Cannabis Stocks: The Massive Gap between Fact and Fantasy

Our Two Cents on Cannabis Stocks

Perhaps the single biggest driver of the global cannabis industry has been the vast amount of risk capital raised by investors of Canadian-based companies, which in turn has been due to political leadership in Canada, and specifically by its Prime Minister Justin Trudeau.

A small but long-popular stock exchange in Canada, the Canadian Stock Exchange, is now even referred to as the Cannabis Stock Exchange because at recent count there were 146 cannabis-related companies listed there. As well, the Toronto Stock Exchange including its Toronto Venture board has numerous listings. Many of these companies are dually listed on NYSE, NASDAQ and OTC markets in the U.S. and Germany, and those exchanges also have other listed cannabis companies too.

Combined, I follow over 300 listings in the cannabis space. I also have been non-executive chairman of one aspiring company that is in the process of being sold. In addition, because of my interest in this industry, I initiated a course of study at the prestigious Howard University in Washington DC, taught by my associate Omowale Crenshaw, and I frequently blog about the subject at billcara.com.

Suffice to say, I have some business experience with cannabis although I have never been a user. For that, I can count on the expertise of many friends.

As a registered portfolio manager, I will also disclose that I have never invested client money in cannabis and for good reason. While all of us have unique circumstances and interests, the plain fact is that the cannabis industry does not yet measure up to the high standards required by most institutional investors. Moreover, over the past 3 to 5 years, extreme promotion in the financial media by these companies has already led to many 30- to 50-times gainers and I don’t see that early venture growth situation continuing.

Only the hype grows that fast.

The marketplace today is maturing, beginning to understand the facts behind the stories. We are discovering there is considerable distance between fact and fantasy.

In this article, I will present some of the hard data that we professional investors review for all stocks. In my case, every week we relatively rank the fundamentals of over 5100 companies based on high quality data from Big Data companies Thomson Reuters and Bloomberg, and every day we also run price trend and cycle-based algorithms against this list. We have two main portfolios: (i) the S&P 500 Top Picks portfolio in which we invest in S&P 500 components on the basis of their relative fundamental growth, value and yield scores to try to out-perform the S&P 500 index, and (ii) a Natural Resources portfolio.

Some wags would have us want to consider cannabis as a natural resource, but that is a bit of a stretch for clients.

Of the total 5100 companies we rank weekly, there are only some 400 that we consider as viable candidates for investment although because there are relatively few natural resource companies, we do expand that particular group of candidates beyond the very best company fundamentals performers.

This past week, there were 4282 companies that met the criteria for scoring Relative Growth, as well as 3103 for Relative Valuation and 1656 for Yield.

For cannabis companies, none met the required Relative Ratings minimum scores that we require for client investment and none came close. Of the 21 cannabis companies we had wanted to study for this article, we were able to evaluate Relative Growth scores of 16 from the Thomson Reuters database, and that included seven from our study universe of 5100.

In due course, many more cannabis companies will be followed by broker-dealer analysts, which will lead to ratings by Thomson Reuters and Bloomberg and hence into our study universe.

For our purposes today, we ranked the 16 cannabis companies on Earnings, Balance Sheet, Relative Valuation, and Risk with each getting a Composite Average Ranking.

Because of the extreme volatility of stock prices, we decided to drop Price Momentum as a ratings factor. We prefer to see how these companies walk the talk. Almost none of them do.

Measuring Relative Growth, of the 4282 companies we ranked this past week, there are seven cannabis companies that qualified for Ratings. Each trade on the Toronto Exchange, of which five are also listed on the NYSE or NASDAQ. Except for Hexo Corp (a fairly good ranking of 1254 out of 4282), the Relative Growth scores are middling for Canntrust Holdings (2245) and poor for the other five: Aphria (2859), Tilray (3058), Cronos (3453), Canopy Growth (3799), and Aurora Cannabis (3809).

These scores are substantially different than public perception, which is why I labeled this article Fact vs Fantasy.

Moreover, because of their hyper-inflated share prices, none of them qualify for ranking on a Relative Value basis. And forget yield because none of them pay a dividend.

Let’s examine the data more deeply.

Based on Composite Ratings, only Organigram Holdings (at 6.25 out of a highest 10 score) and Aphria Inc (at 6) had scores typical of S&P 500 company average performance. The other scores ranged from 3 to 5.

Clearly, cannabis is a new and rapidly evolving industry that does not yet measure up to the basic requirements of institutional investors.

Relative to Earnings, only Organigram (10) and Aphria (9) were acceptable on that basis.

Earnings Ratings (which do not correspond to absolute earnings) are based on Earnings Surprises, Estimate Revisions and Analyst upgrades and downgrades of earnings in the past four months. What investors most want to see here are analyst upgrades based on earnings surprises.

Based on the Fundamentals strength, the acceptable companies were Canntrust Holdings (9 out of a highest 10) followed by Aphria (8), Aurora Cannabis (8) and Organigram (7).

The Fundamental Rating is based on Profitability (Rev growth, gross and net margin and return on equity), Debt and Earnings Quality (Free cash flow, and days of sales in inventory and receivables).

What conservative investors want to see are high profit margins, low debt levels and (if possible) dividends. For cannabis companies, there is a competition to survive and grow. They are most keen to seek an investment or buy-out by a larger company, so dividends are unlikely. Their gross margins are nowhere close to net margins in terms of what investors want to see.

