Sep 19, 2018
'Stay away': Bay Street cautious on pot stocks as legalization looms
As Canada inches closer to the legalization of recreational cannabis, the hype around pot stocks continues to grow. But not everyone is buying into the mania around this sector. A chorus of influential Bay Street voices is cautioning investors about buying into marijuana companies in recent months amid sky-high valuations.
Below, BNN Bloomberg speaks to five Canadian portfolio managers about the risks of investing in the marijuana sector, and what it would take for their views to change in the coming weeks.
(Interviews have been edited and condensed for clarity.)
RYAN LEWENZA, SENIOR VICE PRESIDENT AND PORTFOLIO MANAGER AT TURNER INVESTMENTS, RAYMOND JAMES
What would you tell investors looking to get into the cannabis space?
Wait for a pullback and only invest a small percentage of your savings in the space (i.e. no more than five to 10 per cent).
What’s your biggest reason for avoiding pot stocks? Has your view changed in recent months?
The stock prices have become completely divorced from underlying fundamentals and valuations are at nose-bleed levels. My view has changed in recent months in that I think prices are even more divorced from reality. While stocks could double from here given the mania, I’m very concerned about a future crash in stock prices.
What advice would you give to a retail investor who insists on getting into the space?
Right now it’s all hype and little revenue/profits. We’ve seen this story before and it never ends well. So play it safe by investing in the best of breed companies (i.e. Canopy Growth) and only invest a small percentage of your savings in the space (i.e. no more than 10 per cent).
What’s the biggest risk for those investing in cannabis?
The high valuations and that you’re late to the party.
Do you see your viewpoint changing after legalization?
Nope. I believe we’ll see a big sell on the news on the day/week of legalization.
BRIAN MADDEN, SENIOR VICE PRESIDENT AND PORTFOLIO MANAGER, GOODREID INVESTMENT COUNSEL
What would you tell investors looking to get into the cannabis space?
Cannabis stocks are the riskiest segment of the Canadian stock market (although it could be a toss-up between cannabis and blockchain/bitcoin mining). Legal marijuana will present economic opportunities in Canada, and some of these stocks will still be around in three years’ time. But most will not. The industry is nascent, and there is a gold rush mentality surrounding the stocks, but the fundamentals (revenue, earnings, cash flow, dividends, etc.) simply do not support the current share prices.
What’s your biggest reason for avoiding pot stocks? Has your view changed in recent months?
Until proven otherwise, marijuana is an unbranded, undifferentiated agricultural commodity like corn, wheat or soybeans. Unless and until the cannabis producers can demonstrate high margins (i.e. 35-50 per cent operating margins) and high returns on invested capital (high teens to 30 per cent or more), like the branded tobacco companies and the liquor companies do, they have no business trading at these lofty multiples.
What advice would you give to a retail investor who insists on getting into the space?
Buy a basket of the top three to four largest/leading players in the space. Limit the size of your total marijuana investment to no more than one to three per cent of your overall portfolio. Much like the early days of the Internet, there will be dozens if not hundreds of lousy companies with unproven business models that will fail in short order, and a relatively smaller number of early movers that will survive.
An alternative approach would be to look for “backdoor” plays on the sector … Who are the real estate owners that will see occupancy increase as dispensaries and commercial grow-operations open up? What technology suppliers will benefit from growth in legal marijuana? What crop nutrient businesses are well-positioned to benefit from growth in legal marijuana?
What’s the biggest risk for those investing in cannabis?
Risk of total, irreversible capital loss. Speculating blindly and against the odds and available evidence that a batch of nascent, unproven companies will continue to exist, despite burning rapidly through their dwindling cash balances is not really investing at all – it is speculating.
Do you see your viewpoint changing after legalization?
The day may come when the manic frenzy subsides and the industry evolves into something akin to a steady state, at which point traditional fundamental analysis will actually be relevant and useful. At that point, we will consider the marijuana producers with an open mind, evaluating growth, profitability, management quality, sustainable competitive advantages, industry structure, valuation, etc. just as we do with any other company, and should the facts and fundamentals at that time support a purchase decision, we will buy with confidence.
