indicatorMarkets

The legalization of cannabis and your investments - October 2018

By Scott Lacombe, CFA 30 October 2018 3 min read

Legalization has Arrived

Cannabis is now legal in Canada, but what does this mean for the cannabis investment landscape? When we last discussed cannabis investments in January, legalization was still many months away. Several cannabis companies experienced significant price gains through 2017, so much so that the industry was starting to look like a stock bubble. Cannabis share prices lost over 40% of their value in the next three months, before again turning upwards in the autumn.

Over the past two months, several episodes of investor exuberance drove cannabis company stock prices to new peaks. Tilray, whose shares went public this summer at $17, rose from $100 to $300 between September 14 and September 19, before dropping back down to $100 within another three days. What news drove its spectacular rise? According to headlines, it seems that Tilray was the biggest cannabis company investors had never heard of. Because Tilray’s shares were listed only in the US rather than in both the US and Canada, it had flown under many investors’ radar.

For the overall sector, it seems that the price boom since August was first driven by headlines that Canopy Growth would enter into an agreement with Constellation Brands (the maker of Corona and other familiar liquor brands) to develop cannabis infused beverages. This was further bolstered by other agreements and partnerships through the cannabis industry with such companies as Molson, Coca-Cola, and Altria. The cannabis company stock price index increased roughly 70% from mid-August to legalization on October 17.

 

Current Share Valuations

Within the next year, all companies will report their first post-legalization financial results. Will companies like Canopy, Aurora, Tilray, and Aphria grow as quickly as investors currently expect? Few estimates were available in January, but estimates of 2019 sales revenue are now available for many companies. Do these companies’ shares represent good value?

 

Comparisons to other high flyers today

Of the ten most expensive companies from the Nasdaq 100 index, where valuation (how much someone is willing to pay for a dollar of a company’s revenue) is measured as the ratio of share price to revenue per share (“price/revenue”), the average valuation ratio is just over 10x and ranges from 8x to 13x. Some of the most recognizable names in the list are Netflix, Facebook, Adobe and Nvidia. Of the largest ten companies in the Canadian cannabis index that have 2019 revenue estimates, the average valuation ratio is 28x and ranges from 5x to 95x. The larger cannabis companies also tend to have the highest price/revenue ratios. This latter anomaly may be due to a perceived first-mover advantage (in which the first companies will be able to establish barriers to competitors), or it might also be due to name recognition among new investors. Whatever the apparent reason, cannabis companies today seem expensive when compared to other growth stocks.

Price to revenue ratio based on 2019 revenue expectations 
Source: Bloomberg *As of March 31, 2000 using trailing 12 month revenue


A lesson from the past on high expectations

For those that disregard high cannabis company valuations because they are long-term investors, the “4 Horsemen” of the late-1990’s technology boom are a good example of what can happen with high expectations. Cisco, Intel, Microsoft and Dell were viewed as the four companies best positioned to capitalize on the the internet boom then occurring. The internet was believed to be disruptive to many industries and on a global scale, much like some currently view cannabis legalization. The average price/revenue ratio among the 4 Horsemen as of March 31, 2000 was 17x, well below the current average of 28x among Canadian cannabis stocks.

After March 2000, each company experienced share price declines of at least 65% in the following few years as the technology share price boom turned into a bust - even though the companies experienced better financial results and internet use became more ubiquitous in our everyday lives. Dell was taken private in 2013, but the share prices of two of the three other companies are lower now than they were 18 years earlier. Even the best horse of the four (Microsoft) had a cumulative return - including dividends - that was negative for nearly 14 years.

Value of $100 invested with dividends from March 27, 2000 to Sept 30, 2018


Staying the course

Much excitement surrounds the Canadian cannabis industry. The sharp rise of cannabis company share prices, along with stories of those who “struck it rich” as early investors, leads naturally to fears of missing out. Those fears in turn can drive investors into higher-risk investments than they would have otherwise considered. The tech share boom-and-bust of the early 2000’s provides a powerful reminder that if the high expectations reflected by cannabis company share prices don’t become a reality, the result will be severe disappointment for current investors.

 

ATB Wealth experts are ready to listen.

Whether you're a beginner or an experienced investor, we can help.