This Small-Cap Marijuana Stock Might Dilute Shareholders to Death

The marijuana industry is, pardon the apropos pun, growing like a weed at the moment, and it's shown little signs of slowing. What was once a taboo topic is now completely mainstream, with the latest Gallup poll showing that almost 2 out of 3 Americans want to see pot legalized across the country.

Support for medical cannabis is even more convincing. An August Quinnipiac survey found 94% support for legalization and just 4% of respondents opposed to the idea of physicians prescribing medical cannabis to patients.

This support is also seen through legal weed sales growth and expectations. Leading cannabis-research firm ArcView estimates that legal pot sales in North American can grow from $6.9 billion in 2016 to $21.6 billion by 2021, working out to a compound annual growth rate of 26%. It's this rapid sales growth, along with budding support for legalization, that's driving investors into marijuana stocks.

Buyer beware when it comes to this small-cap pot stock

While a small handful of pot stocks have certainly given investors reasons to be excited, quite a few marijuana stocks are still downright dangerous. Yes, this even includes Canadian marijuana stocks, where the federal government appears to be pushing toward a July 2018 recreational legalization.

One such company where "caveat emptor" could very well be the motto is The Supreme Cannabis Company (NASDAQOTH: SPRWF), which was known as Supreme Pharmaceuticals until about two weeks ago.

Over the past two years, Supreme Cannabis Co. has surged by 367%, mainly on account of growth expectations in Canada. Remember, Canada legalized medical cannabis back in 2001, so it's had plenty of time to get its burgeoning medical weed business up and running. According to a press release from Health Canada back in May 2017, the number of eligible medical patients was increasing by about 10% a month, providing more than enough demand for the 44 licensed growers at the time.

The company has also benefited recently from Prime Minister Justin Trudeau's push to legalize adult-use weed. The thinking is that medical-cannabis producers should have little trouble pivoting from just the medical market if recreational weed is eventually legalized. The influx of demand from adult consumers is expected to add between $3.7 billion and $5 billion in sales a year to the Canadian market -- and that's not chump change.

As for Supreme, it also benefited in a big way from a September announcement that its primary subsidiary, 7Acres, had completed its first sale of dried cannabis to primary retail partner Aurora Cannabis (NASDAQOTH: ACBFF). Aurora then sells the product as "SunGrown by 7Acres" to its medical-cannabis patients. 7Acres is a 342,000 square foot hybrid greenhouse facility in Ontario that uses advanced HVAC and CO2 enrichment and full-spectrum sun to grow its cannabis.

Here's why you should be concerned

Now that you've got some idea why Supreme Cannabis been soaring, let's take a look at some of the red flags associated with the company. Let's begin with one of the more glaring problems: It only received approval to begin selling medical cannabis on June 28, 2017.

While its much larger peers were busy expanding their growing capacity and building partnerships for the past two or three years, Supreme Cannabis was left waiting on the sidelines. Trying to play catch-up in a rapidly expanding market is going to be next to impossible.

Companies like Canopy Growth Corp. have pockets deep enough to squeeze players like Supreme Cannabis out of certain markets. It doesn't necessarily mean that'll happen, but Supreme Cannabis is clearly at a size and experience disadvantage.

The company is also at a cash disadvantage. The popular way to raise capital in Canada is through bought-deal offerings, which involves selling a block of common stock to an institution or large investor prior to the release of a prospectus. The good news for marijuana stocks is that they're having no trouble finding buyers. The downside, though, is that shareholders in these companies are getting diluted to death in the process.

According to Supreme Cannabis Co.'s interim financial update through Sept. 30, 2017, released in November, there were nearly 82.8 million warrants outstanding, 17.4 million stock options, of which 10 million expire between 2019 and 2022, and $53.2 million in convertible debentures. Every single one of these instruments is capable of significantly increasing the number of outstanding shares -- and when that happens, existing shares become diluted since they're less scarce than before.

Between the end of Supreme Cannabis' fiscal 2013 and its latest interim update, its outstanding share count has grown from 9.63 million shares to 192 million (based on outstanding shares for its Canadian listing). Mind you, this doesn't include a recently completed bought-deal private placement of nearly $32 million in debenture units, or the impact of future warrants or options exercised, or debt notes converted into shares. When things are said and done, this company could crush the same shareholders who hoped to get rich riding the green rush.

Yes, the marijuana industry is growing like a weed, and yes, Canadian marijuana stocks look uniquely positioned to capitalize. However, that doesn't mean every company can be a winner. Despite Supreme Cannabis' focus on high-end products -- a role that's currently being filled by MedReleaf and other players -- there's simply nothing to suggest that it'll be a winner at this point.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.