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.