Marijuana stocks have been hotter than a firecracker lit at both ends. As state after state voted to legalize medical marijuana (and recreational marijuana for some), money flowed into the nascent industry.
But is it now time to sell marijuana stocks? Here are two compelling reasons you should sell, along with one reason you shouldn't.
Sell: Valuations are unsustainably high
What do you call a scenario where stock prices skyrocket in a short period of time to levels far above any realistic valuation for the underlying companies? If you answered a bubble, pat yourself on the back.
It's not too difficult to make a case that marijuana stocks have followed the typical pattern of a stock bubble. Canopy Growth Corporation's (CGC 10.64%) share price rose more than 220% in the past 12 months. Medical Marijuana Inc. (MJNA 8.51%) stock tripled during the same period. Aurora Cannabis' (ACB 2.56%) shares have soared more than 350% in the last 12 months.
As a result of this phenomenal growth, Canopy Growth's market cap now stands at $1.1 billion. Medical Marijuana's market cap is close to $300 million. Aurora Cannabis is valued near $650 million. Are the businesses really worth that much? No.
Canopy Growth made $25.2 in revenue in the last nine months of 2016 with $6.8 million in earnings. On an annualized basis, that means the stock trades at more than 19 times sales and nearly 72 times earnings. The best word to describe Canopy's valuation is astronomical.
But at least Canopy Growth is profitable. Medical Marijuana lost $25.9 million last year on $8 million in revenue, while Aurora Cannabis lost $5.6 million on nearly $7 million in revenue during the last two quarters of 2016.
What happens to bubbles? Sooner or later, they burst. It's much better to sell before that happens than afterward.
Sell: There are better stocks to own
One of the most significant but least noticed costs associated with investing is opportunity cost. Every dollar you invest in one stock is a dollar that could have been invested in another stock that might make you higher returns.
It's true that few stocks have generated the returns that marijuana stocks have over the past couple of years. However, marijuana stocks aren't the next big thing, because they've already been a big thing. There's no guarantee that these stocks will outperform others in the future.
Are there better stocks to own? Probably so. Check out telehealth, for example. A recent survey found that 78% of Americans are interested in receiving healthcare virtually, but only 21% have actually received virtual healthcare of any kind. That's a big opportunity for growth – and represents a potential "next big thing" beyond marijuana stocks for investors.
Don't sell: The potential rewards are worth the risks
If you think the risk-reward profile of owning a given marijuana stock is more attractive than owning other stocks, then by all means don't sell. There are some marijuana stocks that I could see where this perspective could be appropriate.
GW Pharmaceuticals (GWPH) is probably the best example. The stock trades at a whopping 272 times sales, so GW is definitely not a bargain buy based on previous performance. However, should the company's Epidiolex win regulatory approval, some analysts think the cannabinoid drug could reach peak annual sales of up to $3 billion. If actual sales for the drug are even in the ballpark of that projection, GW stock should go up a lot higher.
There are risks, of course. Epidiolex might not win approval. Its sales might be much lower than what some analysts project. Still, I don't think it's unrealistic for an investor to evaluate the possible outcomes for GW Pharmaceuticals and determine the potential gains more than compensate for the risks.
Should you sell?
Whether or not to sell marijuana stocks should involve the same decision-making process used for determining when to sell any stock. Definitely look at current valuations in light of realistic growth prospects. Look at other investing opportunities. Consider the risks versus the potential rewards.
It's quite possible that you should sell some marijuana stocks while others are worth keeping. Whatever you do, don't hold on to any stock just because it's been hot in the past. Like the mutual fund disclaimers state: Past performance is not necessarily indicative of future results.