The cannabis industry is saturated with large incumbents, emerging startups and everything in between. For value investors looking to invest in cannabis, it can be overwhelming. So, is value investing in cannabis a good approach?
Not only must they balance how each company is working to capture more of a growing market, but they also need to be aware of the country in which the company is based. A new cannabis firm hoping to start a large grow operation in Canada is far less bullish than one in Macedonia, for instance.
In the following article, we’ll walk through two kinds of investment theories as well as a basic set of tools novice value investors can use to accurately navigate a complex market. We’ll even use one of these tools to evaluate the strength of a leading cannabis company.
Value investing in cannabis
There are two leading philosophies in the investing world. The first, sometimes called the ‘castle-in-the-air’ theory, refers to making bets based on market psychology. Followers of this theory suggest that markets are irrational and that investors need only be aware of trends.
Instead of examining a company’s balance sheet, investors must examine the behaviour of other market participants. A classic example of this was the Dot Com Bubble in the late 1990s and early 2000s. We all know how this period ended, but that doesn’t mean that certain investors didn’t make money before the bubble burst.
The second philosophy is referred to as the ‘firm-foundation’ theory.
They use these metrics to paint a picture of how a business is doing. Based on this picture, they can evaluate whether a particular stock is currently undervalued or overvalued. An investor would then only purchase undervalued stocks and only sell overvalued stocks.
Each of these investor philosophies also come with their die-hard communities, celebrities and spokespeople. Naturally, castle-in-the-air representatives come and go as bubbles form and pop. Firm-foundation theorists have, for the most part, stood the test of time.
Also called ‘value investors’, this tribe includes names like Warren Buffet, Bill Ackmann and Benjamin Graham, to list a few.
The cannabis industry has primarily attracted members from the first tribe. After Canada legalised cannabis in 2018, investors made a quick buck riding the hype. And, though many of the companies at that time are still in business, Canopy Growth, Cronos, Aurora and Aphria, have fallen substantially since the first cannabis wave.
CGC is the American ticker symbol for Canopy Growth. It trades on the New York Stock Exchange (NYSE). Source: Trading View
When we compare the entire cannabis market with, say, the S&P 500, many investors would still be in the red. As reported by Investopedia:
‘Marijuana stocks, as represented by the ETFMG Alternative Harvest ETF (MJ), have dramatically underperformed the broader market, providing investors with a total return of -47.2% compared to the S&P 500’s total return of 23.9% over the past 12 months.’
The ETFMG Alternative Harvest ETF is essentially an index fund of top cannabis companies. There are many like it; each differs in the companies that are included as well as the weighting of each company.
In traditional finance, buy-and-hold index funds have consistently outperformed active managers over the past few decades. There have been a few exceptions to this rule, but rarely have active managers beaten the market for longer than a few years. We’ll assess the viability of this strategy in the cannabis sector shortly.
Indeed, much has changed since this boom and bust. And, though the details are still murky, if not outright bearish, you can be sure that the cannabis industry is far from over.
Later this year, the WHO will vote on a series of cannabis recommendations, the result of which could change the legal status of medicinal cannabis as well as CBD, its non-psychoactive component. A suite of new derivative products is also entering the market, which may entice first-time users and grow the pie.
Finally, cannabis is also enjoying a much better reputation than it did in 2018. Study after study has emerged in North America, Europe and beyond to provide more nuanced information about the benefits and drawbacks of this powerful plant.
Investors will, however, have to wait for all of these factors to coalesce into a new bull market like that of 2018. But, in the meantime, here are a few tools you can use to stay ahead of the curve with a few undervalued cannabis stock picks.
The cannabis value investor toolset
As mentioned above, there are three essential tools that can help you better evaluate the strength or weakness of a stock, cannabis or otherwise. The P/E ratio, YOY ratio and P/S ratio. Each of these metrics can help value investors better understand the health of the underlying company.
The P/E ratio can be derived by dividing the current price of a stock by the earnings per share (EPS). Now, EPS is determined by dividing a company’s net income by the number of outstanding stocks. As you can see, calculating these metrics can take a bit of digging into public filings to arrive at a valuation.
Though there are two types of P/E ratios, forward and trailing, we’ll focus on trailing, as it is based on past performance rather than future expectations. Forward P/E ratios can be miscalculated simply because they are estimates; anything can happen from one year to the next, especially in the cannabis industry.
Let’s examine the trailing P/E ratio for Canopy Growth. The company’s trailing EPS for the past 12 months is -$3.80 (-€3.17) per share, according to MarketWatch data. This is also true for CGC, Canopy’s American ticker that trades on the New York Stock Exchange (NYSE).
Now that we have the EPS, we can establish the P/E ratio by dividing the current stock price, $16.45 (€13.72), by -$3.80 (-€3.17).
The result is -$4.32 (-€3.60). It isn’t conventional, however, to post a negative or zero P/E ratio. Instead, Canopy will report ‘N/A’ on formal financial statements. So, what can we do with this number?
Well, the P/E ratio gives investors insight into whether a stock is over- or undervalued. If a company has a P/E ratio of $10 (€8.34), then the company is trading ten times its earnings. This would be a sign that the stock is overvalued.
A negative P/E ratio, like in the case of Canopy, indicates that the company is losing money. This data point doesn’t paint a positive picture, but there are a few caveats to consider.
Using value investing to paint a complete picture of cannabis
The cannabis industry has barely gotten started, and it is currently flourishing in just two countries. Because the sector is so new, investing here comes with a host of risks not seen in other, more traditional markets. This is why many investors have so far steered clear of the niche.
It is also why investing in a cannabis-centric index fund may not be the best way to gain exposure to the space. It isn’t uncommon for businesses that are just a few years old to disappear entirely. This could wreak major havoc on your index.
Returning to our earlier analysis of Canopy, a negative P/E ratio would traditionally be a red flag. But, in today’s markets, many of Canopy’s competitors are experiencing similar troubles. And, if one believes that cannabis is here to stay, a negative P/E ratio may even be a good reason to pick up some of these stocks.
Ultimately, there is more than one metric that one must consider before buying or selling a cannabis stock.
Including tried and tested tools certainly makes up an investor’s due diligence, but it doesn’t stop there. Just recently, Canopy’s CEO, David Klein, reported an unusual uptick in the popularity of their line of cannabis-infused beverages. He said:
‘We grew our revenue year-over-year and are seeing market share improvement, notably achieving number one market share in cannabis-infused beverages in the Canadian market.’
This emerging market sector could help propel the company to new highs. Klein also outlined the details of Canopy’s restructuring and how the company plans to continue reducing expenses. Whether this materialises is yet to be seen.
Also, without a vaccine for coronavirus widely available, all markets, not just cannabis, will continue to suffer. Attempting to price this in, however, is far beyond the skill set of even the most seasoned value investors.