Tread Carefully With Pot Stocks, Including Canopy Growth

Speculating in the hot cannabis market is becoming riskier. After Canada legalized pot, and many of the major players in the marijuana field fell, chances are high that the sector will continue selling off. Does that apply to all weed stocks or are there exceptions? Investors have two considerations when buying marijuana stocks.

First, at a macro level, the addressable market for pot is bigger now that it is legal in one of the biggest G8 nations. Yet, markets always look forward and did so by pricing in the potential for revenue growth in stocks like Canopy Growth (NYSE:CGC).

Prior to the stock’s run-up that began in August, CGC stock traded in a tight range between $20-$25. By October, buying momentum capitulated and the stock topped $59.25. Trading recently at below $40, merger and acquisition activities could slow as markets cool on pot stocks.

Canopy Growth acquired ebbu, a hemp research provider, on Oct. 15. It paid a mere $25 million in cash but issued 6.2 million CGC stock. Ebbu gets another $100 million if it meets a  milestone within two years. On the press release for the deal, Canopy Growth did not say what that milestone was.

M&A Catalyst Fades

With CGC stock and others like Tilray, Inc. (NASDAQ:TLRY) down sharply from their peak, M&A could slow down completely. Without expensive shares to pay for acquisitions, the froth in pot stocks may never return. Fundamentally, the market needs time for the macro story on growing demand for marijuana playing out. If that happens, there’s a second consideration: valuation.

At current levels, pot stocks are valued in anticipation of multiple years of double-digit revenue growth. Canopy trades at 125 times sales. In Canada, the shortage of weed signals the market’s strength in demand but also tells investors that these companies will not meet their revenue forecasts. And if the backlog in demand fades faster than expected, the addressable market for the product may end up far smaller.

That pot is not legal in all of the U.S. poses another problem. Canada is a big country but has far fewer people than its neighbor south of the border. With total demand reliant on the Canadian market, the long-term prospects may not play out as strong as markets expect.

Just as 3D Systems Corporation (NYSE:DDD) fell into a multi-year bear phase after 3D Printing demand faded, the same may happen for Canopy Growth. Canopy’s ebbu acquisition may bear no fruit. If ebbu fails to create a cannabis-infused beverage or if the final product fails to win consumer interest, CGC stock will fall.

Related Stocks

Tilray is an expensive version of Canopy Growth stock in that it trades at 364 times sales and also has a debt-equity of 1.55 times. Its growth prospects are not necessarily better. On Oct. 9, Tilray smartly took advantage of the market valuation by closing a $450 million convertible debt offering.

It made just a few million in revenue in its last quarter, so the huge cash injection will keep the business running – at the cost of existing shareholders. Despite the discrepancy between revenue generation and cash raise, Tilray will now have plenty of cash to expand its business in the quarters ahead.

Bottom Line on Pot Stocks

Tread carefully when speculating in pot stocks. If the paper loss becomes too great, consider booking the loss and waiting until the storm settles.

As of this writing, Chris Lau did not hold a position in any of the aforementioned securities.

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