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Pot Stocks Are Lighting Up — But Let the Market Chill Out Before You Buy

pot stocks - Pot Stocks Are Lighting Up — But Let the Market Chill Out Before You Buy

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Just when the rally in pot stocks couldn’t get any hotter, it got hotter.

On October 15, leading cannabis player Canopy Growth (NYSE:CGC) agreed to acquire ebbu, a Colorado-based hemp research company. According to the press release, Canopy’s acquisition of ebbu has the potential to improve and expand Canopy’s product line, while also reducing the cost of CBD production. In response to the news, CGC stock popped 10%.

All other pot stocks popped, too. Tilray (NASDAQ:TLRY) jumped 10% higher. Aurora Cannabis (OTCMKTS:ACBFF) rallied 9%. Cronos Group (NASDAQ:CRON) surged nearly 15% higher.

Why the widespread optimism across pot stocks? Two big reasons. First, Canopy’s acquisition of ebbu shows that the cannabis industry, while still nascent, is already starting to consolidate. That means lots of M&A activity, which means smaller pot stocks should benefit from M&A interest while bigger pot stocks should benefit from reduced competition. In that world, all pot stocks go higher, which is exactly what you saw today.

Second, we are now on an hour-by-hour countdown to October 17, when cannabis will officially be legal across all of Canada. This legalization is the biggest catalyst in recent memory for pot stocks, if not the biggest catalyst ever. Naturally, then, any slightly positive news heading into October 17 will be perceived by the market as materially positive news.

So, with so much positive momentum behind the industry, should you chase the rally in pot stocks? No. Not here, and not now. If you own some names (like I do), stick with them. But, if you are looking to jump into the cannabis craze, wait for a better entry point. You should get one soon.

Pot Stocks Have Huge Long Term Potential

When it comes to the cannabis market, I believe current trends and data points strongly support two theories:

  1. Global legalization of marijuana isn’t a matter of “if,” but simply a matter of “when.”
  2. When fully legalized, the marijuana market could be as big, if not bigger, than the alcoholic beverage market.

Global regulation of marijuana is currently one giant mess. It is tough to follow and highly fragmented. But, there is only one important trend to note here. In 2001, two countries were exploring cannabis legalization. In 2014, that number grew to five. Now, that number stands at over 25. In other words, whereas it took 13 years to add three countries to the marijuana legalization docket, that docket is now adding more than five countries per year.

Regardless of your personal belief on the matter, there is no denying the current trend of accelerating cannabis legalization. If this trend persists and even continues to accelerate, then we are looking at largely global cannabis legalization in the not-too-distant future.

If cannabis becomes as globally legal as alcoholic beverages, then usage data points suggest that the recreational cannabis market could be as big, if not bigger, than the alcoholic beverage market.

Roughly 33% of U.S. high school seniors drink on a monthly basis. That rate is down big from 50%-plus in the early 1990’s. Meanwhile, roughly 23% of high school seniors use marijuana on a monthly basis. That rate is up big from under 15% in the early 1990’s. If current trends persist, marijuana and alcohol consumption rates among high school seniors should be roughly equivalent in five-plus years.

The U.S. alcohol market measured $120 billion in revenues in 2016. The U.S. cannabis market measured under $10 billion in revenues last year. Given current consumption trends, I reasonably see the U.S. recreational cannabis market going from under $10 billion to over $120 billion over the next decade. That’s just the U.S. — and just recreational marijuana. If you consider all other aspects of this burgeoning industry, you are easily talking about a $200 billion-plus market within a decade.

The Legalization of Weed in Canada Will Be Bumpy

If the global cannabis market grows to $200 billion-plus within a decade, then there will be a handful of pot stocks out there with $5 billion-plus in revenues. Assuming fairly normal operating margins of 35% and a 20% tax rate, that $20 billion in revenues should flow into $1.4 billion in profits. Throw an average 20 multiple on that. You are talking about a $28 billion valuation in a decade. Discount that back by 10% per year. You arrive at a present value of over $10 billion.

Thus, today’s multi-billion dollar valuations for leading pot stocks like CGC make sense.

But, I don’t think that means investors should be chasing the rally in pot stocks here and now. Current valuations are supported by long-term growth potential. But, they are nonetheless big, and big valuations tend to have big corrections during operational hiccups.

I think it is fairly likely we get one of those operational hiccups soon. Legal weed is coming to Canada. That is a big deal. Without a doubt, demand will be huge. But, there are murmurs that supply won’t be able to keep up. After all, why should it? Cannabis is going from niche and illegal, to mainstream and legal. Such a massive transformation promises to have some road-bumps on the supply side.

Pot stocks will drop when those road-bumps come up. Those dips will be the time to buy, not now when the sector is on fire and many of these stocks are hitting new highs.

Bottom Line on Pot Stocks

Certain pot stocks like CGC are great speculative long-term investments. But, adding more on a rally seems foolish. Instead, you want to buy pot stocks on big dips, and such a big dip could happen soon given inevitable hiccups with the nationwide legalization of cannabis in Canada.

As of this writing, Luke Lango was long CGC. 

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