If there was one investment that took the financial markets by storm in 2018, it was marijuana stocks. The group, headlined by Canopy Growth (NYSE:CGC), Tilray (NASDAQ:TLRY), Aurora (NYSE:ACB), and Cronos (NASDAQ:CRON), wasn’t well known to investors at the beginning of the year. But, by October, these stocks were flying high, with many of them more them doubling between July and October.
What sparked the cannabis craze of 2018? Well, a number factors shed mainstream light on the long-dormant, niche industry. First, everyone started getting excited in 2018 about the nationwide legalization of cannabis in Canada in October. This was arguably the industry’s biggest catalyst ever, and as pot stocks started listing on U.S. exchanges, investors started bidding those stocks up.
But, what really kicked this rally into overdrive was a massive $4 billion investment into Canopy Growth from alcoholic beverage giant Constellation Brands (NYSE:STZ) in August. That was when marijuana stocks took off like a rocket ship. The logic was that big money was finally moving into the space, and thereby legitimizing the long-term potential of the recreational and medicinal cannabis markets.
Alongside this hype, there was a significant amount of volatility. Thus, just as 2018 was the year of the cannabis craze, it was also the year of marijuana stock volatility. After more than doubling between July and October, pot stocks have since broadly dropped into bear market territory, with Canopy, Tilray, and Aurora all 45% or more off all time highs.
I expect 2019 to be different for marijuana stocks. The cannabis craze isn’t over. These stocks will do well in 2019 and thereafter. But, there should be significantly less volatility, thus making pot stocks more attractive investments in 2019.
Why do I think this? There are four major reasons:
The “Pop” Already Happened
The big marijuana stock bubble has already popped. The cannabis craze swept through markets in mid-2018 after Constellation Brands poured $4 billion into Canopy Growth. That pushed pot stocks mainstream, and everyone and their best friend bought in.
But, this whole craze was building towards the October 17th nationwide legalization of cannabis throughout Canada. When that date finally arrived, you had a massive “Sell the News” event. Marijuana stocks dropped in a big way. The bubble popped.
Ever since, marijuana stocks have gradually slid lower. But, sentiment has normalized to a more realistic and less euphoric level, while pot stocks are generally starting to find their footing at key technical levels. For example, CGC stock is stabilizing around $30, while TLRY stock has found solid support at level just below $100.
As such, it increasingly looks like the pot stock bubble has already popped, and we are now in the post-pop phase. This inherently implies more stability going forward.
Marijuana Stock Valuations Are More Reasonable Now
Valuations across the whole cannabis sector are reasonable today and are supported by long-term fundamentals, whereas they generally were not a few months ago.
In the Canadian cannabis world, you have the Big 4: Canopy Growth, Tilray, Aurora, and Cronos. The present combined market cap of those Big 4 marijuana stocks is just $26 billion, versus $40 billion-plus in mid-October.
More importantly, the $26 billion figure is supported by long-term fundamentals. The recreational cannabis market in Canada measured $6 billion in 2017. Inevitably, that number will grow as legalization prompts new people to try cannabis (read this story about first-timer Genevieve Despres). Meanwhile, the medical cannabis market in Canada is projected to be a $3 billion annual revenue market. Thus, the overall cannabis market in Canada projects as a $10 billion revenue opportunity.
Constellation Brands estimates operating margins in the space to run around 30%, implying a $3 billion operating profit opportunity, or $2.4 billion after taking out 20% for taxes. A growth-average 20 multiple on that implies a total market cap of the Canadian cannabis market at scale of nearly $50 billion. Assuming it takes five years to get there and using a 10% discount rate, the present value of the Canadian cannabis market is just under $30 billion.
Thus, under the assumption that the Big 4 take home most of that market and gain some international share, a $26 billion combined market cap for the Big 4 Canadian pot stocks makes sense today.
Financials Will Start To Support Valuations
A big problem with pot stocks in 2018 was that relative to trailing financials, the current valuations made absolutely no sense and inherently lent themselves to tremendous volatility. That won’t be the case in 2019.
At the current moment, ACB stock is the cheapest among the Big 4 at over 100x trailing sales. These huge, triple-digit sales multiples are a result of premature euphoria hitting the stock before the financials have caught up.
In 2019, the financials will have a chance to catch up. The Big 4 recently reported their first quarterly numbers following the legalization of pot in Canada. Growth rates across the board were impressive. We are talking 100%-plus revenue and volume growth.
This big growth should persist into 2019. Next quarter will be the first full quarter of Canada cannabis legalization, and the next four quarters will all have easy laps due to Canada legalization lapping against no such thing a year ago. Thus, growth rates will be huge and impressive throughout 2019, broadly resulting in much larger revenue bases which will help support valuations across all marijuana stocks.
Big Investments Will Reduce Volatility in Marijuana Stocks
On Friday, the cannabis market got a nice kick when Marlboro cigarette maker Altria (NYSE:MO) announced a massive investment in Cronos Group. When all is said and done, Altria will own 45% of CRON. That’s a huge vote of confidence in not just the company, but the sector as a whole. Meanwhile, Coca-Cola (NYSE:KO) is also hosting partnership talks with Aurora. This of course follows Constellation’s earlier investment in Canopy.
Broadly speaking, the more big money moves into the cannabis sector, the more stable marijuana stocks will be since they finally have some tangible support in the form of resources, distribution, branding, and expertise.
Throughout 2019, M&A chatter in the cannabis sector will only pick up. In all likelihood, we will get some more big investments from the likes of Coca-Cola, and Pepsi (NYSE:PEP). Those investments will provide stability to pot stocks, and ultimately reduce volatility by a significant margin.
Many pundits labeled pot stocks at bitcoin 2.0. This is a misnomer. Cryptos were all hot air and fluff. Cannabis is a tangible good that consumers already use in bulk and has the potential to produce billions and billions of dollars in revenues and profits.
As such, the cannabis craze which swept through financial markets in 2018 will persist in 2019. But, those same hyper-growth pot stocks will be subject to much less volatility, thereby making them more attractive investments.
As of this writing, Luke Lango was long CGC.