Home Stock & Shares Pot Stocks Have Suffered A Correction But This Is Still A Sector Very Much Worth Watching

Pot Stocks Have Suffered A Correction But This Is Still A Sector Very Much Worth Watching

by Jonathan Adams
stocks

2019 is turning out to be a bad year for ‘pot stocks’ – the term given to shares in companies that service the legal marijuana market. The ETFMG Alternative Harvest ETF, a passive tracker of the ‘pot stock’ index listed on New York’s NYSE Arca and probably the easiest and cheapest way for investors to add diversified exposure to the legal marijuana sector, has lost around a third of its value this year.

Shares in some of the ‘frothier’ individual companies in the sector have seen values slide by up to 80% this year. Often after gains of up to 150% over the preceding 12-month period.

ETFMG Alternative Harvest ETF December 2018-December 2019

bloomberg markets

Source: Bloomberg.com

But what’s gone wrong for pot stocks over the course of 2019? And is the sector still worth keeping an eye on for investors who have yet to take the plunge but have been interested observers? We believe there still is despite, and to no small extent because of, the drop in value of public companies in the legal marijuana sector have suffered this year.

Why Have Investors Been Turned Off Pot Stocks In 2019?

The most obvious reason why pot stocks have gone off the boil in recent months is that they had probably entered bubble territory and were over-valued as a result of a gold rush as investors became over excited by the upside the new and quickly growing legal marijuana sector offers. Some analysts, albeit mainly industry insiders rather than the generally more conservative position of independent experts, have forecast use of the drug will grow 500% to 55% of adults in the USA, within ten years. That would place the use of legal marijuana on a similar footing with that of alcohol – a forecast that it is hard not to see as overly-optimistic. At least within a decade.

But industry insiders and proponents believe that recent valuation falls are less a result of over ambitious market growth projections, though it’s hard to argue those have not been a factor, and more about kneejerk investor behaviour. Hadley Ford, the co-founder and chief executive of iAnthus, one company that has lost 80% of its market capitalisation over this calendar year and had gained around 150% over 2018, told the Financial Times:

“When stocks run up there’s always this irrational exuberance on the upside. There seems to be an irrational downside as well. Obviously, the entire sector is just wildly oversold.”

If Mr Ford is right, that would mean now represents a good buying opportunity for investors interested in, at the right price, exposure to pot stocks. But is there also further potential downside before things get better?

One factor that has contributed to investor sentiment around pot stocks plummeting is a slowdown in the number of new U.S. states legalising the drug for full “recreational” as well as medical use. It has reached 11, including the huge market of California, but there is no clear timeline now when other big states might join the party. Big northeast U.S. markets such as New York, New Jersey and Connecticut have seen regulators take a more cautious stance and have not pushed forward bills in favour of legalising recreational use of marijuana. Momentum towards legalisation across the USA has, at least for now, stalled.

And there’s another problem. Even in territories, like Canada which last year become the first G-7 nation to fully legalise the recreational use of marijuana, many buyers are continuing to opt for the cheaper, non-taxed, product sold by unlicensed dealers. Basically, rather than pay a little more for a legal, regulated and taxed product, a significant part of the market is still buying marijuana on the black market. That’s led to a legal marijuana surplus estimated at some 400 tonnes, sitting in warehouses.

Another negative that has dampened demand has been the problems that have this year engulfed the vaping industry. Vaping, which is an alternative way to smoke either nicotine or marijuana using devices that apply a higher level of heat than the burning of traditional smoking, resulting in a ‘vapour’ rather than smoke, was thought to be, and marketed as, a much safer method of consumption. But the emergence of a string of illnesses related to vaping has dented confidence.

The combination has seen demand growth for legal marijuana over 2019 grow incrementally rather than exponentially, as optimistic market forecasts had expected it to. That’s seeing the nascent legal marijuana industry being compared to the pre-dotcom crash tech sector.

There are certainly parallels that can be drawn. Fast-growing start-ups attracting high levels of investment capital, both institutional and private but having to contend with regulatory barriers and more sceptical and reactive investors once they become public companies.

Pot stocks are also difficult to trade because the drug is still technically illegal under U.S. federal law, even if numerous states have legalised it for either medical or recreational use, or both. That means many stock brokers and investment platforms don’t offer the stocks to retail investors. Ironically, while the major Wall Street exchanges such as the NYSE and Nasdaq have no issues listing large Canadian pot stocks, such as Canopy Growth and Tilray, which both have U.S. listings, they do not list U.S. companies because of the federal-level illegality of their business. This means U.S.-based pot stocks are often forced to list on Canada’s exchanges.

Large U.S. banks often also don’t lend to companies in the legal marijuana sector and they can find it difficult to manage their finances as many basic financial services, such as bank transfers, can be restricted.

As a result, the legal marijuana industry is spending huge amounts of cash of federal lobbying – $3.8 million over the first nine months of the year, according to data from the Center for Responsive Politics.

marijuana

Source: opensecrets.org

Steve Fox, strategic adviser to the Cannabis Trade Federation comments:

“We’ve invested a lot of resources into really making a push during this session of Congress to have significant changes.”

