Investing in pot stocks: Is the ‘gold rush’ over legal cannabis worth the risk?

Investing in pot stocks Is the 'gold rush' over legal cannabis worth the risk

Many experts are saying buyer beware: while cannabis stock prices have risen overall, they’ve also been prone to wild fluctuations.

The logo for Canada’s Canopy Growth Corp. appears on a screen at the New York Stock Exchange. “Pot stocks” have been one of the hottest Canadian investments in recent years, dramatically outperforming their peers in other industries. RICHARD DREW /ASSOCIATED PRESS


Long before they sold a single gram of recreational weed, the key companies in Canada’s new legal cannabis market were already publicly traded.

It’s an unusual and defining feature of Canada’s cannabis industry. Traditionally, companies listed on Canadian stock exchanges are older and more established. In the cannabis market, the oldest companies have been growing marijuana for only four years. And yet, all six suppliers to the Société québécoise du cannabis are public.

And “pot stocks” have been one of the hottest Canadian investments in recent years, dramatically outperforming their peers in other industries.

The S&P/TSX Composite Index, which tracks the stock performance of almost 250 of Canada’s largest public companies, rose 11.09 per cent between October 2015 and October 2018.

During that same period, the Canadian Marijuana Index, which tracks the stock performance of 18 Canadian cannabis companies, had risen by more than 1,111 per cent when markets closed on Oct. 17 — legalization day in Canada. While that was down slightly from the previous day, and most cannabis stocks have continued to decline since then, as of Oct. 23, the Index was still up 634 per cent from Oct. 23, 2015.

So, as Canadians keep lining up to buy legal cannabis (there were still more than 40 people waiting to get into a Montreal SQDC store on Tuesday morning, almost a week after legalization), is it time to start thinking about investing in those stocks? And if you buy in, how do you do it?

The huge gains already reported certainly make it tempting. And because they came before legalization and the long lines, some investors think there’s more money to be made.

However, many of the experts consulted for this story are saying buyer beware: while these stocks have risen overall, they’ve also been prone to wild fluctuations.

Shares in Nanaimo-based Tilray were priced at US$17 each for its July 19 initial public offering on the NASDAQ. (Tilray is one of a few Canadian producers listed on a United States stock exchange.) Exactly two months later, the stocks were trading at US$214.06 — an increase of 1,159 per cent. But while shares in the company declined steeply in the following days, as of Oct. 23, they were trading at $112.14 — still a 559.65-per-cent return for investors.

It’s this potential for massive profits that has attracted investors and resulted in the sector becoming one of the most heavily traded on Canadian markets.

Last January, the online discount brokerages operated by TD and RBC crashed because so many people were selling cannabis stocks.

But experts warn that there’s a disconnect between the sky-high valuations of pot stocks and the actual amount of cannabis that Canadians will buy.

Shares in Nanaimo-based Tilray were priced at US$17 each for its July 19 initial public offering on the NASDAQ.BEBETO MATTHEWS / AP

Brian Pinchuk, a portfolio manager at Lorne Steinberg Wealth Management, says enthusiasm is pushing the price of cannabis stocks higher, not fundamentals — the actual amount of money these companies will generate from selling cannabis.

“It is important to remember that the value of a business is, and will always be, a function of its financial strength, earnings and growth. With little earnings and a lack of measures on which to anchor a valuation, much of the sector remains speculative and priced for perfection,” he said.

“While the burgeoning industry has enormous growth potential and will undoubtedly create a healthy level of profits and new jobs, it is still early innings and it will not be long before a shakeout occurs after the cannabis ‘gold rush’ runs its course.”

Investors look at things like a company’s past revenue, profitability and growth when trying to judge how much a company is worth. But the cannabis market is so new, that’s impossible.

The medicinal marijuana market that some major players participated in was much smaller than the recreational market is expected to be. And because cannabis companies have been so focused on rapidly growing their production facilities, the biggest players have no history of profitability.

Pinchuk said the five largest cannabis companies in Canada had an aggregate market capitalization — the value of their shares multiplied by the number of shares issued and outstanding — of just over $50 billion on Oct. 11, but their combined revenue over the past 12 months was only $225 million.

While the market for these companies grew dramatically on Oct. 17, Pinchuck said, forecasts put the total cannabis market in Canada at US$8 billion to US$10 billion in five years.

“While legalization signifies an important cultural change in Canada, marijuana is ultimately a commodity that will bow to the laws of economics,” he said.

If sales can’t justify the valuation of cannabis companies, those stock prices could come crashing down.

It’s hard to say just how much Canada’s new legal cannabis market will eventually be worth.

In a May report by CIBC Institutional Equity Research, authors John Zamparo, Prakash Gowd and Mark Petrie forecast that total cannabis sales in Canada will be worth $6.5 billion by 2020.

But around 70 per cent of profits will go to provincial governments, the report forecasts.

