Could British American Tobacco plc or Imperial Brands plc dominate a new $45bn cannabis industry?

With its use legalised in many US states, Imperial Brands plc (LON: IMB) and British American Tobacco plc (LON: BATS) could soon dominate the cannabis market.

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Its no secret that vice stocks such as tobacco and gambling have outperformed the market. Many investors reject these shares on moral grounds and the lack of buy demand can result in valuations that don’t reflect the impressive business models. But stocks in the sin bin can often posses attractive qualities such as steady demand, pricing power and high barriers to entry.

All this is true of FTSE100 behemoths British American Tobacco (LSE: BATS) and Imperial Brands (LSE: IMB), but I believe these companies could be on the verge of entering a new ‘sin’ market. Yes, it could put off even more investors but it could also boost profits, presenting those who aren’t morally opposed with a fantastic opportunity to reinvest the dividends at a low price.  

This, combined with 3.5% and 4.5% respective yields, could see these stocks seriously outperform the wider market. I’m talking, of course, about the $45bn US cannabis industry.

I believe it’s simply a matter of time before these massive companies steamroll the competition and dominate this burgeoning market place. 

Is legalisation inevitable?

Attitudes towards cannabis are easing in the US. Recreational and medical use of the plant is already legalised in eight states, including Washington, California and Colorado. Over 20 states allow some form of medical use.

States representing nearly half the population now have some form of legal access to the plant. In my opinion, not even Trump will stand in the way of eventual legalisation despite his frequent flip-flopping as chronicled by The Washing Post here.

Trump often champions the right of individual states to set policy and he clearly supports medical use. However, I believe he’s unlikely to make this decision based purely on moral grounds. The President-elect has a deficit to deal with and the tax dollars this new industry could provide are significant. Colorado is already raking in more greenbacks from the green stuff than from alcohol.

But one massive barrier remains before Big Tobacco can dominate the industry: Federal Legalisation. Blue-chips wont risk the attention of the government, so until the stuff is legalised across the US my theory remains little more than a pipe dream.

But if enough states legalise recreational use, momentum could build to the point where even Trump won’t say no.   

Infrastructure to dominate

Imperial Brands generated an £823m, or 23%, operating profit in the US this year, but has been absent from the US for 12 years, aside from its 42.2% stake in Reynolds American. The company recently tried to buy the rest of the outstanding shares. The combined cash-and-stock offer worth $47bn was rejected and another bid is said to be in preparation. If the two merge, the company would be the largest in the industry.

If the deal goes ahead, both Imperial and British American would have the existing infrastructure and scale to dominate the US industry. The companies even have transferable vaping technology from e-cigs.

Perhaps most importantly, there aren’t many big players in US cannabis yet and tobacco companies could eventually sweep the board.

The real driver of outperformance here, however, could be that these companies are both listed on the London Stock Exchange. Of course, cannabis looks likely to remain illegal in the UK for some time, which may double the ‘sin’ reputations of these companies, therefore driving further outperformance in the long run.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Zach Coffell has no position in any shares mentioned. The Motley Fool UK has recommended Imperial Brands. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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