I can’t recall the last time I discussed investments without “pot stocks” entering the conversation – whether at the gym, at lunch, or at the barber (not sure if he’s wealthy or not).
The infatuation doesn’t match the insanity of the late 1990s tech boom. Back then, internet stocks soared based on reported website visitors, instead of revenues and earnings. But investors speak of, and invest in, cannabis stocks with similar enthusiasm as dot-com investors did twenty years ago.
Many people are investing in cannabis stocks, and many have made a lot of money. As has been the case my entire career, my HighView partners and I have not joined this party, but our recent analysis of cannabis stocks’ investment merit left me feeling good for sitting this one out.
A Fundamental Perspective
I recently completed an analysis of North American cannabis stocks to assess the industry’s investment merit. I did not examine the industry stock-by-stock in an attempt to find the best individual companies. My analysis was instead a high-level one, focused on the aggregate “basket” of stocks that make up the Horizons Marijuana Life Sciences Index ETF (HMMJ). I aggregated some financial statistics for this group of stocks, made some assumptions about future growth and profitability and valued the broader group of stocks based on a few scenarios.
For this group of stocks, I modeled scenarios based on recent prices, whereby the industry grows revenue, like Google and Facebook, for the next decade, realizes profit margins, like tobacco and spirits companies, and keeps growing at double digits forever while maintaining those same fat profit margins. In one scenario, I even assume that those profit margins start today.
These scenarios paint a rosy picture for investors, but there is only one problem. Any level of scrutiny or realism applied to key assumptions shows cannabis stocks to be a money-losing investment over time.
This isn’t a comment on the businesses so much as it is a comment on the prices and valuations. Too many investors get caught up in the story behind the investment, and too few investors take the step of evaluating the financial implications (i.e. what you’re paying for the story and whether the price makes sense). That was my focus, and the outcome isn’t good for investors.
Picking Winners Is Tougher Than You Think
That’s not to say that you can’t make money investing in cannabis stocks, but the odds of any reasonable success look razor thin. If you believe my analysis, the entire sector is extremely overvalued. The only hope of investing profitably, then, is to: a) make a quick trade (but that’s pure speculation) or b) to successfully pick the relatively few companies that will survive and thrive as the industry evolves.
If you think it’s easy to identify those companies, look up the history of automobile manufacturers over the past century or so, and note the many names you have never heard of because they didn’t make it. Or look up the list of dot-com companies from twenty years ago that enthused investors but quickly died.
But let’s assume you pick a winner – itself a tall feat. And let’s assume that your pick stages impressive revenue growth, strong profitability, and retains a strong competitive advantage. This is also highly unlikely given the uncertainty of evolving regulation and pricing power. Get all of this right and sky-high valuations could easily make your picks horrible investments.
If you don’t believe me, refer to the poster child for this scenario: Cisco Systems Inc. (CSCO-Q).
The Risks of Excessive Valuation
If you rang in the new millennium by buying shares of Cisco Systems, you selected a quality, profitable technology business. You would have also purchased a business that would see revenues nearly triple over the subsequent eighteen years while growing earnings per share by more than 600 per cent (or about 12 per cent per year) thanks to expanding margins.
But had you made this purchase and held it until October 2018, you’d have seen the share price tank by 18 per cent in U.S. dollars.
So even if an investor can be guaranteed to pick the relatively few cannabis businesses that are sure to survive and thrive longer term, today’s excessive valuations seem destined to kill an already-challenged investment. This is why none of our chosen money managers have made any cannabis investments, and it’s why we’re in no hurry to see them do so.
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Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com.