Ever since Constellation Brands reignited interest in the cannabis space with $5 billion investment in Canopy Growth, the entire sector has been on fire.
As of August 29, Canadian producer stocks are up 30% in the past two weeks, with some US-listed companies such as Tilray (NASDAQ: TLRY) up an amazing 113%.
With short-term gains in the double digits what is an investor to do?
Investor Psychology Explained
Historically, when a stock or sector is making new highs day after day, it signals a general excitement among investors.
Academic studies have shown that dopamine is released in the brain when investors see they’re making money in the stock market.
Dopamine is the neurotransmitter responsible for the high we feel when doing something daring like driving fast or skydiving out of an airplane.
More dopamine in the brain leads to more risk-taking behaviour, such as chasing the herd and investing in stocks seeing the largest price increases.
Dopamine explains stock market bubbles and the crowding behaviour that often defines investing.
Beware of Rapid Price Appreciation
The cannabis industry is a brand new industry with excellent growth potential and deserves to see market leading stock performance.
However, even the best company can see its stock price run up too fast when investor exuberance reaches a peak.
Looking at previous stock spikes during the tech bubble, rare earths bubble and earlier this year in cannabis, we see a similar pattern emerging today.
When stock charts are going straight up and to the right they often fall soon after as many of the investors who rushed in for quick gains will sell in fear as they start to realize losses.
Cannabis stocks look to be setting themselves up for a correction.
Profits are Still Months Away
Cannabis stocks have significant earnings potential ahead of them, but with Canadian legalization still 47 days away, investors will not have fundamental cashflow to fall back on if stock prices correct.
The industry is still in its infancy and nobody knows how quickly it will grow or how profitable it can be.
With this lack of fundamental information, investor psychology and news flow are the main drivers of stock performance, leading to large up and down daily swings.
Top Ways to Protect Yourself from a Short-Term Correction
If you find yourself sitting on short-term unrealized gains of 30% or more, it may be time to realize those gains or look for safer and cheaper producers to own.
Moving money from a high multiple (expensive) stock into a low multiple (cheaper) stock is a smart way to both limit your downside and set yourself up to benefit from potential out-performance in the future as the cheaper stock catches up to peer valuation levels.
With the recent stock run in producers with premium multiples like Tilray (Ticker: TLRY), Canopy Growth (Ticker: WEED) and Cronos Group (Ticker: CRON), we think a smart strategy would be to recycle those gains into one of the more moderately priced growers like Aphria (Ticker: APH), Organigram (Ticker: OGI) or Hydropothecary (Ticker:HEXO).
Selling out of stocks trading at 35x-45x EBITDA into similar companies with multiples of only 8x-14x sets you up well to avoid a potential market correction as the cheaper stocks have not seen the same investor crowding and rapid run up in value as the rest.
Licensed Producer EV/EBITDA Multiple (2020)
An even more conservative strategy would be to realize your gains and wait to deploy the cash back into the cannabis industry until the investor euphoria subsides and the stocks correct by at least 15%.
New investors and significant sums of money flooded into the industry in August, but investors can be fickle and the stampede is likely to reverse itself temporarily.
Cannabis investors would do well to remember that even the best stocks never go up in a straight line.