Even in most provinces where private companies are allowed to open cannabis retail stores, those retailers will have to buy all the pot they sell from the provincial government (the only exception is Saskatchewan). That means some companies are growing cannabis, selling it to provincial governments and then buying it back to sell in their retail stores. 

The authors of the CIBC report expect the entire cannabis industry in Canada to have earnings before interest, taxes, depreciation and amortization — a measure known as EBITDA that’s often used to judge a company’s profitability — of $1 billion a year by 2020.

A report released by professional services firm PwC in July suggests that in order to bridge the gap between forecasted revenue from cannabis sales in Canada and the valuations of cannabis growers, those companies will have to expand internationally.

Many of Canada’s largest cannabis companies are already expanding into international medicinal markets, but there are still many open questions about just what the international market for recreational cannabis will look like — or if there will actually be one.

The medicinal marijuana market that some major players participated in was much smaller than the recreational market is expected to be. TED S. WARREN / AP

Julien Brault, the CEO of Hardbacon, a Montreal-based company that makes an app for investors, said the high valuation of cannabis stocks reminds him of another recent phenomenon: Bitcoin.

“For me, pot right now is definitely speculative,” he said.

“Canopy Growth, which is the market leader,” he said, “they’re making sales of $98 million and their valuation is $15 billion.”

The ratio of Canopy Growth’s market capitalization — or price — to sales is 167. It’s 1.6 for Imperial Tobacco, “which is a highly profitable company,” Brault said.

“I think they’re going to be profitable. There’s a lot of money to be made in pot. It’s just those companies have crazy valuations. The companies need to multiply their sales by 100 to justify their current valuations. It might happen, there’s a huge market,” he said. But “they need to execute perfectly and everything to work out to be worth what they’re worth.”

The highly valued companies are perhaps the closest thing to blue chip stocks in the cannabis sector. They have deals with provincial governments, large growing operations and, in some cases, retail operations and a track record of selling cannabis to those with medical reasons to consume it.

But as with any new sector that offers the possibility of rapid growth, the cannabis industry has attracted many new entrants that have little or no history and may still have few operations.

Unusually, many of these new companies have gone public. And they have listed on the TSX-Venture, the Toronto Stock Exchange’s junior exchange, or the Canadian Securities Exchange, which has lower listing requirements than the TSX.

Both of those exchanges were previously best known for being home to small resource companies.

Some investors are looking to these markets for value, hoping to find a low-priced stock that’s poised for growth.

But here there may be additional risks. With smaller stocks, investors also need to think about volume, Brault said. Some small stocks don’t trade much. “You can get stuck with it,” he said.

One red flag to watch out for, Brault said, is companies that frequently switch what type of business they’re in.

“In the very small cap, that’s where you see companies that are supposed to be mining companies, or companies that were buying mining rights, then suddenly they’re in the blockchain business or the pot business,” he said. “That just shows that they’re more in the business of attracting investment and spending it than generating value for the shareholder.”

In the long run, there may be some advantages to a more boring strategy, Brault said.

“I have no idea about the future, but at the end of the day if those companies are worth so much money that if you’re a value investor and you’re buying companies to own for the long term, I would buy companies that you can buy cheaper, that are profitable and that are great businesses,” he said.

Investors also need to be aware of warnings from regulators about the risks associated with cannabis investments, Pinchuk said.

On Oct. 10, the Canadian Securities Administrators, an umbrella organization of Canada’s provincial and territorial securities regulators, released the results of a review into the disclosures of 70 publicly traded cannabis companies.

It found that “licensed cannabis producers often did not provide sufficient information in their financial statements and management’s discussion and analysis for an investor to understand their financial performance.”

Of the companies reviewed, 100 per cent had issues related to how they disclosed the value of cannabis plants growing in greenhouses, according to the Staff Notice issued by the CSA, which did not name the companies.

As well, it said, “74 per cent of issuers with cannabis operations in the U.S. did not provide sufficient disclosure about the risks related to their U.S. operations to satisfy the disclosure expectations.”

There may be some non-monetary risks internationally as well.

U.S. Customs and Border Protection recently changed its policy and has said that people who are “facilitating the proliferation” of Canada’s legal cannabis industry will generally be allowed to enter the U.S. if they are travelling for personal reasons — people travelling for cannabis-industry-related reasons can still be denied entry.

But more than 20 companies that trade on Canadian stock markets sell cannabis in the U.S. and Canadians who hold investments in these companies — which operate in markets that are legal at the state level but illegal under U.S. federal law — could be denied entry to the U.S.

Ultimately, investors will have to decide whether they feel comfortable participating in a market that up until very recently was illegal.

Even though the cannabis market is legal — and potentially lucrative — some banks, analysts and investors are still hesitant to even talk about it.

Three major banks declined to comment for this article, as did several large investment firms. Some cannabis investors contacted by the Montreal Gazette also refused to speak on the record, saying they don’t want their employers to find out about their cannabis holdings.


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