Once high-flying cannabis stocks have come crashing down over the past few months. After starting off 2019 on good footing, investors grew optimistic with respect to the growing Canadian market, U.S. federal legalization and new edible cannabis products. Then cannabis stocks started crashing down as all of the industry’s potential tailwinds have turned into headwinds.
As of this writing, the ETFMG Alternative Harvest ETF (NYSEARCA:MJ) is about 50% off its 2019 highs and trading at fresh all-time lows.
Time to throw in the towel on pot stocks? I don’t think so. The industry got way too hot for its own good in late 2018 and early 2019. The 50% correction since then is just a normalization to more tangible valuation levels. Importantly, the long-term growth fundamentals underlying pot stocks remain favorable. Once this near-term valuation retrenchment ends, these stocks will move significantly higher in the long run.
Those favorable fundamentals are as follows.
Data shows that cannabis consumption is on the up and up, and that it nearly equals alcoholic beverage consumption today among high school seniors. Thus, demand for cannabis is big — alcoholic beverage big. The problem right now is that most of that demand is in the black market. It won’t stay there forever. Eventually, government incentives and supply shifts will push demand into the legal market, at which point the global legal cannabis market will start to look a lot like the global legal alcoholic beverage market.
That’s a multi-hundred billion dollar industry that has birthed a handful of $20 billion-plus companies. The cannabis market at scale will do the same, so many of today’s cannabis stocks have potential to hit $20 billion-plus market caps in the long run. And they trade with single-digit billion dollar market caps today.
If you’re willing to stomach near-term volatility, I think a few cannabis stocks are solid long-term investments at current levels.
Cannabis Stocks: Canopy Growth (CGC)
Percent Off All-Time Highs: 60%
By virtue of being the largest supplier of cannabis in the Canadian market, and with the support of alcoholic beverage giant Constellation Brands (NYSE:STZ), Canopy Growth (NYSE:CGC) has been the most important cannabis company in the world over the past year. During that year, when cannabis stocks were up, CGC stock was leading the rally. Now, with cannabis stocks down big, CGC stock has led the plunge, and presently trades 60% off its all-time highs.
I get the red flags here. The company jumped out to an early lead in the cannabis market, but has since fallen flat. At the same time, there’s been some major C-Suite turnover which is troubling, a big hit on margins which is also troubling and a lack of profits which doesn’t help support the valuation.
I see those red flags. But, I think in the long term, they are just noise. Sluggish growth is attributable to hiccups in the legal Canadian market, and those hiccups will smooth out over time. C-Suite turnover? Constellation Brands expects greatness. They should, and there’s nothing wrong with that. Weak margins? Only temporarily weak, as Canopy builds out supply and competes with black market prices. Lack of profits? All early stage growth companies lack profits.
In the big picture, Canopy has the biggest balance sheet in this market, the biggest growing capacity, the most global reach, the strongest distribution deals and the most visible runway to penetrating the ultra-valuable U.S. market. Considering all that, Canopy Growth still most reasonably projects as the biggest player in this market in a decade — and by then it could be a $200 billion market.
As such, I think that by the end of the 2020s, CGC stock will command a $20 billion-plus market cap, at the very least. The company has an $8 billion market cap today.
Percent Off All-Time Highs: 70%
In short, Aphria (NYSE:APHA) is one of the lesser-known cannabis companies that has been surrounded by a ton of controversy over the past several quarters. All that controversy is why APHA stock has dropped 70% off all time highs — much more than the average pot stock.
But, let’s take a step back and look at the core fundamentals here. This company is a fairly sizable player in the Canadian cannabis market, selling over 5,000 kilograms of cannabis last quarter, which puts it right in the middle of the market. It is also one of the fastest growers, nearly doubling cannabis revenue and volumes sequentially last quarter. Most importantly, it is the most profitable player in the industry, leveraging low-cost production capabilities to drive cash production costs and keep gross margins high.
Long term, I think Aphria has the most visibility to be the discount provider in the global cannabis market at scale. Again, that market will likely hover around $200 billion by 2030 — and as the discount king in the market, Aphria should be able to control a respectable share. That means that by the end of next decade, Aphria has an opportunity to be a multi-billion dollar revenue company with a $10 billion-plus market cap.
The market cap on APHA stock today? Just over $1.3 billion. Thus, long term-upside potential in APHA stock is quite compelling.
Percent Off All-Time Highs: 65%
In terms of kilograms of cannabis sold last quarter, Aurora (NYSE:ACB) is the biggest player in the Canadian cannabis market. Yet, Aurora’s market cap of just over $4 billion isn’t anything near the largest market cap in the cannabis industry.
Why the disconnect? Aurora doesn’t have the backing of a huge consumer staples company. As such, its balance sheet doesn’t have the necessary cash reserves to keep absorbing big operating losses. Aurora projects to keep running big operating losses for the next several quarters. At the current rate, Aurora could run out of cash pretty soon — and the company could go belly up.
That’s the bear thesis here. But, that bear thesis misses three big points. First, Aurora can tap into the debt markets — and I’m sure it will — to fund operations for the foreseeable future. Second, Aurora is growing very, very quickly, and if it keeps this pace of growth up as the cannabis market expands globally, then the company will one day be a multi-billion dollar revenue company. Third, Aurora’s margins are only temporarily depressed. Once the focus shifts from expanding market share to cutting costs, Aurora’s margins will come roaring higher, and big losses will turn into big profits.
As such, I think the big picture fundamentals here remain healthy. Aurora is a big player in a rapidly growing market, with a chance to improve margins meaningfully over the next several years and produce huge profits at scale. ACB stock isn’t priced for any of this. As such, in the long run, this stock has tremendous upside potential.
Percent Off All-Time Highs: 64%
Much like every other stock on this list, Cronos (NASDAQ:CRON) has plunged in 2019 on concerns that the stock’s valuation got way ahead of the fundamentals in the cannabis market.
Indeed, this is true. In early 2019, CRON stock sprinted to prices above $20. Those prices were supported by nothing other than investor euphoria. That euphoria has since turned into realism, and CRON stock has come crashing down to levels below $10.
Here and now, Cronos stock is still richly valued. The forward sales multiple? Nearly 20. The fundamentals also remain relatively weak, as demand in the Canadian market is leveling off and vaping crisis related headwinds remain very real. Thus, investors shouldn’t expect a near-term bounce in CRON stock anytime soon.
But, Cronos is also one of only two cannabis companies that has scored a multi-billion dollar investment from a global consumer staples giant, and Cronos’ partner — Altria (NYSE:MO) — is very big with deep pockets and wide distribution deals. As such, Altria’s financial backing should allow Cronos to both weather near-term financial volatility (because huge cash reserves can absorb operating losses) and grow into a long-term big player (because Altria’s backing gives Cronos the resources to invest more aggressively than peers).
Again, the global cannabis market should hit $200 billion within the next decade. Say Cronos grabs just 2% share, for $4 billion in revenues, and runs at very average 20% operating margins. That should produce $800 million in operating profits and $640 million in net profits, assuming a 20% tax rate.
Based on a market average 16 multiple, that equates to a $10 billion-plus market cap. CRON stock has a market cap of under $3 billion today.
As of this writing, Luke Lango was long CGC, APHA and ACB.