Some Thoughts on the Medicinal Marijuana Sector

“A growth opportunity, yes, but at what cost?”

These days it seems that many clients are interested to invest in the stories of cryptocurrencies (Bitcoin, Ethereum, etc), artificial intelligence, automation/robotics and cannabis. They are exciting and I can certainly see the growth to come and how many of these will be catalysts of change in the future. That said, as an advisor for more than 20 years now, I get concerned when I see this level of excitement as it often correlates to a peak in the market cycle. When there is froth in the markets and a general perception that the growth stories heard from neighbours or co-workers are “easy” to achieve and “we might miss out on a great opportunity” my Spidey-sense starts to tingle. Given all the interest, I wanted to write a short piece on my current view of the cannabis sector from the perspective of how we manage portfolios; from the framework of our disciplined investment management process and as value-investors.

As an advisor for more than 20 years now, I get concerned when I see this level of excitement as it often correlates to a peak in the market cycle

First from the perspective of our disciplined process (because this will be short and simple): one needs to ensure they stick to their risk tolerance levels and recognize that these are high-risk investments. How much money could you afford to lose? If you put 2.5% of your portfolio in these investments, ask yourself how much money this is and what would happen if you lose 50% or even more of it? It’s important to setup the framework for how much of a position to take before going down the road analyzing merits, valuation, etc. Perhaps some people actually haven’t thought about what an appropriate amount would be and I suggest one should do this before proceeding to the next step.

As you’ll see in a moment, these types of investments don’t fit within our particular style of investing, so we typically recommend that a separate account be opened with the sole purpose of holding shares like this. This lets us keep the money separate from your long-term pension-style investments and the performance results (good or bad) don’t skew the measurement of our success in our regular portfolios.

VALUATION

When we invest, we are buying an ownership stake in a business. If someone asked you today to buy their business you’d clearly want to know what its worth so you can decide if you’re paying a fair price. Many investors don’t do this – or don’t know how to do this – when it comes to a stock. It’s easy to conclude that it’s a growing industry and so just “getting in now” is most important and that the price appreciation will continue for a long time due to this growth. However, please remember the market anticipates future growth and prices this information in far more quickly that I believe most investors understand. It’s just like broad markets right now – yes, the economy is strong and earnings are improving, but that doesn’t mean stock prices will go up in the future. Stock prices already reflect this information. The same goes for cannabis companies – future growth is already priced in. As I’ll go on to explain now, I believe the growth assumptions have been wildly exaggerated.

“I believe the growth assumptions have been wildly exaggerated.”

The four largest cannabis stocks in Canada have rallied in price over the last five months anywhere from 240% to 400%. In mid-January, Canopy Growth (ticker: WEED) seemed to easily raise $200M in a secondary offering of shares. Last year around this time, the total market capitalization (i.e. the “size” of the company… technically measured as shares outstanding multiplied by the price of these shares) of Canopy Growth was $2B. Today it has soared to over $7B with significant public investment and now greater interest from institutional investors. Canopy Growth wasn’t the only company to raise capital either with over $800M of new shares issued so far this year. Trading volumes have also picked up considerably from $3M a day two years ago to over $500M exchanging hands each day so far this year. There has been more trading of Canopy Growth each day this year than any other stock in Canada – more than the banks, telco’s, railways, etc. It’s a hot sector, to say the least.

But what is a cannabis company actually worth?

What are the fundamentals? I thought the easiest way to convey this information would be to make a comparison to a similar more established company in another “consumption” business; the beer industry. The four top cannabis companies trading in Canada now have a combined valuation of $18B. Molson Coors, a household name for many years, has a similar valuation at $17.9B. Molson has the largest share of the Canadian beer market and in the last year alone has generated sales of over $13B. The top four cannabis companies have generated $148M in revenue. This will grow, to be sure… but will it grow by a factor of a whopping 87 times? Sales would have to double (exponential growth) over time to reach this level. If it could happen, how long would it take? Even though there was $60M in revenue for Canopy Growth they actually lost $40M in cash flow compared to $2B in positive cash for Molson Coors. Is Canopy Growth worth more than $7B today? If the answer is to be yes, it will have to experience growth rates that are incomprehensibly high to match Molson Coors in a relatively short period of time. The marijuana market will also have to grow to match the beer market over a relatively short period of time. How much infrastructure would it take? Both of these are unlikely in our opinion. At least they won’t do this quick enough or in this current market cycle and when the market does go through a correction, the companies with poor fundamentals will be sold off much faster than those with solid cash flow and good valuations.

“it will have to experience growth rates that are incomprehensibly high to match Molson Coors in a relatively short period of time.”

So, to summarize what I’m trying to say in the previous paragraph, there are two key questions to ask:

Will we ever get to the point where there are an equivalent number of cannabis users to equal the number of beer drinkers? Even if this was to happen, which we doubt, will it happen over a relatively short period of time as this is what really matters to stock prices anyway.

This valuation frenzy is particularly fascinating because we really don’t even know the regulations that will govern this industry. Yes, consumption will become legalized in the summer of this year but we don’t know the rules around pricing or distribution. This makes it particularly challenging to project sales growth or to have confidence in how the market will evolve and which businesses will be competitive and which won’t. We simply don’t have enough data to arrive at a definitive valuation for the companies. Given that, we think an investor is paying far too much for the shares today and caution new entrants to the sector to exercise discipline and due-diligence. Don’t throw good capital at an industry in an indiscriminate fashion where the long-term returns look to be diminishing rapidly based on the valuations we see today.

“we think an investor is paying far too much for the shares today”

I apologize in advance but I have to say it: your investment may just go up in smoke.

Buyer beware.