Why Are Marijuana Stocks Declining?

BY: MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS

October 26, 2018

Little more than one week after the legalization of recreational marijuana in Canada, equities in the Cannabis sector are down collectively. Investors who have entered into the most recent rally understandably want to know what has changed so much post-legalization.

The answer is: not much, but unfortunately, that might be the problem.

There is an old adage in investing: “Buy the rumour, sell the news”. This is basically the idea of buying an asset class or sector in anticipation of new investors entering the space over some sort of impending event or news. Short-term investors tend to buy early into the “rumour” and “sell” to the news. The excitement over the first federal legalization of marijuana in a G7 nation certainly fit this bill, and we saw a lot of new investors entering this space over the last few months. It’s a natural inclination that some investors would seek to take profits, particularly in light of the fact that there doesn’t seem to be any significant events on the horizon.

At Horizons ETFs, we continue to believe that the Marijuana equity sector is still in its early stages and this is an exciting long-term investment space to watch. However, going into legalization, we have also cautioned about the high valuations of many of the stocks, particularly those of the larger licensed producers (“LPs”).

Even after this most recent correction, valuations of most marijuana producers remain high in the absence of being able to evaluate revenue from recreational sales. This is something that will take at least a few months to determine.

Right now, most of the big Marijuana names trade at a negative price-to-earnings ratio, since their share prices tend to reflect earnings expectations. We can apply a price-to-book ratio – but again, it’s a bit misleading because of what revenue growth could be. Any way an investor looks at it, most of the widely followed names are likely to be seen as expensive.

Source: Bloomberg, as at October 24, 2018.

In the absence of reliable, fundamental valuation methods as a means of valuing these stocks, sentiment and news will initially be the big drivers of investor returns. This makes this equity sector particularly volatile because investors can see firsthand that momentum can shift quickly, despite nothing really changing dramatically for the underlying businesses of these companies.

Causes for Pessimism

Branding: Something we brought up before recreational legalization was the importance of branding in other consumer products and the difficulty of establishing branding in the Canadian recreational market when packaging is obligated to be non-descript and advertising is basically nonexistent.

While it appears that, overall, there is a shortage of supply nationally – long-term that’s probably a good thing for producers with the ability to quickly add supply. At least initially, there doesn’t appear to be any rhyme or reason as to why Canadians have chosen particular brands of marijuana – it could very well be cost and availability.

This line of thinking hurts the rationale for owning the larger Marijuana companies, where there had been a consensus that they would have marketing and distribution advantages. Some of these advantages are irrelevant if users are not discerning about what they buy. 

Revenue will matter: The earnings over the next couple of quarters may well separate leaders from non-leaders. We would expect that companies that beat expectations could see a bump in valuations, where companies that fail to meet expectations could be punished, potentially significantly.

This could well be a new source of volatility and dispersion that investors will need to contend with. In our view, the diversification offered by the Horizons Marijuana Life Sciences Index ETF (HMMJ) and the Horizons Emerging Marijuana Growers Index ETF (HMJR) (both managed by Horizons ETFs) could be a more favorable way to invest in the sector. Much of the sector performance will likely be driven by a smaller handful of companies – however, which companies will be successful at this point is difficult to determine. Investors need to be ready for company failures in the Marijuana space. Certainly, it is unlikely that all these companies will be successful.

Causes for Optimism

International Expansion: We expect this will be one of the most significant sources of potential growth for Marijuana stocks going forward. The global medical marijuana opportunity dwarfs the total opportunity potential in Canada. Overseas sales of medical marijuana could be very lucrative in new markets that have opened up, such as Australia and Germany. One report from Grand View Research suggests the aggregate global medical marijuana market could be worth USD $55 billion by 2025.

Many of the Canadian LPs have already invested substantially in these foreign markets. However, a challenge is that the regulatory and political environment in these regions is likely going to favour domestic providers. The world is not going to give the global Cannabis industry to Canada. Strategically, through local partnerships however, many of the Canadian LPs seem well-positioned to capitalize on global growth.

Any further liberalization of the U.S. Marijuana market will likely have a big impact on valuations. Even the recent small movements forward – such as allowing Tilray and Canopy Growth to export marijuana to the U.S. for clinical trials – had a big impact on valuations. 

As the U.S. moves towards more legalization at the state level, and potentially the federal level at some point, stocks that have meaningful distribution opportunities in this market will start to garner attention. It’s hard to fathom how big the U.S. opportunity could be, but given that Canada’s recreational market opportunity is valued between CAD $4 to $6 billion by various estimates, it’s not out of the realm of possibility to see the U.S. market 10 times that size.

Edibles and Beverages: We are still a full-year away from the likely legalization of edibles in Canada. For many market observers, this is the big consumer growth market, as users look for commercially sold alternatives to smoking dried flower marijuana.

This is the aspect of the business that most intrigues commercial manufacturers of both alcoholic and non-alcoholic beverages. The appeal of edibles and their avoidances of the carcinogenic side-effects of smoking could have a lot of appeal with key demographics of consumers, most notably Millennials and women.

Ultimately, the biggest revenue to be generated from recreational marijuana sales could be disruption of Canada’s $22.1 billion alcohol market (StatsCan, 2017). 

In It for the Long-Term

The key takeaway from these opportunities is that they are longer-term in nature. A brand new industry is not constructed overnight, and investors will likely need to be patient to see new positive industry trends emerge that will support earnings growth.

In our view, using a combination of HMMJ and HMJR would provide exposure to a significant portion of investable Marijuana equities that have enough market liquidity to be held in ETFs. Using this diversified approach could be a way to continue to benefit from the potential long-term growth, while possibly reducing the impact of sector volatility. As this market matures, we expect the frequency of the volatility in this sector will likely decline.

Until then, investors who wish to remain invested in this sector have to be ready for sell-offs like we’re witnessing right now.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.