernaut

Colorado, one of the first two states to legalize recreational marijuana in 2012, wound up generating $996.2 million in legal sales during 2015, leading to $135 million in tax and licensing revenue. Yet that's peanuts compared with legal pot sales in California, the eighth-largest economy in the world by GDP.

Since passing medical-cannabis legislation in 1996, California has amassed more than 720,000 current patients, at least according to a September 2016 estimate from the Marijuana Policy Project. That's about 1.8% of California's total population as of 2015, and it represents half of all legal medical-marijuana patients in the entire United States.

According to Troy Dayton, the CEO of ArcView, California generated $2.7 billion in medical-cannabis sales in 2015, which amounts to 62% of all medical-cannabis sales in the U.S. in 2015, as well as more than half of all cannabis sales, medical and recreational combined , in 2015. California's medical-marijuana industry is simply enormous.

But it may not stay that way for long.

The cannibalization of medical cannabis

In November, California's residents went to the polls and overwhelmingly voted in favor of Prop 64, which will legalize recreational, adult-use weed for the state's more than 39 million residents. In 2018 alone, California's legal pot sales are expected to climb to $6.6 billion, based on estimates by New Frontier and ArcView.

We also can't forget that the U.S. Drug Enforcement Agency declined to reschedule marijuana when given the opportunity this past August. The DEA noted a lack of safety and clinical data, as well as a lack of understanding the chemical properties of marijuana, in its decision to leave the drug classified as Schedule 1. This means pot companies are still primarily forced to deal in cash, as most banks want nothing to do with them, and they continue to face higher corporate income tax rates since they are unable to take normal business deductions. These persistent disadvantages are what make investing in this space so incredibly dangerous.

Even if the incoming administration or the DEA does decide to reschedule marijuana, it doesn't mean things would necessarily get easier. Schedule 2 through Schedule 5 drugs fall under the tight regulation of the U.S. Food and Drug Administration. The FDA would likely implement strict marketing and packaging regulations, oversee all medical grow operations, and require that approved clinical trials be run to prove that medical cannabis treats certain ailments This all translates into big expenses for the medical-pot industry.

While marijuana's state-level expansion has been something to marvel, this remains an industry best watched from the sidelines.

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