That investment is seeing some return. In September of this year (2019), the Safe Banking Act was passed by the House of Representatives. The act means federal banking regulators will no longer be able to act against banks that lend to legal marijuana companies. And in November the House’s judiciary committee advanced the More Act bill with a majority of 24 to 10. 22 Democrats and 2 Republicans made up the 24 in favour. If the Act were to advance to the point it passed into law, it would decriminalise, though not legalise, the use of marijuana at a federal level.

Optimising fuelled by those developments, some legal marijuana companies are gearing up for a market that encompasses the entire United States. Centralised manufacturing plants are being positioned to offer a logistics launch pad to serve the entire country. Cannabis One is one company taking that approach with chief executive Jeff Mascio, explaining the strategy of establishing new manufacturing facilities with “we will be able to scale those up and distribute to the entire country.

For companies able to take on the financial burden of such planning for a future market spanning the length and breadth of the USA, there is an obvious incentive. At that point the market will genuinely be huge. Bank of America, which has been covering the legal marijuana industry since April, estimates global sales will total $166 billion in 2019. The legal market of Canada and the U.S. states that have passed legalisation legislation, account for only $15 billion of that total.

Why Investors Should Keep An Eye On Pot Stocks Despite The Major Correction Of 2019

With policy the biggest barrier to pot stock companies accessing their full potential market, it is not surprising that the amount of money being funnelled towards federal lobbying has increased so much. But practically speaking, it seems like a full legislation bill will not be possible before 2021, at the earliest. For that to happen, Republican lawmakers will have to change their position. But there is a chance that could happen in the run up to the next presidential elections. As Mr Ford comments:

“The big irony here is that cannabis is one of those few issues that has majority of votes on both sides of the aisle.”

That means Republican candidates could use their support of legislation decriminalising or legalising marijuana on a federal level as one promise to voters – with millennials voters a particular target as most likely to support legalisation.

So in terms of legislation, there is hope that the coming years will see a much bigger market open up for legal marijuana companies. Many stock market analysts hold a position of bearish sentiment on the short term prospects for stock pots. But believe the longer term horizon offers much more encouragement.

The positive long term prospects for pot stocks rely on three factors.

Diversification – the legal marijuana market is a diverse one. The first big contributor to that diversity is the major distinction between the medical and recreational use markets. Both have different drivers and geographies. Europe is much more focused on the legalisation of marijuana for medical use, and is home to some of the most developed medical marijuana companies. A prime example of such is the UK’s U.S.-listed GW Pharmaceutical, which already owns a potentially very valuable intellectual property resource.

Validation – the future success of pot stocks, both in the recreational and medical markets, is tightly entwined with validation. Or earning greater trust from consumers. In the medical sector, that means more positive clinical trials overcoming regulatory cold feet. In the recreational use sector, validation will come with larger consumer brands trusted by users.

Achieving the level of validation needed to spur market growth will, for both medical and recreational sectors, involve time and money. But once a tipping point is reached, market growth rates would be expected to benefit enormously.

Legislation – the final factor is the one mentioned earlier – regulatory change. In the UK, neither of the main political parties are prioritising marijuana legalisation legislation for now. But, as already mentioned, more movement is expected in the USA.

Analysts at Barclays Bank recently commented in a note to investors:

“The US federal government is moving towards adopting a more accommodative cannabis policy given increasing public acceptance, growing support from state and federal government officials, and the prospect of sizeable economic benefits.”

As well as potential leverage to win millennial votes, the potential tax revenue is another major driver of possible marijuana legalisation in the USA. Colorado, the first U.S. state to fully legalise recreational use of marijuana, brought in $223 million in tax revenue from the sector over the first nine months of 2019. That puts it on track to significantly improve upon the $226 million generated over 2018.

Where To Look For Pot Stock Investment Exposure?

For investors with a long term view, interested in exposure to pot stocks, what are the options? We’ve already mentioned the ETFMG Alternative Harvest ETF, which offers low-fee and diversified exposure to the whole North American industry. Its 2019 slump means it now offers significantly better value than it did a year ago. But investors might wonder how long the bear market might continue and if now or later is the right time to invest. One work around would be to drip feed money into the ETF, rather than try to time the market.

Financial Times columnist David Stevenson also believes the U.S.-based legal marijuana companies that operate across multiple states, known as MSOs (multi-state operators), both offer better value than most of their Canadian peers and are well positioned to potentially benefit from merger and acquisition activity over coming years.

U.S.-based MSOs, says Canaccord Genuity data, trade at an average multiple of 7.9 times of their forward-looking (expected revenues over the next 12-months) EV/Ebitda ratios.

Mr Stevenson also thinks medical cannabis companies operating in Europe are worth keeping an eye one. These companies could also quickly diversify into brands targeting the recreational market as legislation changes as they will already have their logistics in place and many of the kinks faced by new companies ironed out. He also believes financiers of the legal marijuana market are worth keeping an eye on as well as businesses that do not sell the plant itself but growing equipment such as industrial greenhouses and processing machinery.

Important
This article is for information purposes only.
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.

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