If you have invested in cannabis stocks, without taking advantage of the upside when they reached their highs at the end of 2018, you may have suffered through one or two sleepless nights over the summer of 2019. News that CannTrust Holdings Inc (TSX:TRST) may have had dealings with an illegal plantation was just one of the factors that helped erode overall confidence in the cannabis sector. After all, the Government was supposed to have made the industry safe and wholesome. Then companies like Canopy Growth, Tilray and HEXO posted terrible quarterly numbers – relative to expectations – triggering shakedowns in corporate boardrooms that saw, among other victims, Canopy Growth dismissing its CEO in a surprise move that shocked investors.
Most cannabis stocks, from Canopy Growth (TSX:WEED) to Aurora Cannabis (TSX:ACB), Tilray Inc (NASDAQ:TLRY) and countless smaller startups have lost half or more (Tilray, the rocket that went from $30 to $148 in a matter of weeks, has dropped back down to $21.0/share) of their value by the end of August 2019 compared to the same month of 2018. Those investors, who have decided to hold on to their cannabis stocks remain in limbo, anxiously waiting for a catalyst to revive the sector in order to pull away with a modicum of honor. My opinion may be unorthodox and overly optimistic – and it’s an opinion, after all to be taken with spoonsful of salt – but, there’s reason to be optimistic. If nothing else, judging from Tilray’s performance alone, cannabis stocks may have reached a bottom.
It’s evident that none of the big cannabis names of 2018 have been raising any capital lately, while their price to earnings ratios (P/E) have been moving in all the wrong directions. Consider Aurora Cannabis for example. In the period between December 2017 and January 2018, Aurora was trading at a P/E that ranged between 900 and 1415.31. That kind of ratio indicates extreme over-confidence and highly unrealistic expectations. The current P/E ratio is about -19.0 and at current performance levels, it’s about to drop to -45.0 (Source: Nasdaq). The other former cannabis unicorns don’t fare much better. And that has affected the many juniors struggling for attention with innovative techniques and interesting products.
The optimism starts with the October 17 legalization of recreational cannabis edibles, topicals and concentrates (which should become available for sale to the general public by December 2019) could trigger enough of a tide to ‘lift a few boats’. While investors should have learned the lesson that cannabis stocks are not an Eldorado, they can expect some cannabis companies to improve margins if they can build brands, able to produce higher margins by exploiting the cannabis edible and beverage market. If nothing else, such products will appeal to a wider public and help increase overall sales by opening up to a general rather than commodity market. The U.S. market has already shown that cannabis derivatives, or byproducts such as beverages, gummy-bears, foods, creams represent some 60% of the legal market, driving growth. (BDS Analytics) rather than dried flower. A related development to watch for is the increase in the number of stores to buy legal cannabis products. The Canadian government has adopted confusing legislation, which has created a shortage of retail locations relative to demand. As more retailers obtain licenses – through a lottery system – more users will have the opportunity to buy legal cannabis.
Another potential development from the United States also bodes favorably for the cannabis companies that survive the current – and inevitable process of Darwinian selection. In short, Trump is seeking re-election, and his position on cannabis is one rooted not in ideology, but in what’s necessary to beat an opponent – whether it’s a real estate deal, a foreign policy negotiation or an election. Most of the Democratic presidential candidates have adopted progressive views about legalizing cannabis. By adopting a similar stance, Trump would be able to weaken a potential opponent’s argument. Ultimately, until that happens, note that cannabis companies will remain in a kind of ‘stand-by’ mode until legalization prevails at a global scale.
So far, only Canada and Uruguay have fully legalized cannabis for recreational use, even if many have legalized cannabis for medicinal purpose. But, that doesn’t mean that cannabis legalization will remain limited. Chinese companies are interested, and their research has led to hundreds of related industry patents. Finally, there’s little doubt that the cannabis industry will experience massive global growth in the next few years, which means investors cannot afford to stay out of it.
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