BARRY SCHWARTZ, CHIEF INVESTMENT OFFICER AND PORTFOLIO MANAGER, BASKIN WEALTH MANAGEMENT
What would you tell investors looking to get into the cannabis space?
I would tell them to stay away. There is clear euphoria within the space today, not unlike cryptocurrencies in late 2017.
What’s your biggest reason for avoiding pot stocks? Has your view changed in recent months?
Biggest reason is valuation and lack of demonstrated ability to earn profits. The valuations of the companies today have far surpassed any reasonable projection of the recreational Canadian marijuana industry.
What advice would you give to a retail investor who insists on getting into the space?
Make sure you truly understand what you’re investing in and have good reasons why the stock you’re buying represents good value. Buying a stock simply because you see other people getting “rich” is a recipe for disaster.
What’s the biggest risk for those investing in cannabis?
At the current valuations, there is a real risk of permanent loss of capital particularly if the market opportunity turns out to be less than expected (i.e. public interest in consumables is less than expected).
Do you see your viewpoint changing after legalization?
No.
NORMAN LEVINE, MANAGING DIRECTOR, PORTFOLIO MANAGEMENT CORP.
What would you tell investors looking to get into the cannabis space?
The initial easy money has already been made and it is high risk.
What’s your biggest reason for avoiding pot stocks? Has your view changed in recent months?
Our biggest reason for avoiding pot stocks is that it is too early for us to commit clients’ funds to the area. Nobody knows how big the market will be, who will be the leaders, what their sales, margins, or earnings will be.
What advice would you give to a retail investor who insists on getting into the space?
If someone insists on getting into the space, be very careful concerning the management of the companies you are considering. There are some very high-quality people behind some companies and some quite questionable and shady people as well. Size doesn’t tell you who is good and who is bad.
What’s the biggest risk for those investing in cannabis?
The biggest risk is valuations. All the cannabis stocks are trading at valuations that make no sense, and sooner or later reality will set in and it won’t be pretty. The unknown answer is: when.
Do you see your viewpoint changing after legalization?
Once the market becomes established, winners and losers are identified, and valuations become more reasonable, then we will take a look.
GREG TAYLOR, PORTFOLIO MANAGER, PURPOSE INVESTMENTS
What would you tell investors looking to get into the cannabis space?
The big thing I’d say is that you really have to do your homework, because the space has got a lot of people that are just throwing money at it … and not everything is going to succeed. I think it’s going to be a very competitive space going forward, so you want to make sure you’re looking at companies that are going to win, and companies that have an edge, versus some of their competitors.
Has your view changed in recent months?
[Pot stocks] are one of the few areas of growth in the Canadian market right now, you really have to be paying attention to them. I think all Canadians should be looking at this space – or should have been looking at it in the last six months, because we’ve had a lot of success and a lot of money made in the space. Now, I think there’s a little more risk because we’ve had a lot of money thrown at the sector already, and as we get closer to the [recreational marijuana legalization] launch, I think it’s going to be a much more challenging environment to make money.
Do you think investors should avoid the space entirely?
I don’t think you should avoid [the cannabis sector] altogether, I think you need to do the work to make sure that you’re looking at companies that will succeed. What we’re looking for are low-cost growers and companies that are doing something different to add value with new products – and also look internationally. I think you want to avoid the middle-of-the-road company that doesn’t really have anything niche that they’re working on.
What’s the biggest risk for those investing in cannabis?
The biggest risk I’m seeing is that there are a lot of companies that are just focusing on growing. And I think that is an area that the margins are going to get crushed over the next few years, because I think there’s a lot of capacity coming on right now. And I think at the end of the day, the value is going to be created in the brands.
Do you see your viewpoint changing after legalization?
Up until this point, everything has been trading off of sentiment. As we move to actually-operating businesses, it’s going to be more looking at which are the better operators, who can grow at the lowest cost, who can actually make money in a very competitive market. And I think that’s going to change the game in the next few months.
Cannabis Canada is BNN Bloomberg’s in-depth series exploring the stunning formation of the entirely new – and controversial – Canadian recreational marijuana industry. Read more from the special series here and subscribe to our Cannabis Canada newsletter to have the latest marijuana news delivered directly to your inbox every day.
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