The ever-growing legal marijuana industry has inspired a wave of confidence among eager investors who expect cannabis-related stocks to continue to rise. There are ample reasons to expect that this trajectory will play out, including the recent move toward national legalization in Canada and the increasing number of states in the U.S. which have legalized marijuana in one form or another. Still, though, investors looking to take part in the growing industry should carefully analyze their options before diving in. Exactly how should one go about determining which companies are well-run and likely to do well as the market continues to evolve and grow?

A recent episode of Bloomberg Markets’ Odd Lots podcast aims to answer that question. A small group of analysts known as the “Cannalysts” has developed a rigorous and detailed process for analyzing companies in a new and largely unexplored industry. Craig Wiggins, one of three analysts making up the “Cannalysts” group, suggests that the legal cannabis market is highly risky, even as it seems equally promising. “You’ve got to be very careful jumping into this market,” he says, adding that there are significant discrepancies between company valuations and fundamentals owing to the excitement in the industry.

Importance of Management

Investors have to remain cautious when selecting a legal cannabis company in which to invest. One of the first aspects of a company an investor should consider is management. This is, admittedly, a difficult facet of any company to evaluate, particularly because many companies have successfully made a strong case for the credentials and qualifications of management on paper. The key, though, is to ensure that management follows through on its goals and promises: “making sure you map what management says to what they actually do” is critical, says Wiggins.

Given that the legal cannabis industry is new and that there are numerous regulatory and legal pitfalls and roadblocks facing any company, management must be positioned to be able to address these potential issues and prepared to navigate the company to success in a changing sphere.

Scalability

Another crucial aspect to consider is the scalability of a company. Wiggins suggests that the size of a company is not as important as its profitability. Those companies which are able to sustain themselves and to continue to grow and bolster profits over time are the most likely to be able to succeed. Companies which expand too quickly, which limit themselves within a particular niche corner of the legal cannabis space, or which are not properly managed are less likely to be scalable over time.

Low Production Costs

Companies involved in the growth and sale of cannabis products will likely rely on maintaining low production costs in order to thrive, Wiggins suggests. This is particularly the case with Canadian companies participating in the recreational use market. One important reason for this is that the regulations in Canada stipulate that a licensed producer (LP) that grows marijuana must partner with a government-run warehouse in order to house and distribute product to licensed retailers. The government-run warehouses will also be responsible for online sales directly to consumers, meaning that there is going to be intense competition between retailers (that have to purchase product to sell to consumers through government-run warehouses) and the warehouse middlemen. Companies with higher production costs are thus less likely to be able to generate sustainable margins, making them less likely to succeed in the long term.

The process is different in the U.S., where individual states have their own regulations. Still, low production costs remain a crucial component of most successful legal cannabis companies, particularly in states like California and Colorado where there is intense competition among growers and retailers.