Few industries have been as smoking hot as the legal marijuana industry over the past couple of years. Many of the world's largest publicly traded pot stocks by market cap have seen their valuations rise by 1,000% or more over the trailing two-year period.
What's the buzz behind pot stocks?
The impetus behind this surge in marijuana stock valuations is a combination of three factors. First, we've seen legal weed sales catapult higher in North America, and they're beginning to pick up in Europe, considering that a number of countries have legalized the use of medicinal cannabis. According to ArcView, North American legal weed sales rose 33% in 2017 to $9.7 billion, and they're estimated to hit $24.5 billion by 2021.
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Second, a decisive shift in the way the public views cannabis has investors excited. Within the U.S., national pollster Gallup found in its October 2017 survey that an all-time high 64% of respondents favored the idea of legalizing marijuana. Comparatively, only 25% of respondents were in favor of legalizing pot back in 1995, the year before California became the first state in the U.S. to allow the use of medical marijuana for select ailments.
Lastly, it's all about the potential for recreational weed legalization in Canada. It appears the votes are well in place to pass the Cannabis Act, and the federal government has worked out a two-year tax-sharing agreement with all but one province, Manitoba. Legalization in our neighbor to the north would generate $5 billion or more in annual sales.
The North American Marijuana Index has plunged recently
Yet if we were to take a closer look at the North American Marijuana Index, a representative measure of the performance of a collective 39 pot stocks throughout North America, we'd see it's been tumbling of late. Understandably, things should be taken into context. Over the trailing six-month period, the North American Marijuana Index has risen by 127%, which isn't too shabby. However, since hitting an all-time closing high of 363.31 on Jan. 23, the highly followed measure of pot stock health has plummeted 29% in a matter of eight weeks.
What on Earth is going on? My suspicion is that three catalysts have been pushing valuations lower.
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1. Canada pushed out the official launch of recreational pot sales until August or September
First, we have the delay in the projected launch of legal recreational weed sales in Canada. When legislation was first introduced in April 2017 to green-light the sale of adult-use pot, Prime Minister Justin Trudeau hammered home a timeline of allowing sales by this July. Even though progress has been made in terms of proposing a tax rate and formulating a tax-sharing agreement with most provinces, the individual provinces themselves have stated on numerous occasions that a July launch wouldn't give them adequate time to get everything they needed in place before the federal government waved the green flag.
The good news is that delaying the launch of recreational weed sales by one or two months, assuming passage of the Cannabis Act, won't have any material impact on the industry over the long run. All it's really done is take the wind out of the sails of short-term investors who'd been counting on a dramatic launch out of the gates this July for legal cannabis.
If anything, this delay could actually be good news for some Canadian growers. In particular, Aphria (NASDAQOTH: APHQF), which is projected to a top-three grower by annual production at 230,000 kilograms, would benefit by being able to close the production gap between it and peers. For instance, Aphria isn't expected to complete its organic, four-phase, 1 million-square-foot project until January 2019. This project should yield around 100,000 kilograms, but it'll be completed a bit later than some of its peers. This delay helps Aphria narrow the production gap a bit.
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2. Dilution could be taking its toll
Next, we could be seeing the initial impact of share dilution beginning to take its toll on Canadian marijuana stocks. The issue pot stocks run into is that even if they're profitable, they aren't generating enough operating cash flow to expand their product lines or growing capacity. They also, in many cases, have little or no access to basic banking services since marijuana is still illegal in all countries but one worldwide, the exception bring Uruguay. The answer for these marijuana stocks has been to turn to bought-deal offerings, where common stock, convertible debentures, warrants, and/or stock options are offered.
For example, Aurora Cannabis (ACB -2.96%), the Canadian grower that's expected to be either No. 1 or No. 2 in overall production at an estimated 283,000 kilograms a year, has been aggressive with bought-deal offerings to raise capital. On one hand, who could blame Aurora Cannabis given that its strong production could be the key to securing long-term supply contracts if recreational weed is legalized? Then again, each of these offerings, which have funded the organic expansion of Aurora Sky, as well as its cash-and-stock acquisition of CanniMed Therapeutics, the most expensive pot acquisition in history, is rapidly increasing its outstanding share count and diluting existing investors.
Since the end of fiscal 2014, Aurora Cannabis' outstanding share count has catapulted higher by more than 2,900% to almost 490 million shares -- and it's expected to move even higher. There are convertible debentures, warrants, and stock options that aren't yet factored into its outstanding share count, and it recently issued new shares to cover its acquisition of CanniMed. Shareholders may simply be discounting this current and future dilution, thus hitting pot stock valuations.
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3. Normal profit-taking and tax-based selling
Lastly, it's perfectly reasonable that simple profit-taking and tax-based selling could be responsible for the recent downdraft in marijuana stocks. Between October and Jan. 23, the North American Marijuana Index more than tripled, so it's not out of the question that investors locked in some of those profits in recent weeks.
The timing of the sell-off, which happens to coincide with the peak in the U.S. stock market, may also have something to do with tax-based selling. Investors might be selling marijuana stocks to pay their 2017 tax bills (should they owe money), or they could have waited until 2018 to sell as a result of potentially lower short-term tax rates in the United States as a result of the implementation of the Tax Cuts and Jobs Act. Regardless of which reason is responsible, profit-taking and tax-based selling aren't long-term concerns for the marijuana industry.
For the time being, the only real concern for long-term marijuana stock investors is dilution. However, this dilution could be more than enough to continue to weigh on weed stocks in the near and intermediate term.
