Cannabis Investing 2: Caveat Emptor
Updated: Jul 7, 2022
This article covers risks and mistakes made by companies, governments and investors in the past. It explains the need for due diligence while investing in the sector and highlights some factors to monitor and analyze further. The title is a warning, Caveat Emptor (Latin for “Let the buyer beware”), alternatively Caveat Investor – investors need to proceed with caution.
The data indicates that the Cannabis sector has been one of the most disappointing sectors for long term investors. I invested first in cannabis in 2016 with shares of Aurora Cannabis and sold my shares in 2018. I was lucky to have exited at the peak of the first cannabis bubble, driven by Canadian legalization.
The following charts for Aurora Cannabis, Canopy Growth and Tilray show historical (all time) share price performance for three well-known Cannabis stocks analyzed in this blog’s ANALYSIS category. You can click on each chart if interested to see detailed charts and data available on TradingView.com, an incredible site for stock market investors.
The Cannabis sector has so far had not one but two bubbles, both of which crashed. The first in 2018 was driven by Canadian legalization. The second was when Joe Biden, Chuck Schumer and other Democrats came into power promising Cannabis decriminalization and progress on legalization. The bubble peaked on February 10th 2021, and then started a painful crash then went on for more than a year as the Democrats failed to follow through on their promises.
To get a better picture of the extent of the damage done to shareholder value, one must look not just at share prices, but also at market capital and my preferred valuation metric for growth stocks – the Price to Sales (PS) Ratio.
The following chart shows the market cap for Aurora Cannabis (from YCharts) for the 5 year period from January 2017 till January 2022. A huge thank you to YCharts.com for giving me permission to share these charts. You can access latest charts by ticker on the YCharts website.
The market cap exceeded US$11 Billion in 2018 before falling, then once again hit almost US$4 Billion in February 2021 before falling.
The crazier picture is the P/S ratio, as shown once again using data from YCharts:
On Jan 23, 2018, Aurora Cannabis hit its peak PS Ratio at 176.37 during the Canada Cannabis legalization bubble. In Feb 2021, the PS Ratio went up to 11.44 during the bubble following Biden’s inauguration. Other cannabis companies have performed similarly, with Canopy Growth for example also having a high PS Ratios above 50 in Feb 2021.
Most investors in the cannabis sector are “bagholders”, who have either lost money or are holding high paper losses. Across the industry you see the destruction of shareholder value when you see the charts for share prices and market cap. Where did all that money go? The wealth has been transferred from investors to the following 6 categories:
1. Management, with their high salaries and bonuses
2. Investment bankers who made money from equity offerings and other services offered
3. Cannabis customers, who benefited from lower price and higher quality products
4. The government, from taxes
5. Hedge Funds and Market Markets who manipulate and short the sector
6. Traders who happen to be skilled or lucky enough to make money trading stocks in this volatile sector
Compared to other sectors, this sector would be a fiasco for investors. I have given much thought to what caused this disappointing performance for investors and would list the following:
1. Bad policies by governments that were not business friendly
2. Bad management decisions
3. Ignorant investors who behaved as lemmings running off a cliff
4. Bad players, who manipulate and short (or pump) stocks for profits
The goal for policy makers for the Cannabis sector should have been the same as the goal for policy makers when Alcohol Prohibition ended (1933). This would be to increase the size of the legal cannabis market, while decreasing the size of the illicit market. The illicit market benefit criminals who avoid paying taxes while simultaneously jeopardized public health without regulations in the products sold. History shows that the same thing happened during alcohol prohibition, where consumption of unregulated products with toxins (like methanol) led to illness, blindness and even death.
In both the US and Canada we saw policy errors that ended up making the legal cannabis market less competitive, and in the process benefitting the illicit market. In the US the Section 280E of the Internal Revenue Code is a tax burden that caused significant challenges in making the legal cannabis market competitive. This prohibits any company from taking standard business deductions on their federal taxes, if they traffic in federally controlled substances. Cannabis is currently a Schedule I substance under the Controlled Substances Act in the US. The US Drug Enforcement Administration (DEA) includes it in the same category as Heroin and LSD.
Restrictions on vertical integration in Canada, between producers and retailers was another factor that made it harder for companies to control costs (with better margins) and compete with the illicit market. Other restrictions, such as a 10mg limit on edibles and beverages in Canada, have also impacted competitiveness. This is made worse by the limited law enforcement activity to shut down many operators and websites that sell 1200mg chocolate bars and even higher potency gummies and edibles. Restrictions on the number of beverages consumers can buy is also an obstacle to the shift in consumption from alcohol to cannabis infused beverages.
One additional policy error we see ongoing in both Canada and the US is too many licenses issued leading to oversaturation of retail stores. This has impacted the small businesses most as they lack the benefits of economies of scale, easier access to funding and the inability to implement strategies such as vertical integration. Many are now struggling and shutting down.
While bad policies have been a factor in the sector’s lackluster performance, bad management decisions are equally to blame. In Canada, great errors were made by management and their advisors on estimating the size and potential for the cannabis market. This led to overcapacity and significant losses.
In some companies that executed poorly planned strategies, the high burn rate led to significant destruction in shareholder wealth. Through equity offerings via bought deals and At-the-market (ATM) offerings, acquisitions paid for by shares and other practices, share counts increased. Stock (or equity) dilution has been the greatest destroyer of shareholder value in this industry. Dilution leads to higher total shares outstanding and hence the decrease in existing shareholders' ownership percentage of a company. In essence, management took investors for granted and treated them as piggy banks.
