Opportunities And Risks In The Cannabis Sector

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Winds of Change Lifting the Sector

Once in a while, a hot new sector bursts into life and captures investors’ imagination. Remember those internet stocks twenty years ago? Or those raging crypto-currencies a year ago, particularly Bitcoin? More recently, a new such sector has emerged: Cannabis stocks.

What are cannabis stocks? Mainly, these are listed companies engaging in producing or selling cannabis, a type of drug that is used for medicinal and recreational purpose. It is popularly known as marijuana or weed.

‘Drug?!’ you may wonder. Yes, the drug that Elon Musk was reportedly smoking during his podcast interview recently, which caused a huge drop in Tesla’s share price overnight (see picture below).

In many countries, cannabis is still illegal. Many governments around the world – including the UK – assume these drugs are addictive and dangerous. Just this week, a front-page headline in The Times (September 12, 2018) read: ‘Policy catch 11-year-olds being used to sell (cannabis) drugs.’

If cannabis is so controversial, why are cannabis stocks popular these days? Because legalising cannabis is becoming a trend. Uruguay, Canada and some US states are now opening public access to cannabis. With this change, people are expected to spend more money buying the drug. Some estimated that legal cannabis market will triple from the current US$10 billion to $30 billion in five years time*. Very good prospects indeed.

In fact, the sector is so new and exciting that investors are willing to bid aggressively for any cannabis stocks. Canopy Growth (Can:WEED!) and Aurora Cannabis (Can:ACB) are trading at valuation that are on par with internet stocks in the nineties. In fact, WEED is so hot that its share price rallied from $2.5 in 2016 to $75!

The question now, at least for new investor/traders unfamiliar with cannabis stocks: Should you join the party?

To answer this question, I have devised a small flexible framework for analysing ‘Hot Sectors’.

Framework For Analysing ‘Hot Sectors’

Before you consider buying these weed stocks, ask yourself three questions:

  1. Do you know a lot about the sector? Meaning, do you have some form of ‘knowledge edge’?
  2. Why do you need to buy the sector? In other words, do you really need to participate now?
  3. What is the sector priced at now? Depressed, normal, or high?

To see this more clearly, you should place the sector in the Sector Cycle below and assess the risk-reward prospect.

Sector Cycle – Five Stages

Stage 1: Dormant – Few know about the sector. It is virtually non-existent. Public knowledge is low. Alternatively, it is a ‘sleeper’ sector. Boring, few exciting prospect. A sector could stay here for many years.

Stage 2: Catalyst – New technology, changed laws, or shifting political landscape becomes the market catalyst that incite changes. Prospect becomes better.

Stage 3: Smart Money/Insiders move in – Astute investors start to place bets in the sector, via venture backing, loans, or new companies. This stage can occur over some years.

Stage 4: Public Participation – Once the trend persists for a while, media starts to take note. Also, early investors reaped huge gains. Articles, books, videos, internet, and interviews amplify these juicy returns – and investor greed. Public Joe became a ‘convert’ and buy.

Stage 5: Hysteria, Bubble, and Collapse – Hysteria sets in. Prices go ballistic. The sector becomes a bubble that lasts for a few months (even a couple of years). When the last buyer is in, the sector implodes.

Where do you the cannabis sector is right now? I suspect between 4 and 5. Why? Because when a stock goes up by 30x in two years, you know that many investors would be looking to cash out. At these high valuation levels, the sector is ‘priced for perfection’. In other words, any negative factor – such as lower-than-expected revenue growth – could cause a massive drop in share prices.

Moreover, many cannabis firms are investing heavily to position themselves strategically in the sector. You can expect equity dilution, higher balance sheet leverage, and low dividends. Also, who will survive in the long term? Nobody knows right now.

Conclusion

Cannabis is a new hot sector. Its prospect is driven by a growing market (due to a changing legal landscape). But note this, higher cannabis demand brings about higher cannabis supply. At some point, a tipping point will cause street prices to plummet as the sector becomes saturated. Are we there yet? Perhaps not. Thus, it is quite likely that the sector may remain popular for the time being.

Turning to risk-reward prospect of buying the sector at the moment. If you know next-to-nothing about the sector but still want to trade NOW when the sector is trading at high valuation levels – better set clear rules and follow them. It is a volatile sector. Huge gains and severe drawdowns are equally possible.  After all, it is a novel sector filled with uncertainties.

*Investor Chronicle (September 7, 2018)

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Jackson has over 10 years experience as a financial analyst. Previously a director of Stockcube Research as head of Investors Intelligence providing market timing advice and research to some of the world largest institutions and hedge funds.

Expertise: Global macroeconomic investment strategy, statistical backtesting, asset allocation, and cross-asset research.

Jackson has a PhD in Finance from Durham University.