What's the scariest thing you can think of about marijuana stocks?
Maybe your first thought was that the U.S. government could crack down on states that have legalized marijuana, causing stocks of companies in the marijuana industry to plunge. Or perhaps you worry about the potential for the many penny stocks of small marijuana companies to become worthless as bigger players enter the market.
Both of these are valid fears about some marijuana stocks -- but not all of them. Canadian marijuana growers Aphria (NASDAQOTH:APHQF), Aurora Cannabis (NASDAQOTH:ACBFF), Canopy Growth Corporation (NYSE:CGC) and MedReleaf (NASDAQOTH:MEDFF) don't have to worry much about what the U.S. government does. None of them are penny stocks. And there isn't a significant reason to be concerned about having bigger players enter the market.
However, there is something very scary about these stocks that also applies to most other marijuana stocks.
One scary chart
All four of the Canadian marijuana growers are small-cap stocks, with market caps ranging from around $760 million for Aphria to $1.75 billion for Canopy Growth. I was curious about how these marijuana stocks' valuations compared to the other 2,000-plus small-cap stocks traded on U.S. stock exchanges. The following chart shows what I found -- and it's pretty scary.
Around 90% of small-cap stocks have share prices that are less than 10 times sales. Almost three out of four small-cap stocks have prices that are below five times sales. Half of the small-cap stocks claim a price-to-sales multiple of two or lower.
Then there's the aforementioned marijuana stocks. MedReleaf is more than twice as expensive as 90% of all small-cap stocks. Aphria and Canopy Growth are over four times more pricey than similar-sized companies. Aurora Cannabis claims the dubious distinction of having a valuation nearly six times greater than most small-cap stocks.
I also looked at the small-cap stocks with even steeper valuations than these marijuana stocks. The list was heavily populated with clinical-stage biotechs. Many of these biotechs don't actually have ongoing sales, but they have received revenue from collaborations with larger drugmakers. If only small-cap stocks with true sales were included, the valuation comparisons for the four marijuana stocks versus similarly sized companies would look even scarier.
Are fears overblown?
A lot of people are probably thinking to themselves (or even saying aloud), "But what about the incredible growth prospects for marijuana stocks?" I'll be the first to agree that all four companies should enjoy tremendous growth.
Canopy Growth is leading the way. The company claims the strongest momentum of the group. My colleague Sean Williams calculated that Canopy Growth could increase revenue by a compounded annual growth rate (CAGR) of 232% through 2019.
All four companies are experiencing strong sales growth already with the expanding medical marijuana market in Canada. Assuming plans to legalize recreational use of marijuana in 2018 stay on track, each of these marijuana growers stands to see super-charged sales growth.
For three of them, the German medical-marijuana market is another source for increasing revenue. Aurora Cannabis, Canopy Growth, and MedReleaf have German business units that are seeking to provide medical cannabis to patients in the country. Meanwhile, Aphria is betting on growth in the U.S. marijuana market.
If the companies can increase their revenue to 10 times current levels, their valuations would be much more in line with most other small-cap stocks. With professional services firm Deloitte projecting that the Canadian recreational market could generate at least $4.9 billion annually, that kind of growth (or better) should be attainable.
So are sky-high valuations for marijuana stocks just an imaginary bogeyman of which investors shouldn't be afraid at all? I wouldn't go that far.
Tremendous expectations for growth are already baked into the prices of these stocks. Any bump in the road could be very painful for investors. It's also highly likely that the stock prices go up at least as fast as sales do. Sooner or later, gravity will kick in. Stocks won't trade at price-to-sales multiples of 20 or greater for long.
Also keep in mind that Aphria, Aurora Cannabis, Canopy Growth, and MedReleaf are pretty much the creme de la creme of marijuana stocks. Most marijuana stocks, especially those for companies operating in the U.S., carry even higher levels of risk.
I fully expect all four of these Canadian marijuana stocks to move significantly higher in 2018. However, I won't put any of my money in them. Call me a scaredy-cat if you want, but I prefer less stratospheric valuations for the stocks I buy.