The big event is now just 50 days away. On Oct. 17, 2018, Canada will lift the curtain on recreational marijuana, and in the process become the first industrialized country in the world to have approved the sale of adult-use cannabis.
This big day was a long time coming for Canada, with Parliament debating Bill C-45 (better known as the Cannabis Act) for months, and Prime Minister Justin Trudeau promising a push to legalizing pot for years. Now that it'll be legal, the cannabis industry is looking forward to bringing in billions of dollars in added annual revenue each year.
But throughout most of 2018, marijuana stocks haven't looked like they're part of an industry that's on the verge of major change. The North American Marijuana Index plunged by around 40% in the six months between mid-January and mid-July, raising serious questions about whether we were witnessing the beginning of marijuana bubble bursting or not.
Image source: Getty Images.
Pot stocks find their stride, once again
However, the past week and change have turned that cannabis frown upside down. Since their close on Aug. 14, 2018, and through their close on Friday Aug. 24, here's how a handful of the largest pot stocks have performed:
- Canopy Growth Corp. (CGC +6.48%): up 83%
- Aurora Cannabis: up 61%
- Aphria (NASDAQOTH: APHQF): up 61%
- Tilray: up 81%
- Cronos Group (CRON 0.38%): up 76%
Why such a dramatic surge in valuation in less than two weeks? The way I see it, there have been three catalysts.
1. Alcohol companies are looking for cannabis partners
Far and away the leading catalyst has been the suddenly ramped-up interest in marijuana stocks by alcohol companies. Spirit, wine, and beer makers have struggled to generate significant growth in developed markets and, frankly, they fear losing even more sales if consumers decide to make a conscious choice to purchase cannabis products instead of liquor, wine, or beer in legal markets. By partnering with cannabis companies, alcohol businesses are hopefully offering themselves a new path for growth.
Image source: Getty Images.
Before the opening bell on Aug. 15, Constellation Brands (STZ +1.66%), the company behind the Corona and Modelo beer brands, announced that it was significantly upping its existing equity stake in Canopy Growth Corp. to 38% with a $3.8 billion investment (the purchase of 104.5 million shares of Canopy's common stock). This was actually Constellation's third such investment, with the company taking a 9.9% equity stake worth about $190 million back in late October 2017, and then acquiring a third of Canopy's convertible debt offering of 600 million Canadian dollars in June. If Constellation chooses to convert these notes to shares, it could up its equity stake even more.
The big news here is twofold. First, Constellation Brands received 139.7 million warrants as a result of its investment, which, if exercised, could push Constellation's ownership in Canopy Growth over 50%. While such a scenario would likely result in Constellation Brands acquiring what it doesn't already own of Canopy Growth, such a move is unlikely for a variety of reasons prior to late 2020 or 2021, at the earliest.
Secondly, it has Wall Street wondering what pot stock is next to partner with big alcohol. We saw Molson Coors Brewing announce a joint venture with Hydropothecary Corporation four weeks ago and, based on the surge in share price noted above, Wall Street appears to be looking to Tilray or Aurora Cannabis as the next logical partner to the alcohol industry.
2. Donald Trump isn't happy with Jeff Sessions
Another reason pot stocks could be soaring is the growing rift between U.S. President Donald Trump and Attorney General Jeff Sessions.
Sessions is perhaps the most ardent opponent of marijuana's state-level expansion on Capitol Hill, and was the primary figure behind the rescission of the Cole memo in early January. The Cole memo provided a set of guidelines that legalized states were to follow if they wanted the federal government to leave them alone. Its rescission opened the door to potential state-level prosecution of businesses and or individuals in violation of the Controlled Substances Act -- and remember, cannabis is a Schedule I (i.e., wholly illegal) drug.
Image source: Jeff Sessions' Senate webpage.
However, Trump and Sessions haven't eye to eye since Sessions recused himself from the Russia investigation that's been ongoing and has since resulted in convictions. Recent tweets from the president show displeasure with Sessions' lack of action on the Russia investigation and hint that he could be removed from his position as attorney general.
The marijuana industry has long viewed Sessions as the leading obstacle in Washington to legalization. His possible removal, along with the recent approval of GW Pharmaceuticals' cannabis-derived drug Epidiolex, could be the catalysts that encourage lawmakers on Capitol Hill to reschedule or deschedule cannabidiol or marijuana as a whole.
This rift between Trump and Sessions could be why Aphria and Canopy Growth have both had legs of late. Aphria divested what assets it held in the U.S., but has shown clear interest in entering the U.S. market in legal states. Meanwhile, Canopy Growth's press release outlining Constellation's equity investment makes specific mention of the U.S. in its expansion plans. Though it's highly unlikely to enter the U.S. with the federal government keeping cannabis as a Schedule I drug, any change to that classification would likely encourage Canopy and Aphria to jump right in.
3. This is a momentum-driven industry, and the tide has again shifted
Finally, we have to realize that marijuana stocks are more of an emotion-based or momentum trade at the moment than they are a fundamental long-term investment.
Image source: Getty Images.
Though there are obviously big dollar figures behind the legalization of adult-use weed in Canada, it's going to take some time before pot stocks are generating recurring profits. For instance, Cronos Group is nearly sporting a $1.8 billion market cap, but has a trailing P/E of nearly 1,000, a forward P/E of roughly 130, and is trading at almost 250 times its trailing-12-month sales. On a fundamental basis, Cronos Group is a nightmare and a company that long-term value investors would (and should) avoid. It could take years before a company like Cronos Group grows into its current valuation, which suggests that many of today's investors are in for the momentum or quick buck, rather than the long haul.
As a reminder, it's virtually impossible to perfectly predict the peaks and troughs in the stock market or individual stocks with any consistency over the long run, which makes short-term momentum trades with marijuana stocks not advisable.
Ultimately, I do expect the marijuana industry to be successful, but I still struggle to see how investors will make money with valuations already having ballooned into the stratosphere.
