High Expectations For Marijuana Stocks Suited For Speculators Only–For Now

Most Western nations are becoming more permissive toward marijuana, so companies that legally produce and sell marijuana should enjoy strong growth over the next few years. The concept is so simple and appealing that even conservative investors are buying shares in marijuana start-ups, and a mutual fund or exchange-traded fund that focuses on the marijuana industry can’t be far off.

Investors are especially enthusiastic about Canadian pot producers, as this spring the federal government is set to act on the recommendations of a task force on marijuana legalization, which reported late last year. Once marijuana is legalized for both medical and recreational or “lifestyle” use, likely sometime in 2018, investors expect Canadian pot producers’ sales and earnings to skyrocket. This optimism has pushed up the shares of publicly listed Canadian marijuana companies so they trade at many times their sales and book value per share, and once they start showing some earnings, their price/earnings ratios will be stratospheric.

Unfortunately, universal enthusiasm rarely works out for investors.

Although the prospects for the industry are legitimately bright, buying shares of any relatively new company is risky, particularly when their shares are, as the saying goes, priced for perfection. This makes marijuana stocks a bad choice for investors who are poor, retired or old (or all three) or predisposed to sell at the first sign of trouble. Your children or grandchildren may be better positioned to invest in the sector, but even then, they should invest only a tiny part of their portfolio in the industry.

Until the law is changed, only medical marijuana may be legally sold to registered patients, technically making pot producers biotech companies. In the biotech sector, even minor setbacks can have a disastrous effect on the share price. If a marijuana company’s products were found to contain carcinogens, pesticides or other contaminants, it could trigger costly product recalls and liability claims, and even shift public sentiment away from legalization entirely.

This shift may be happening in the United States already, as the new Republican administration is likely to portray marijuana in an unfavourable light.

Writing in the Financial Post, James West, author of the Midas Letter, warns that Donald Trump’s nominee as U.S. Attorney General, Jeff Sessions, is opposed to marijuana legalization and has the power to reverse legislation.

Eight U.S. states—Alaska, California, Colorado, Oregon, Massachusetts, Maine, Nevada and Washington —have legalized both medical and recreational pot, while Washington DC has legalized personal use but not commercial sale.

Legal sales in those states “could all be destroyed with the stroke of a pen by Sessions, should he decide to aggressively dismantle legal marijuana in the U.S.,” Mr. West writes. “Sessions' pursuit of marijuana re-prohibition could be a killing stroke for the nascent industry,” he writes, noting that high prices for Canadian marijuana producers are partly the result of interest from U.S. investors who recognize that Canadian names are a safer bet.

Late last year, the Canadian government’s Task Force on Cannabis Legalization and Regulation released a report containing recommendations on how governments should control access to marijuana, focusing on public health and safety. The 75-page report, viewable online at http://www.healthycanadians.gc.ca/task-force-marijuana-groupe-etude/index-eng.php, says marijuana should only be available to adults, that advertising and promotion should be restricted, and that production, packaging, labelling and distribution of marijuana should be properly regulated. Among its many recommendations, the report suggests the federal government “use licensing and production controls to encourage a diverse, competitive market that also includes small producers.”

The government will examine the report this spring and even if marijuana is legalized next year, ongoing changes to regulations mean producers will likely have to retain lawyers to ensure they remain in compliance.

In materials for investors, all the publicly listed companies now licensed to produce medical marijuana under the Access to Cannabis for Medical Purposes Regulations (ACMPR) boast about their prospects, with emphasis put on numbers of registered patients, large and expanding production capacity, high gross profit margins and low production costs. Almost all publicly listed Canadian marijuana stocks traded for less than $1 until last summer, when they began climbing dramatically and peaked in November.

Here is a brief look at some of the largest producers. Neither I nor anyone in my family owns shares in any of them.

Canopy Growth Corp. (CGC/TSX)

Canopy, the largest publicly traded Canadian marijuana producer, is the only one that trades on the TSX proper, having graduated from the TSX’s junior Venture exchange last summer. Canopy has a market capitalization (shares times share price) of $1.3-billion, and leads the industry in sales and assets. Canopy’s size makes it the most likely candidate to acquire its smaller competitors.

A former Hershey Chocolate factory in Smiths Falls, Ontario, houses Canopy’s head office and 168,000 square feet of indoor marijuana growing facilities, along with laboratories and other research and development space. Canopy also owns the 375,000-square-foot Tweed Farms greenhouse in Niagara-on-the-Lake, Ont., and Bedrocan Canada, a 52,000 square foot facility in Toronto.

