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The 2019 Outlook For ‘Pot Stocks’

by Paul
Pot Stocks

2019 is the first full calendar year in which cannabis is fully legalised, for both medical and recreational use, in a major industrialised nation and member of the G8. Canada made the move on October 17. Every year new states in the USA are also legalising either recreational or medical use of the drug. In 2018 the tally of states where recreational use is legal hit 10 and 33 allow medical use. Another several, including New York, are expected to follow in 2019 and even more through the ballot in 2020.

Among nations, Spain, Portugal, Italy, the Netherlands, Mexico, New Zealand, Colombia, South Africa and Jamaica are all considered among the front runners to follow Canada’s lead in full legalisation. At a federal level there is still opposition to legalisation in the USA and it looks unlikely to happen under the current Trump administration, at least in the next few years.

But with Canada to the north having already legalised, Mexico to the south mulling doing so and a growing number of states changing their own laws in favour of legalisation, it seems like only a matter of time before the USA makes federal-level changes to laws around cannabis use and commerce. A 2020 change of government, especially if a Democrat triumphs in the elections, could accelerate that.

What about the UK? There was some movement on the legal status of cannabis in the UK last year. Limited access to medical cannabis under prescription is now available in cases where other treatments have already been shown as ineffective. Experts believe that cannabis will be fully legalised in the UK within around 5 years. Quoted in the Independent newspaper, Steve Rolles, a drug policy expert from the Transform think-tank commented:

“The tide has turned. Canada is a G7 nation and one of the largest commonwealth countries. We expect the UK and many others to follow suit in the next five years, so that they can put government, not gangsters in control of the production and supply of cannabis.”

And Paul North, of Volteface, another think-tank stated:

“We will certainly see a regulated cannabis market in the UK in the near future.”

Making concrete forecasts on when and which nations will join Canada and Uruguay by fully legalising cannabis is a risky business. But a more general outlook that many will over the next 5-10 years does seem a pretty solid prediction. The market for legal cannabis is set to grow significantly.

But in terms of capital markets for publically listed ‘pot stocks’ what is the outlook for 2019? Most are listed on Canadian stock exchanges, several now also on Wall Street and London is showing early signs of becoming the European capital for publically listed ‘pot stocks’. The excitement at the opening up of a huge market with proven demand, accompanied by significant media coverage, has seen a lot of money flow into pot stocks over the last couple of years. However, there is genuine concern that investment capital is getting ahead of market reality and throwing money at companies with modest revenues and usually no profits on the prospect of future growth.

That, of course, raises the prospect of a market bubble forming. There is little doubt that the legal cannabis sector with boom over the next decade. What is in doubt is exactly how many of the companies that are early entrants to the market will go onto establish themselves as sustainably successful, well-run businesses. There is a risk of investors paying for pot stocks at inflated valuations in the short term, even in the case of listed companies that go on to establish themselves.

So is 2019 a good moment to gain exposure to pot stocks or would investors be wiser to sit on the sidelines this year, wait for a correction and then buy at more attractive valuations with the weaker companies weeded out? Let’s take a look at the 2019 outlook for ‘pot stocks’.

The Case Against Cannabis Sector Investment in 2019: Are Pot Stocks Overvalued?

Late 2018 saw a significant valuation correction for the sector. The North American Marijuana Index, which tracks the leading cannabis stocks listed on Canadian and Wall Street exchanges, dropped over 40% between September 22nd and December 22nd 2018. There has since been a gain of close to 50% from the end of year low, though the recovery still represents a loss of around 15% on September’s high.

