Cannabis: The New Kid on the Block

With the federal government’s target of this summer to pass legislation on cannabis, Canada will join Uruguay to become only the second country in the world to legalize its consumption and sale. Since Canada announced its intent to legalize marijuana, the market has rapidly changed. According to Bloomberg, there were 84 cannabis-related companies trading on Canadian stock exchanges at the start of the year, collectively worth $37 billion.1

As equity prices have skyrocketed over recent months and attracted significant attention, investors may be curious about the sector. Here are some thoughts:

Companies are in their infancy.

Few cannabis companies trading on the Canadian markets have positive earnings and many have modest sales. The total revenue in 2017 for the four largest publicly-traded firms was only $119 million, which is very small. Of course, this is expected to rise once legalization occurs.

Valuations are high.

A considerable amount of euphoria has surrounded the industry since the end of last year, with valuations becoming extremely high. As an example, the largest publicly-traded firm by market capitalization, was valued at $5.4 billion at the start of February and was trading at a price-to-sales (P/S) ratio of 73. Compare this to a tech giant which has a P/S ratio of only 3.6.2

There are many market players.

The market appears saturated, with over 80 publicly-traded companies and at least another 20 privately-held firms. To put this in perspective, the Toronto Stock Exchange (TSX) consists of only 251 publicly-traded companies.3 Given relatively low barriers to entry, it has been easy for start-ups to enter the market. It is expected that the industry will see significant consolidation.

Political and regulatory changes will impact the industry.

The evolving regulatory environment may put downward pressure on the industry. As an example, last year the Canadian Securities Administrators warned Canadian companies with U.S. operations that they were violating U.S. laws and therefore not compliant with the TSX exchange’s requirements. This is because cannabis is currently a prohibited substance under U.S. federal law (despite it being legal in certain states). Other regulatory changes, such as Australia’s intention to export medical marijuana, may impact market share.

Concerns about reporting.

Accounting rules have allowed for variability in how cannabis companies assess a value on their plants, which may overstate profitability. In some instances, inventory may have been given higher values relative to future pricing and demand, which remain unknown and will become clearer once legalization occurs.4

The Bottom Line: These Are Early Days

There is no doubt that the industry’s growth opportunity is real, and it will be interesting to see how the industry evolves once legalization is in place. Some reports have estimated that future recreational cannabis sales will reach $6B by 2021, with a potential market of up to $22B.5

As the sector continues to generate excitement, the prospect of rapidly growing equity prices may be tempting. But investors should remain mindful of the risks associated with investing in the sector today: as is often the case, the potential for high returns comes with high risks. While there will be winners in this sector, there will also be losers, and these are early days.

Notes:
1. http://www.cbc.ca/news/business/canada-pot-investing-1.4505353
2. P/S figures as at 2/18/18
3. At Jan. 31, 2018. Source: TMX
4. http://www.macleans.ca/economy/canadian-weed-stocks-have-a-serious-accounting-problem/
5. https://www2.deloitte.com/content/dam/Deloitte/ca/Documents/Analytics/ca-en-analytics-DELOITTE%20Recreational%20Marijuana%20POV%20-%20ENGLISH%20FINAL_AODA.pdf

This information has been prepared by Chris Briggs who is a Mutual fund representative of FundEX Investments Inc., and does not necessarily reflect the opinion of FundEX Investments Inc. The information contained in this blog comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Mutual Fund representative can open accounts only in the provinces in which they are registered. For more information about FundEX, please consult the official website at www.FundEX.com.