Equity dilution is IMO, the single greatest risk that investors should look out for. It has led to the death of cannabis companies especially those who are penny stocks, and significant losses for shareholders. It is important to keep an eye on share count and analyze what the new shares are being issued for.
A factor to look out for is whether the dilution is being used to maintain high executive compensation, keeping the operations running or for acquisitions that don’t bring in revenues or earnings justified for the price of the acquisition. This is the sign of a management that treats shareholders with disrespect and is using shareholder wealth for personal gains. Shareholders eventually lose in this scenario. The only people making money are management and their advisors, including investment banks who make good money via equity offerings. Often excess dilution leads to a reverse split, and further dilution and decrease in shareholder value. Although legal, this is an incredibly unethical practice. I often wonder how managers who engage in destruction in shareholder value through dilution get to sleep at night, for this is essentially blood money built on the suffering of shareholders who believed in these managers.
Although dilution is highlighted as a risk, there are good companies and management teams who are responsible deployers of capital and treat their shareholders with respect. The factor to look out for is whether the dilution is being used for accretive acquisitions, defined as an acquisition that increases earning per share (EPS) for the company that is doing the acquisition. Accretive acquisitions are a sign good management, as they lead to growth in value for both the company and shareholders. It is important to review each deal to see if it increases value. Key metrics to look at are the multiples paid in terms of revenue, EBITDA, etc. Low multiples paid, especially during a bear market with low multiples across the sector, increase revenue and earnings, which will reflect in the market cap and share price of the company during a bull market with higher valuations. The other factor to analyze is the presence of any synergies from these acquisitions. I’ll elaborate on these topics with future articles and examples when I get a chance to create more content.
In addition to policy makers and management, investors are also to blame for the woes that plague the cannabis sector. Many investors invested in the sector without doing due diligence and without focusing on valuations. The behavior is that of lemmings running in a herd and falling off a cliff. The video below is a must watch for anyone interested in stock valuation, and is the first in a series of Valuation videos presented by Aswath Damodaran, Professor of Finance at NYU’s Stern School of Business.
In this video, Professor Damodaran talks about fighting the “lemming within you” and using valuation as a life vest. At exactly 3 minutes, Professor Damodaran says the following in context of the lemmings who blindly follow those in front of them:
“They must know something that you don’t. Remember those seven words. They are the seven most deadly words in investing.”
As an early cannabis investor, I remember hearing the exact seven deadly words being used by my mentor who got me to invest in the sector. We invested together in the sector in 2016 and monitored the news and updates from the companies in the sector. I remember Aurora’s bought deal (Jan 2017) in excess of C$50 million at C$27, slightly above our investment cost. I remember my mentor mentioning the seven deadly words as a way to justify staying invested, although at that time the stock was stagnating and getting frustrating to hold. The sector and most cannabis stocks boomed in 2017/2018. In 2018, Aurora bought MedReleaf for C$3.2 Billion and the combined company was the largest cannabis producer in the world and had a market cap around C$7 Billion. Valuations by that time were irrationally high and my mentor and I exited the sector, but we continued to monitor it over the years. It seems like a lifetime ago and Aurora now has a market cap more than 90% lower. I have used Aurora as an example but most cannabis companies fared similarly or worse. The Aurora of today is a different company and has pivoted towards medical cannabis rather than recreational cannabis.
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The other factor contributing to the poor performance of cannabis stocks is the presence of entities I will refer to as “bad players”. As you track these stocks you start to notice a variety of unusual and suspicious activities that indicate some degree of manipulation. Especially with lesser known stocks with low volumes traded, you see sharp share price decreases with low volumes, triggering stop loss trades and panic among investors. These are often accompanied by high volumes of trades on dark pools, and posts on social media designed to spread Fear, Uncertainty and Doubt (FUD) amongst investors. This is just my opinion as I can’t prove anything, but I believe manipulation has a role to play in keeping share prices suppressed at low valuations in spite of several companies growing revenues and improving fundamentals consistently.
I have tracked the industry since 2016 and have never seen investor morale as low as we have seen since the prolonged bear market cause by stalled US legalization. Many investors are frustrated with their investments. While share prices have disappointed, many well run companies in the cannabis sector have continued to grow revenues and strengthen their fundamentals. Some of the growth rates are phenomenal and well worth analyzing. The pages in the ANALYSIS category present detailed analysis on various metrics worth analyzing. And the remaining articles in this INVESTING category go into more detail into the investment thesis for the Cannabis sector.
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Disclosure: I (username Adastra) am an investor not a trader. I am bullish on the Cannabis sector as a long-term investment (2025 and beyond), provided stocks/ETFs are carefully picked based on data-driven due diligence. Of the 15 stocks covered in the Best Cannabis Stocks analysis, I own only High Tide, which I am holding as a long-term investment. But my analysis indicates (without any guarantees) that there is a potential for impressive gains in investing in the stocks best ranked in the analysis, including WM Technology, Trulieve, Curaleaf and any other stocks that will have a dedicated page. I reserve the right to buy or sell at any time any of the stocks mentioned in this blog. I do not short stocks and never will short any stock in a company that makes the world a better place. I do not have insider knowledge of any company covered in this blog. All data used for analysis is from public sources. I have received (as of last update date of this page) ZERO funding for this blog from any of the companies featured in this blog.