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As Weed Goes Legal in Canada What Does It Mean For Pot Stocks?

distilleries

It’s now more than 80 years since it started to become apparent that the American Prohibition’s days were numbered. As detailed by are recent article in The Economist, Prohibition in its southern neighbour was a huge boon for Canada’s distilleries. Alcohol may have been illegal in the USA but demand for it was never quelled. The thirst for booze was unquelled during the Swinging 20s and 30s and a huge black market business thrived.

Illegally selling and buying beer, a relatively low alcohol and high volume alcoholic drink, simply didn’t make good business sense. Too much work for too little money or too much risk for too little reward depending on what side of transaction you fell.

While home-brewed moonshine produced domestically by bootleggers was certainly a popular resort during Prohibition, the ‘good stuff’ was mainly the rum and whisky professionally produced by Canada’s legal distilleries and smuggled into the USA. Puget Sound, with its deserted beach that stretch for hundreds of miles between the coast north of Seattle and what is now the Olympic National Park in Washington State was a favoured drop-off point for ‘rum runners’ bringing Canadian liquor into the USA from British Columbia.

Alcohol’s legality in Canada during America’s ‘Noble Experiment’ of Prohibition made Canadian distilleries very wealthy businesses. While the decades that followed the end of Prohibition saw the influence and wealth of Canada’s distilleries wane as local U.S. rivals gradually gained market share, Hiram Walker and Seagram’s, still two of the biggest producers of hard liquor in North America, can trace their roots back to the strong financial foundations the U.S. Prohibition allowed them to build.

Several decades later the Prohibition scenario looks like it is being repeated. As of Wednesday this week, October 17th 2018, the sale and consumption of marijuana, or cannabis, for recreational purposes became legal. Canada is not the first country to fully legalise recreational marijuana, Uruguay did so last year and in several other countries such as the Netherlands it is close to legal, and nine U.S. states also permit it. But it is certainly the biggest, most influential country to take the plunge and its geography as a neighbour to the USA adds extra significance from a commercial point of view.

How long it might take for the USA to follow Canada by legalising the recreational use or marijuana on a federal level is guesswork but few now believe it is not simply a matter of time and there’s a good chance it will happen within a decade at most. The same can be said for most other countries in the developed world, including the UK. However, Canada’s legal marijuana companies certainly now have a head start and they will try to capitalise on that. They have a runway of probably a few years to build up both know-how in cultivation and distribution logistics as well as sales and marketing knowhow.

Perhaps most crucially, just like the Canadian distilleries back in the days of the Prohibition, they also have the opportunity to build wealth. And in the contemporary world of business and finance that opportunity is a far bigger one than it was back in the 1930s. Canada already has dozens of legal marijuana companies listed on its stock exchanges, many more trade over the counter, and a ten are also listed in the USA to take advantage of the bigger capital market. Tilray listed on the Nasdaq through a July IPO and next week Aurora, which is currently listed on the Toronto Stock Exchange, will complete a dual listing in New York. There are two U.S.-listed legal cannabis stocks ETFs made up of public pot stocks from both sides of the border.

Until now, while exciting, the huge bulk of the market for public cannabis companies, dubbed ‘pot stocks’, has been the medical marijuana market. The drug is legal for prescribed medical use over a far wider range of territories than is currently the case for recreational use. Despite the fact that capital has poured into legal cannabis, until now it hasn’t been a hugely lucrative industry. Over the 100 companies that are considered to be in the legal cannabis industry and tracked by Bloomberg, combined revenues totalled only $2.5 billion and losses, not profits, $1.2 billion. Their combined market capitalisation is only $76 billion. Over so many companies that is small fry.

It’s the legal recreational marijuana market where the real money is. Faith that it will quickly grow internationally over the coming years is why pot stocks have attracted so much investment and why the sector has a high value in terms of its earnings multiple. In the USA alone a future fully legalised recreational marijuana market is estimated to be worth $55 billion. To put that in context, it’s around half the size of the current beer market. Big business for a brand new, at least legally, product.

And the head start Canada’s pot stocks have mean they will be in the best position to take a large share of that market despite the fact that domestic rivals will inevitably quickly spring up. The big corporations recognise that as evidenced by Constellation Brands, the NYSE-listed maker of Corona beer, investing in a 35% stake in Canopy Growth, the second 24.1% stake valuing the company with the stock market ticker WEED at C$19 billion (£11.13 billion). Constellation’s peers and rivals, from Diagio to Coca-Cola and Altria (formerly Philip Morris) are also said to be in talks about similar moves with other big pot stocks if industry rumours are to believed. And it could be easily argued that they would be extremely foolish not to be.

However, while those investing online would do well to consider pot stocks as an interesting and potentially very profitable opportunity, a word of caution should be heeded. While the legal marijuana market takes shape and matures it is likely to prove a bumpy ride for investors. Not every company among those first to market will prove to have the business acumen and resilience in the face of the inevitable future international competition to go on to be successful. There will likely be consolidation in the industry and some will simply either fail or return to private ownership as more modest enterprises.

With financial markets giddy over the prospect of the first huge industry with proven demand since the Prohibition opening up for legal investment, a pot stock bubble is an obvious danger. New markets that show huge promise in their early years not only make millionaires and billionaires while they grow and mature. They are also fraught with danger for investors – dotcom anyone?

On Wednesday, the first day of Canada’s legal recreational cannabis industry, most of the leading pot stocks fell and fell significantly. Canopy Growth lost 4%, Tilray 6% and Aurora Cannabis 3%. The sell-off was presumed to be the result of ‘flippers’ banking quick profits but provided a warning for what might lie ahead by catching many investors, particularly retail investors, off guard.

The road ahead towards a mature legal recreational cannabis market is a long one. Investors are certainly presented with an enticing opportunity that many may do very well from in the long term. But investing in pot stocks is also unlikely to be the kind of ‘easy money’ that many may think it is. Companies invested in should be chosen with care and carefully researched. ETFs, made up of a range of actively picked stocks with exposure to the market, provide risk-diversification for those who are less experienced stock pickers but are also not a fool proof guarantee of legal cannabis investment success.

For investors pot stocks should certainly be on the radar but caution should also be the watchword.

Risk Warning:

Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.

There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

Paul

The author Paul