Cannabis stocks are in crisis mode, there is no doubt about it.
Last week alone the industry was down a whopping 11%, not to mention underperforming the S&P 500 by 34% in 2019.
Retail investors, the ones who provided the capital that built this industry, have been crushed under the foot of big cannabis as insiders and retail alike rush for the exits.
Industry Multiples in Freefall
Stock market capitulations like this are the forest fires of the capital markets.
These selloffs are extremely painful and absolutely devastating for current investors, but the corporate green shoots that are left behind will one day grow into large thriving companies.
Though this selloff certainly looks and feels like a four-alarm fire, sector valuations are finally reaching a palatable level.
If the market turns and investor sentiment recovers, these companies that screen cheap will raise the cash they need to stay in business and investors will be well rewarded.
However, if companies continue to struggle with financing into 2020, there will be a large-scale industry shakeout where the weak players run out of funding and go bust, leaving only the best-capitalized management teams standing.
We think the industry is closer to the end than the beginning of this selloff, but that doesn’t mean there isn’t more pain to come.
To help avoid the traps and pinpoint the survivors we use a decision tree approach.
Filter: Does the company have more than a year of cash? NO
Most management teams are plowing ahead with option B even though there is a serious flaw in this strategy.
The outcome for option B is exactly the same as A, in that the company is worth far less under both scenarios, but option B has the added risk of completely blowing up the company.
Option B will only work if the company can avoid diluting shareholders by more than 32%, otherwise, everyone was better off cutting to the bone and taking a hit on the trading multiple.
Option A is the clear winner among cash-starved pot stocks, but still pales in comparison to just simply buying companies flush with cash.
Filter: Does the company have more than a year of cash? YES
- These stocks should be the focus of your cannabis portfolio — Margin of safety.
- More years of cash the better.
- Larger market cap signals better shape and more valuable licenses.
Calling the bottom of any selloff is a mugs game, but looking at the potential newsflow we can at least handicap the probability of more pain ahead.
Adding up the potential catalysts, both positive and negative, it looks like sentiment is still solidly in the selloff category for now.
- Edibles rollout in Canada could be rocky. Products won’t start hitting store shelves until mid-December at the earliest and will take time to be fully distributed.
- Many companies are running out of cash.
- Vaping crisis is hurting demand.
- Canada Price to Sales still at 14x while U.S. MSOs at 4.5x, still 180% and 50% above the price to sales of alcohol, pharma, and consumer cyclical industries.
- Falling retail prices make future profitability and valuations very hard to forecast, leading investors to remain cautious.
- Institutions won’t enter until they have legal cover to own cannabis stocks.
- U.S. Price to Sales down to 4.5x from 9x only 6 months ago compared to 4.3x for the S&P 500 and 3.9x for consumer cyclicals.
- World Health Organization may de-schedule cannabis in March 2020 setting off a chain reaction of banking and or countrywide legalization in the U.S.
Capital Preservation Is Key
Focus on the low-risk survivors, companies with the cash to get through this capital drought and potentially even buy rivals out of bankruptcy for a song.
Cashed up companies form the support pillars of any cannabis portfolio and should receive the majority of your cannabis investment dollars.
For those truly aggressive investors looking to push risk and return to the limit, another option is to invest in management teams who are hunkering down, waiting out the storm with valuable licenses, IP or commercial contracts intact.
Pick the companies with the lowest cash burn and the deepest discount to net assets.
This is the nitrous oxide in the portfolio.
The companies that survive can access non-dilutive borrowing once the SAFE act passes and institutions open their wallets, ramp up revenue growth and return to trading at multiples far above the market.
Overall there is more than enough potential return if investors play it safe and own the stocks with a very good chance of weathering the storm.
Buying high burn rate companies when the capital markets are largely closed is a recipe for disaster in our view.
The Past is the Past, Time to Move On
Cannabis investors are likely suffering from regret bias in 2019.
Regret bias is when you sit on losing a position instead of selling at a loss and putting the money into a better company with more potential upside and less risk.
Some cannabis stocks just won’t recover from this downturn and the sooner investors can move on the better their future returns will be.
Pick stocks as if the cash you have left is brand new and your cannabis journey is just beginning.
The days of buying weak cannabis stocks for big gains are truly and completely gone.
Owning a cannabis stock starved for cash today is like playing Russian roulette, except in this case all but one chamber is loaded.
The risk of blowing away your portfolio far outweighs the outside chance you make some money.
Investing with a margin of safety is the only way to play cannabis stocks as the market works through a period of capital scarcity and investor panic.
Legal cannabis remains a rapid growth, multi-billion dollar opportunity so investors should not lose hope.
The night always looks darkest before the dawn.