A Few Nuggets of Wisdom on Pot Stocks

By Jimmy Pickert, CFA, CRPS®

Jimmy Pickert, CFA, CRPS®

Jimmy Pickert, CFA, CRPS® Portfolio Manager

Last year around Thanksgiving I wrote about the craze around Bitcoin and cryptocurrencies in general. The blog’s main point was that, after seeing record numbers of new accounts opening up for the purchase of Bitcoin, investors shouldn’t rush in with anything other than money they intended to gamble anyway. Invest a little if you want to take part in the fun, but don’t bank on retiring off your Bitcoin returns. Hopefully you listened: Bitcoin has now fallen around 70 percent from the high it reached late last year. This isn’t a victory lap on my part. I think most people, myself included, suspected we were witnessing a bubble when the price saw double digit gains daily. The question was when the bubble would burst. I bring this up because there is another investment craze this year that I suspect will be discussed around turkey and stuffing: Marijuana stocks. Will pot stocks lead to new highs? Or will returns go up in smoke? Let’s get into the weeds and find out.

With 33 states plus the District of Columbia having made cannabis legal for at least medical, if not recreational use, it’s easy to understand why investor money would be flowing into the industry. In states like Colorado and Washington where recreational use has been legal for multiple years, the demand for legal marijuana is clearly, if not surprisingly, strong. What the United States is now witnessing is similar to the repeal of alcohol prohibition in 1933. And yet there is a key difference: the era of alcohol prohibition by the federal government only lasted from 1920 to 1933. Various states had prohibition laws on the books before and after federal prohibition, some as late as 1966, but the federal intervention was much shorter. By contrast, marijuana was designated as a Schedule I narcotic in 1970 with the passage of the Controlled Substances Act, which is still in force today. The federal government still views the sale or possession of marijuana as illegal nearly 50 years later. If it has been the law of the land for a long time, it likely won’t change overnight.

If not as quickly, it still appears that history is repeating itself with respect to how marijuana will be legalized. During the 20s and early 30s, state legislators paved the way for federal prohibition repeal by rescinding the laws in their own states. After this most recent election, 10 states plus Washington, D.C. have legalized the recreational use of marijuana.

For the sake of this blog, assume that public opinion continues to grow in support of legalization across the country. After all, the future of companies in the marijuana space is pretty easy to predict if the trend reverses and legalization either halts or regresses: the future prospects of those companies would dwindle, if not collapse, and the value of their equity would fall with them. Instead, let’s take as granted that states will continue to relax their laws and that the legal market for marijuana grows.

The experience of publicly traded pot stocks has been volatile. Primarily based out of Canada, where the drug is now legal countrywide, big names like Canopy Growth Corporation (CGC) and Tilray (TLRY) have been attracting most of the headlines, but there are several other constituents jockeying for a share of the current and future market. Marijuana stocks have seen strong, but shaky returns so far in 2018. Tilray’s stock increased by over 950 percent in 2018 before peaking in late September subsequently losing 50 percent of its value.

One reason the stock prices of these companies are so volatile is that it has been difficult to accurately forecast sales and earnings. CGC reported C$23 million in revenue for the third quarter of 2018—a nice 33 percent increase from Q3 2017, but less than half of the analysts’ forecast of C$59 million. Most of these companies are operating at a negative earnings per share ratio, so when sales disappoint the stock price is likely to be even more sensitive. This isn’t unique to cannabis—it is typical for just about any nascent industry.

Another cause for concern is that many of the bigger names in the industry have been aggressively attempting to increase their dominance by expanding via acquisitions. While this consolidation is a sign that the industry is maturing, what’s worrying is that many of these acquisitions have been financed entirely with stock. Not every acquisition target is a winner, and the increasing share base of the acquiring companies makes it more difficult for those companies to create per share profit.

Ultimately the success of investing in any particular marijuana-related stock is dependent on much more than the thesis of inevitable legalization. And even if you wanted to diversify your holdings by, for example, investing in funds like the Alternative Harvest ETF (MJ), you’re still subjecting yourself to the volatility of an industry with a lot of unknowns, not least of which is the uncertainty around the speed of legalization. That Alternative Harvest ETF happens to be negative year-to-date, despite the still-strong returns of CGC, TLRY and others.

Should you invest in marijuana stocks? I offer the same suggestion I gave about Bitcoin. While it’s true that there are differences—there’s a proven market for marijuana, unlike cryptocurrencies; there’s growing public support for mainstreaming of the product through legalization, whereas it’s far from clear cryptocurrencies will ever be widely adopted—the key similarity is that there are massive uncertainties involved. High uncertainty leads to high volatility. Invest a small portion of your portfolio if you’re comfortable with the chance for big losses, but don’t make pot stocks a central theme of your retirement plan.

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— Posted on November 21, 2018 by Jimmy Pickert, CFA, CRPS®

— Topics: Investments, Market Performance