Valuations are, however, looking high again. A couple of weeks ago Canopy Growth, which listed on the New York Stock Exchange in May last year and has sold a minority stake to Constellation Brands for a total of $5 billion, raised by $4 billion in August 2018, reported third quarter revenues of C$97.7 million (£57 million). The company’s valuation is up 76% in 9 months and is higher than the combined market capitalisation of Sainsbury’s and Morrisons.
The forward price-earnings ratio of Canopy Growth stock has reached 385. and it now trades at over 150 times its sales. Tilray, another U.S.-listed pot stock is valued at around $7.4 billion, more than M&S, and recorded Q3 revenues of just $10 million. In late September 2018, around 2 months after IPO-ing at a little under $30, Tilray’s share price had reached a high of over $148. It has since eased to around the $70 level but still represents a huge price to sales multiple of over x225 for a company with very limited current production capacity.

GW Pharmaceuticals is another popular cannabis stock. The UK-founded pharma company that develops treatments derived from cannabinoids has received approval for two of its drugs, Sativex and last year Epidiolex, in several countries. The former treats MS and the latter seizures associated with Dravet and LGS – both rare forms of epilepsy. Many analysts believe that there are also risks to this company’s aggressive valuation. Both treatments are relatively niche and rival treatments are expected to come to market in the next couple of years.

GW’s market capitalisation of just under $5 billion, which represents a multiple of 381 times trailing 12-month sales. With the average P/S ratio for biotech stocks 6, GW need Epidiolex to generate annual sales of around $800 million to support the company’s current valuation. Analysts estimate peak sales of between around $1 billion and $2.4 billion for the drug. Unless it hits the upper end of that range, it’s hard to see any stellar share price growth over the next few years that is based on fundamentals and not hype.

The Case For Cannabis Sector Investment in 2019: Pot Stock Valuations Are Low Considering the Market Potential

The other side to the argument is that multiples are high compared to actual revenues and profits (or losses as is still the case for the growth-focused companies in this sector) because the market’s potential is so vast. GrandViewResearch forecasts the value of the legal cannabis market to reach $146.4 billion by the end of 2025 in the USA alone. The international market size is expected to have reached several hundred billion dollars by that time.

The combined market capitalisation of the ‘big four’ cannabis stocks of Canopy Growth, Tilray, Aurora and Cronos is currently around $35 billion. On the presumption that these companies will go on to take significant market share, it is argued their current valuations are understated when set against their potential.

Therein lies the crux of investing in ‘pot stocks’. For investors who refuse to speculate on future revenues and sales, there is no doubt that as of early 2019 legal cannabis stocks are overvalued on the basis of current revenues. Bulls will, with some justification, argue that the early stage of the market and changing legislative backdrop means that the leading companies have not practically had the opportunity to scale revenues and what is important is how they are now positioning themselves to do so. If the sector develops as expected, the current market leaders will have to be badly mismanaged to no capitalise to the extent current valuations will soon appear measly over the next few years.

Tech companies such as Uber and Tesla can be pointed to as others whose valuations are based on having positioned themselves to capitalise on future trends that have still to translate into revenues. In their case electric and driverless vehicles.

2019 Pot Stock Valuation Boils Down To Investment Philosophy

Ultimately, the 2019 outlook for pot stocks is relatively irrelevant and investors should consider the long term. It’s almost impossible to predict whether the 2018 correction means 2019 will see less volatility in the sector. Revenues growth will start to become more important to investors but international legislation developments will also have a huge influence on the sector. More deals like Constellation Brands’ investment in Canopy Growth can be expected as bigger companies in the alcoholic beverages, tobacco, pharmaceuticals and cosmetics industries look for a slice of the action.

Value and fundamentals investors are unlikely to want to touch pot stocks with a bargepole at current multiples. Growth investors salivating at the future size of the market will be more inclined to ignore current fundamentals and invest in pot stocks based on their 5 to 10-year potential. They will argue that even if every company they invest in doesn’t fulfil its promise, they only need a few to do so to realise impressive long term returns.

The conclusion has to be that in 2019 pot stocks are still likely to be a speculative investment with hopes pinned on potential being realised. Investors happy to take some risk may well be handsomely rewarded. But it is hard to point to any company in the sector that doesn’t involve a lot of risk at this point in its road to maturity.

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