The logic was always obvious. With countries across the world slowly legalizing marijuana, the demand for legal marijuana would skyrocket. Companies and investors poured money into marijuana businesses which could not lose and promised fantastic growth rates.
But marijuana companies have taken a beating over the past few months. Once darling stock Aurora Cannabis (NYSE:ACB) has lost nearly 70% of its value compared to six months ago, with Seeking Alpha warning that it could tumble still further. The Alternative Harvest ETF, the largest marijuana ETF with assets of over $800 million, has lost nearly half of its value over that same time period. The marijuana market, which had expected a fantastic 2019, has entered a major bear market.
If you decided to get out of the market at the earlier peak, good for you. But for everyone else, this crash should be a reminder that hype cannot compete with fundamentals and prudence. And there are a lot of reasons to be skeptical about the marijuana sector despite its supposed massive growth potential.
Where are the Profits?
Marijuana analysts can point to myriad factors for this value decline over the past year. Fears of a marijuana oversupply in the Pacific Northwest and Canada have driven prices down and put growers out of business. The legal process of going into marijuana remains difficult. New concerns about vaping with resulting government regulations will harm the marijuana industry.
But another factor which could keep things difficult for the marijuana industry is the story of WeWork. WeWork is a “tech” company which just last month looked like it would go public and make millions, but has all but collapsed a few weeks later as investors took a second look at the company’s finances and lack of profitability.
Investors have been willing to accept an unprofitable company if it can show high growth potential. For example, Aurora Cannabis reported a 2019 fiscal year revenue of $247 million in 2019, up from $55 million in 2018 and $18 million in 2017.
But WeWork’s fall as well as concerns about a slowing U.S. economy means that investors now want to see profitability as much as growth, and marijuana companies are not profitable. Aurora has recorded gross losses for three of the past four fiscal years, never mind net income. Other companies like Cronos Group (NASDAQ:CRON) have reported operating or net losses in recent financial statements. Maybe some of these companies can become profitable, but it is difficult to imagine all or even most can. And with a potential marijuana oversupply, companies cannot easily resolve this issue just by growing more weed as that will further depress prices.
Still Overvalued
Marijuana has attracted a great deal of attention and hype, but investors cannot forget what it is. It is a plant. A crop. A drug, and not a particularly addictive one at that requiting alternative drug addiction treatment. Its value and profitability have come from its illegal or semi-illegal status as much as anything else, and that will disappear as legalization progresses.
And despite this recent fall in prices, the fact remains that marijuana companies remain ludicrously overvalued. Cronos has a market cap of $2.9 billion yet recorded a 2019 first half revenue of CAD $16.7 million, and is thus approaching a P/S ratio of over 150. Other marijuana companies such as Aurora are trading at lower yet still high ratios around 20, numbers which are comparable to tech IPOs.
Marijuana companies would love to compare themselves to rising tech companies, but that is a pipe dream. Even in the best case scenario where marijuana becomes legalized globally, marijuana growers will never achieve the pull of Facebook (NASDAQ:FB) or Alphabet (NASDAQ:GOOGL). The very real scenario is that marijuana could end up like other plants, where growers and businesses struggle to earn mere pennies on the dollar.
Marijuana advocates can point to companies which sell ancillary products to pot growers under the logic of selling shovels during a gold rush. CannaOne Technologies (OTCMKTS: CNONF) and KushCo Holdings (OTC:KSHB) are examples of this. The former is offering proprietary technologies to start-up marijuana businesses and expects to have marketplaces in Mexico and the UK. The company’s stock price has proven robust and this is one of the few exceptions, when it comes to marijuana companies, that bucks the negative trend.
CannaOne Technologies’ eventual goal is to sell high quality cannabis products to thousands of households, giving them a potential moat to becoming an e-commerce hub for marijuana. This is an example of where investors can find value in the right places, as opposed to going for the biggest marijuana business or thinking that profits can come from a low-margin agricultural crop.
What Happens Next
Enterprising businesses like CannaOne represent marijuana 2.0, but they cannot conceal that existing marijuana investing is filled with more hype than prudent value investing. Yet despite these concerns, the marijuana industry should be expected to grow rapidly as more countries move towards legalization. And practically any rising industry has had a moment where relentless hype for the “cool new thing” created a bubble, and more mature and prudent growth resulted after the bubble popped. Think of the late 90s dot com bubble, when the Internet was a mere shadow of what it is today.
Marijuana cannot be the cool new thing forever, coasting on growth potential like WeWork or tech IPOs. If marijuana companies are to succeed over the long term, they must show that they can become profitable, navigate a highly difficult legal and regulatory framework, and rise above other competitive businesses which risk oversaturating the marijuana market. I don’t know which companies will succeed and fail in such a difficult environment. But I do know that investors can no longer pick any random marijuana company and coast to success on the assumption of high, rapid, endless growth. Picking the right companies requires careful research and a good look at financials and fundamentals.