When Will Cannabis Stocks Find Their Bottom?


Harrison Jordan

March 7th, 2018

Policy


When will they find their bottom? That’s a question that both institutional and retail investors are likely asking themselves after cannabis-based stocks on all the global stock markets have taken a nose-dive in recent times.

According to Bloomberg News, this past Friday marked the tell-tale signs that retail investors were “panic selling” as Canopy Growth (parent company of Tweed Inc) tumbled down to just $25 after reaching highs above $40 just as 2017 was coming to a close – a loss of approximately 40 percent. And while Canopy is the bulwark that investors often look to determine the health of cannabis stocks, it wasn’t alone: Aphria fell 14 percent while Aurora dropped 14 percent.

“People are panicking because they are losing their money,” Chris Damas, editor of the BCMI Cannabis Report, told Bloomberg Markets through email. “Stocks are in bear market territory.”

Just last month things were looking on the up and up for the industry. After a contentious hostile turnover attempt, Aurora eventually gave Cannimed an offer they couldn’t refuse, and the two sides have negotiated a takeover on friendly terms. That seemed to put the market in good spirits.

But then the bad news started to flow. Jeff Sessions rescinded the Cole Memo that allowed many state-licensed operators across the United States to avoid prosecution if they followed some golden rules that included that they do not sell cannabis to minors. Rescinding the Cole Memo provided a great deal of uncertainty to the markets – because it’s anyone’s guess as to whether prosecutors across the United States will actually go after operations that are legal for medical and recreational purposes in dozens of states.

Then, more bad news. Right-leaning members of Canada’s Senate wanted more time to debate the country’s plan to legalize the drug, while progressive, Liberal-leaning senators wanted to push ahead with approving the legalization plan so that the government could meet its self-imposed July 2018 deadline. On February 15, the Senate came to a compromise: Instead of delaying review of the bill for months on end, the final vote on the Cannabis Act (Bill C-45) would be June 7th 2018.

At the time, Senator Tony Dean tried to spin it as a positive, tweeting that “I thought it could be done by May, some conservatives argued for The Fall. The beauty of a consensual agreement is that everyone gets to declare victory.”

The markets, however, reacted more negatively to the news.

When looking at fundamentals – irrespective of any of the bad news – some analysts caution that they believe that the entire cannabis sector is massively overvalued at the moment. Traditional metrics, such as earnings and revenue, are only marginally considered, as new metrics come in. These days, cannabis companies are often valued based on the planned and approved amount of square-feet of cultivation space, regardless of the company’s history of getting the hard work done. Another metric is the amount (typically in kilograms) of cannabis that each company is authorized to grow.

Its important to note that at its current market cap, Canopy Growth is currently valued at more than 50 times its revenue, which is higher than industry competitors and also much higher than stocks in other sectors, such as mining, gold, and consumer technology.

According to the Motley Fool, there are five hidden risks with investing in pot stocks. Sean Williams, author at Motley Fool, cautions first about the political risks that we mentioned earlier. He too notes the Cole memo rescinded on January 4 2018 as a potential market mover. Second, Wiliams points to oversupply. We don’t know how much cannabis Canadians will consume when the drug becomes legal – estimates have ranged that could cost companies to lose out on billions of dollars in revenue depending on which estimates come to be true. Williams points to the 3.7 million square feet of space that Canopy Growth is growing as a potential indicator of potential oversupply.

Shareholder dilution is another problem. Because cannabis companies do not have access to typical financing from banks, these companies have to rely on financing methods that give out large tranches of stock. This is particularly the case with stocks that operate in the United States – as banks are just starting to jump on the cannabis investing bandwagon.

Williams also points to two more problems with pot stocks: investor emotions, and inexperienced management. Because much of the money flowing into pot stocks comes from retail investors, the “panic selling” we talked about earlier could lead to dramatic drops in pot stock prices. Add to that the inexperienced management personnel that does not have the typical experience in capital markets, and viola – you have a disaster waiting to happen.

Where will the bottom be? We may not know for months – since cannabis companies are valued at multiples much, much higher than in other capital market sectors, and the industry is fraught with the specific concerns highlighted in this piece, the bottom may be yet to be found.

The upshot is that the industry continues to experience tremendous growth around the world. These valuations could come down as revenue and profits begin to materialize, and these stocks could still be a good value at their current levels. This is particularly true if Canada becomes a global leader in the burgeoning cannabis industry.

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