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Despite Canada's legalization of pot, cannabis stocks need more than a puff of smoke to stay lit

Cannabis-related stocks have seen a 10 percent increase since summer, but wary investors and a mixed regulatory environment have dampened spirits.
Image: People smoke on the day Canada legalizes recreational marijuana at Trinity Bellwoods Park.
People smoke on the day Canada legalizes recreational marijuana at Trinity Bellwoods Park, in Toronto, Ontario, Canada, Oct. 17, 2018.Carlos Osorio / Reuters

Marijuana has been on fire this week: Canada legalized recreational use, the White House may look to federal cannabis reform after the midterm elections, and the industry saw a $682 million merger.

While the cannabis sector of the stock market has seen close to a 10 percent increase since the summer, it still hasn't hit the big time. Individual investors have been enthusiastic, but a related combination of wariness on the part of institutional investors and a still mixed regulatory environment has been a damper on overall success.

The stock market splits between retail investors — individuals, including ordinary people putting money into equities — and institutional investors. The latter includes mutual funds, hedge funds, pension funds, and private equity firms that have enormous amounts of money available.

Retail investors have been enthusiastic about cannabis-related stocks, most of which are listed in Canada, with a few cross-listed on U.S. exchanges. "There is an enormous amount of new retail money coming into the market," TD Ameritrade CEO Tim Hockey told CNBC early this year. The two big drivers have been cryptocurrencies and cannabis, and millennials have been particularly eager to enter the market.

The excitement is a result of the interest consumers have in the products, whether for medical or recreational use — estimated to be 50 million people. "That's a real market," said Jon Trauben, a partner in Altitude Investment Management, which focuses on cannabis companies. "Our business case is that demand is there and customers will ultimately prefer to buy safe, tested product through legal channels."

Cannabis companies that have gone public include penny stocks as well as shares approaching $150 for the two biggest names, Tilray of Canada and GW Pharmaceuticals, which is based in the U.K.

There is increased corporate interest in cannabis companies. Bloomberg reported that spirits giant Diageo is looking to invest in Canadian firms and possibly to collaborate on cannabis-infused drinks. Beer, wine, and spirits company Constellation Brands invested $191 million last year in Canadian company Canopy Growth and added an additional $4 billion to raise its stake to 38 percent.

However, on the whole, institutional investment has been low. Although the upside is attractive, the regulatory and legal issues are considerable. In the U.S., marijuana is still listed as a Schedule 1 drug, which means the federal government considers it to have "no currently accepted medical use and a high potential for abuse." Pot's company includes LSD, peyote and heroin.

States that have legalized cannabis products, whether for recreational or strictly medical uses, technically are in conflict with federal law. The Rohrabacher-Blumenauer Amendment prohibits the Department of Justice from using any funding to enforce the Controlled Substance Act to prevent states from implementing their own medical cannabis laws. Congress must annually renew the provision and currently they have done so through Dec. 8.

The law doesn't prevent the Justice Department from interfering with recreational use, even if legalized by a state. Nor does it ensure that companies in the U.S. have access to basic banking and financial services, like processing credit card payments from customers or getting access to business insurance.

A change in direction by the federal government, as hinted at by the White House, could potentially turn this around and open the door for big influxes of money from institutions.