Based on Relative Valuation to the broad market, none were truly acceptable to conservative investors; however, Canopy Rivers (scoring a 6 ) came close for consideration. In the case of almost every cannabis company, the valuation multiples were awful.

The Relative Valuation Rating is based on (most importantly) Price to Sales, plus (equally) Trailing PE and Forward PE.

When I hear or read about the grandiose performance these companies are going to have two or three years out, I tune out. But if the Earnings and Fundamentals Ratings are acceptable and improving, then on a trading basis I think the interest level of any company in this industry is justified.

Based on Risk, the only acceptable companies were Hexo (8), which was the least risky, followed by CannTrust, Aurora Cannabis and Organigram, each of which scored an acceptable 7 out of 10.

The Risk Rating looks at 5-year and 90-day stock performance measures including volatility, magnitude of returns, beta and correlation of returns to the S&P 500.

Volatility alone is going to rule out many cannabis companies for conservative investors although that is what short-term traders want to see.

To begin this article, I noted that Canada took the capital raise lead for this industry, and I have been involved a bit in that process, so my personal comments may be important to some of you.

I happen to believe that Canada is well positioned to soon be crushed !! by global competition in the rapidly evolving cannabis industry. In fact, sadly, I believe that Canada will become the example to the world of what NOT to do to build a sustainably successful cannabis industry. Speaking as a Canadian, our cannabis industry will probably one day be a Harvard Business School case study… the biggest flop of first-mover advantage since Napster. The best of them will be taken over and the rest will rot.

Many months ago, I concluded that Canada is now in a financial bubble for cannabis. Speculators in this country have invested lots of money for sure; however, let’s see where they stand after the US has federally legalized cannabis and removed it as a Schedule 1 drug from among stuff like heroin, LSD and Ecstasy, and worse than the narcotics in the Schedule 2 category, like oxycodone and fentanyl. The US industry will then see a lot more legitimate investment, which will flow out of Canada. Soon the world will have legalized cannabis for personal, recreational use or for medical use and American capitalists will take control.

In hindsight, I believe all of us who were observant from the early years knew what was happening with legal cannabis in Canada and then recently we began to discuss how our country has been badly blowing this advantage because of over-regulation, corruption, and oligopolistic political desire.

The undeniable truth is that the Canadian cannabis industry was pioneered by politicians and former police. Political favors were the principal drivers and that is still true today, particularly in Quebec and in Ottawa. Take note of HEXO and its Liberal Party connections. Anyone truly experienced with cannabis-centric business acumen has been ostracized. Cannabis is both federally and provincially regulated and these regulations are, in a word, terrible. Today, the regulatory policies of Health Canada of the federal government are crippling. The provinces are scrambling to maintain a modicum of control and for the same reasons are failing badly. Canopy Growth Corp, in fact, can only get 55% of their capacity to the market for sale.

The legalized industry in Canada will never realize its potential for reasons that are not being widely discussed. As I noted, regulation is a problem, but there are too many problems to mention. That its LP’s are forced to charge excessive prices to make a profit is just one of them.

With almost every professional cannabis report and the ubiquitous public media, there is much talk of excess capacity, which means pricing won’t be the issue in the long run, margin will. And capacity metrics mean nothing — just like “hits” was a meaningless metric of the internet service companies in 1999-2000. Moreover, a lot of production doesn’t mean much when the end-product is mostly junk according to the knowledgeable consumers I talk to. Only Aphria’s Broken Coast product gets a barely acceptable score from them.

Does the legal, accounting and financial community of Canada (or anywhere really) recognize the huge product quality difference between the thriving illicit market and the Licensed Producers? Have they visited these LP’s premises to study their production and follow through to the independent labs that are testing their end-products? Who among the millions of investors has read a laboratory report based on gas chromatography and mass-spectrometry detection? As well as the ubiquitous inferior quality issue, which professional reports in the hands of the public have mentioned the mold, the cross-contamination, the excessive cost of the production that is actually sold to consumers?

Growing great cannabis is not like growing lettuce.

About quality, even the best of the LP’s fails to produce anything today that is decent according to one of my associates. This industry expert opined to me: “Most cannabis is a global commodity and the illicit market, which does produce the best quality product, and has lowest prices will continue to own the lion’s share. The cost of the good stuff is presently running C$160 for 28 grams on the grey market of some of the above stuff, if you’re in the know. You’re the math expert. How are retailers going to sell for $10 a gram of bunk, once the novelty wears off? Let’s remember, we have a cannabis-friendly govt right now. Wait a few years when a new govt is in and the hot topic is to raise sin taxes even more… About the stocks, TGOD is one that will make it and thrive long-term and I own the stock. The only one I own. They have the best grower, solid management and Tim Seymour on their board. And, HEXO also should be good, but their CEO is terrible. They have a lot of greenhouse capacity that produces bunk weed. HEXO’s value is in its relationships with govt and Molson. They are a take-over target. I did own their stock but sold a few months back. Tired of this mismanagement.”

Conclusion

Everybody seems to have a different view of cannabis, and many are highly opiniated. For me though as an investment pro, I just stick to observations and analysis based on big data. My bottom-line on the subject: Most exchange-listed cannabis companies are terrible businesses that I will not invest in. Personally, I’m waiting for the right time to buy put options.

APHA.TO Aphria Inc