As more states have legalized both medical and recreational cannabis (marijuana) in 2018, investors have sought ways to “get in on the action.” However, the United States still has it classified as a controlled substance and recreational use is illegal at the federal level, which supersedes state laws. There are companies in the US that are allowed to work with it as a pharmaceutical, but they have many restrictions and regulations to comply with and have been doing so for years. The actual growers and producers are mostly located in Canada where cannabis was recently legalized nationally on October 17th of 2018. This has drawn many upstart businesses into private and public markets. Having publically listed companies (on the Canadian exchange) has given speculators the opportunity to buy in to the hype, but at what cost?
Just as the warning against buying Bitcoin was laid out a year ago in our fourth quarter letter of 2017, we would like to urge caution here with regard to speculation in cannabis stocks. With year-to-date returns ranging from up +207% to down -70%, it is easy to understand why investing in this space should be viewed as pure speculation with the possibility of total loss. The difference between Bitcoin and the cannabis industry is that Bitcoin has absolutely no intrinsic value at all, whereas the cannabis industry is composed of various businesses that produce actual products, for the most part. Though, In the case of cannabis, caution is warranted due to the relative infancy of the industry, outrageously high valuations, and the inclusion of suspect businesses and management teams with little oversight trying to make a quick buck at investors’ expense.
There is no doubt that there is growth here. Cannabis sales will increase in Canada and MAYBE someday in the US, but how can you avoid getting burned?
Avoid high valuations! The best performing stock in the space this year is up over 200% but has only $40 million dollars of revenue and no profit to show for its $8 billion dollar valuation. That means it is trading at 200 times sales! The highest price-to-sales ratio in the entire S&P 500 is 20 times sales, and the average stock trades at just below 2 times sales. It is hard to justify this type of valuation even for companies with predictably strong growth. In this budding industry, growth is possible and even probable, yet relatively uncertain especially on a company by company basis.
What about oversight? It is easier to solve this problem by seeking the intermediaries. Altria and Constellation Brands have each taken significant stakes in Canadian cannabis producers. These are large, experienced management teams that can conduct significant due diligence to sift through the opportunities and partner with smaller firms which, in turn, allow them broad oversight to ensure accountability. They also have the expertise to expand the producers businesses with their existing networks and scale. The upside is more limited, as is the downside, since the cannabis investment is currently 10% or less of their total business, but risks are meaningfully reduced with this approach as well.
Cannabis and marijuana have been buzz words of late, and a lot of people have been caught up in the hype, buying stocks without much discretion. Please be aware, just because the landscape is changing and there does appear to be a real opportunity in the space over the long term, it does not mean that the available investments are good ones. Anyone diving into a speculative investment with the hopes of quick gains should be prepared for the possibility of the opposite, or to lose it all.