The company is licensed to turn out more than 13,500 kg of cannabis and more than seven million millilitres of cannabis oil.

In December, Canopy paid $430-million or $8.42 per share to acquire Mettrum Health Corp., adding two brands and increasing its production facilities to 665,000 square feet.

Last year, Canopy formed business partnerships with companies in Australia and Brazil, while its Tweed Inc. subsidiary won approval to export medical marijuana to Germany.

Canopy’s shares jumped above $15 in November and despite setbacks have managed to stay over $9 since then. Figures from Morningstar show that at a price of $9.30, Canopy’s shares trade at a lofty 6.4 times book value per share and 38.6 times sales per share, reflecting tremendous optimism.

Aurora Cannabis Enterprises Inc. (ACB/TSX-V)

Aurora, based in rural Cremona, Alta., listed on the TSX Venture Exchange in October. Since then Aurora’s shares have fluctuated between the $2 and $3 level and the company now has a market capitalization of about $710-million.

The company has a cash position of about $50-million, 10,800 active registered patients and, once its new 650,000-square-foot facility at Edmonton’s airport is built, will be able to turn out more than 70,000 kilograms of marijuana per year.

Aurora’s shareholders, like Canopy’s, are optimistic. Figures from Morningstar say Aurora’s shares trade at 13.5 times book value per share and 73.7 times sales per share.

Aphria Inc. (APH-TSX-V)

At a recent price of $5.19, Aphria has a market capitalization of $590-million, trading at about 10 times book value per share and 68 times sales per share.

Aphria has 52 acres in Leamington, Ontario and is buying 200 as-yet-unlicensed acres near and adjacent to its existing site. The company also has a 15% interest in a 40-acre Copperstate Farms in Arizona.

It the first quarter of its fiscal 2017 year, the company had $4.4-million in revenue from 585 kilograms of marijuana sold, generating $895,000 or one cent per share in net income.

Aphria’s management team is impressive. CEO Vic Neufeld was chief executive at Jamieson Laboratories, a well-known manufacturer of vitamins and supplements, while co-founders Cole Cacciavillani and John Cervini are veterans in greenhouse operations.

PharmaCan Capital Corp. (MJN-TSX-V)

PharmaCan does business as Cronos Group, a merchant bank with interests in several licensed medical marijuana producers. Cronos owns 100% of Peace Naturals, which has 95 acres in Simcoe County, Ontario and 100% of The Zone, located on 14 acres in British Columbia’s Okanagan Valley, together with interests in other producers and licence applicants. At $1.50, the Morningstar site says the company has a market capitalization of about $180-million, while its shares trade at 5.8 times book value and 33.2 times sales.

OrganiGram Holdings Inc. (OGI-TSX-V)

OrganiGram, based in Moncton, N.B., has two buildings on 14 acres, turning out 4,200 kilograms per year, with plans to quintuple production by the end of 2017. At a share price of $2.72, OrganiGram has a market capitalization of about $230-million, a price/book ratio of 5.5 times and price/sales ratio of 20.9.

ICC International Cannabis Corp. (ICC-TSX-V)

Although listed in Canada, ICC is based in Uruguay, where marijuana is legal for both medical and recreational purposes. Like other producers, the company is expanding its greenhouse operations, but its focus is on the South American market, including the medical marijuana industry in Brazil.

ICC’s shares have slipped below $1 and the company has a market capitalization of about $100-million.

Emblem Corp. (EMC-TSX-V)

Emblem, based in Paris, Ont. says it has plans and funding in place to expand its annual production to 12,000 kilograms and eventually 21,000 kilograms per year.

Emblem, which listed on the TSX Venture exchange in December, has a market capitalization of $54-million, based on recent share price of $4.22. At that price, its shares trade at 71.4 times book value.

Over the next few years, some mismanaged grow-ops will fail, the larger ones will swallow the tiny ones and a few large, profitable producers will emerge, ripe for acquisition by biotech or agricultural giants. At that point, they will be suited for conservative investors. Until then, I am of the opinion that, marijuana stocks are suited only for day traders, technical analysts and other speculators. If you feel you must invest, wager a tiny stake on Canopy, but be prepared to wait. And don’t bother with any U.S. marijuana stocks at all.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca