We Believe The Odds Favor Another Canadian Cannabis Rally Before Legalization
With the second great sector bull coming to an abrupt halt recently, investors are starting to sort through the body count. The time to start buying shares of select companies may be premature, but the carnage is making for some interesting options. If there’s an upcoming third bull leg, the time to start thinking about positioning is now.
The next bull cycle — which I posit could reignite anytime between the next few weeks leading up to July 1st, 2018 or late summer legalization period — may provide one more excellent investment opportunity before the inevitable sell-the-news event arrives. After all, once the sector goes live, market euphoria will subside. Wild speculative fervor will be replaced by the sterile reality of MoM retail sales comps, quarterly earnings reports and an assortment of credible business anecdotes. Data is a wonderful thing, but it leaves no room for the imagination to run wild.
And that’s a positive thing. It’s the natural transition of a maturing sector putting on its ‘big boy’ pants and going corporate. While the halcyon days of 400% YoY moves (as seen in the sector in both 2016 and 2017) provided amazingly quick returns, we suspect most will appreciate a more balanced risk profile. That will eventually include such benefits as dividends and better sharpe ratios.
Let’s face it: the bubble was in serious need of a short-term pin. At a valuation apex of about $31 billion (as judged by the Canadian Marijuana Index), Big Cannabis was worth more than Telus Corporation (TSX:TO), a cashflow generating behemoth with $13 billion is annual revenues, $5 billion in annual profits, and 7-10% semi-annual dividend increases through the end of 2019.
By comparison, the Canadian cannabis market will be much smaller; at least initially. For example, the California market is expected to reach US$3.7 billion in 2018 and about US$5.1 billion in 2019 according to research firm BDS Analytics. With a population of 39.25 million and similar consumer/regulatory dynamics, the Golden State compares favorably to the Canadian market.
The fact that Canadian cannabis valuations are on par with Telus highlights the frothiness of underlying equities. Sure, select winners will have much higher growth rates for the foreseeable future. But it’s unlikely the cashflow/profit gap will close by the time cannabis growth rates start coming back to earth. This is a highly regulated industry after all. As it often does, the market is pricing-in the Goldilox scenario, even if it doesn’t compute from a analytical perspective. It’s the reason why bubbles keep materializing, despite investors knowing better.
As such, we present our best cannabis stock plays for our anticipated third bull cycle. The focus here is on underestimated laggards with compelling stories. Should that third upleg occur, I believe it will be driven by mid-market which maintain lower ascribed valuations. These companies could be attractive acquisition targets. There’s still business/supply chain/compliance gaps the leaders need covering, and they’re up against the clock.
Therefore, expect sector consolidation to be the next big market driver. January’s Aurora Cannabis-CannaMed merger was just 2018’s opening salvo. If our thesis is correct, more activity on the takeover front is expected in the coming months.