The evolution of the legal marijuana industry has reached another level. Last week on Oct. 17, Canada lifted the curtain on nine decades of prohibition and legalized recreational marijuana for adults. By waiving the proverbial green flag, a new era has been ushered in whereby legal-channel cannabis companies are angling for their slice of $5 billion (or more) in added annual sales.
Given the notable surge in pot stocks since the beginning of 2016, it's pretty evident that Wall Street and investors expect the industry to be a resounding success. However, we as investors know from previous "next big thing" investments, not every company can be a winner.
With that being said, there are a handful of marijuana stocks -- some quite popular -- that I simply wouldn't buy, even if I were given free money to do so. In no particular order, here are those five pot stocks.
1. Aurora Cannabis
Why investors like Aurora Cannabis: The simple reason Wall Street and investors have been enamored with Aurora Cannabis (NYSE:ACB) is the company's peak annual production potential of at least 570,000 kilograms. Assuming the company meets or exceeds this guidance, which doesn't even include its ongoing acquisition of South America's ICC Labs, it should allow Aurora to be the top dog in terms of production. Presumably, this should lead to plenty of long-term supply deals and lucrative partnership opportunities, as well as allow the company to take advantage of lower growing costs as its production expands.
Why I'm not touching it: While not oblivious to the advantages offered by being a top-tier producer, I don't believe Aurora's valuation makes sense given the large sea of unknowns facing the company. For example, it's made numerous acquisitions in recent months and is still in the process of expanding capacity with a number of organic projects. Trying to keep these projects on schedule and budget could prove difficult.
I also worry about the long-term impact of share-based dilution. Yes, acquiring other companies adds value, but Aurora isn't exactly purchasing these other businesses at a great value, in my opinion. In just over four years' time, Aurora's outstanding share count has ballooned from around 16 million to likely close to 1 billion, once its ICC Labs deal closes. Not only does this weigh on existing shareholders, but it makes it that much harder for Aurora to report a meaningful per-share profit. In short, its triple-digit forward price-to-earnings ratio is probably here to stay for a while.
Lastly, I worry about Aurora's chances of standing out in a crowded field. There's going to be far more to success in the cannabis industry than just growing pot, and I'm not entirely sure that this management team understands that.
2. Cronos Group
Why investors like Cronos Group: Cronos Group (NASDAQ:CRON) is a popular stock among the investment community for two reasons. First, with an author-estimated peak production potential of around 140,000 kilograms, Cronos Group should easily slide in as a top-10 grower by yield. Secondly, there's the company's dealmaking potential. Just last month, Cronos Group surged higher after forging a 122 million Canadian-dollar deal with Gingko Bioworks to engineer a variety of rare cannabinoids at commercial scale. These cannabinoids should yield considerably higher margins than dried cannabis.
Why I'm not touching it: Just as there are two reasons the investment community appears to favor Cronos Group, there are two reasons I'd avoid it, even with free money.
To begin with, Cronos Group is somewhat late to the game in its expansion efforts. In mid-July, Cronos announced a joint venture with a group of investors to create Cronos GrowCo and build an 850,000-square-foot facility that's capable of roughly 70,000 kilograms per year, at full capacity. It's going to take some time before this organic build gets off the ground -- meaning Cronos isn't likely to be anywhere near 100,000 kilograms-plus in annual output until 2020 or later. This could cause it to miss out on lucrative supply deals and partnerships.
The other concern I have is Cronos' valuation. Whereas virtually all marijuana stocks are losing money right now, a number of them will transition into modest profitability in fiscal 2019. I'm not entirely certain that'll be the case for Cronos given its spending on capacity expansion and its aforementioned late start to its joint-venture organic build. Fundamentally focused investors like myself simply won't find much to like about Cronos Group.
3. MedMen Enterprises
Why investors like MedMen Enterprises: Bottle-rocket MedMen Enterprises (NASDAQOTH:MMNFF) has caught investors' attention for a number of reasons. For starters, it's focused on the U.S. market, which could be far more lucrative on a peak sales basis than Canada. Secondly, it's trying to reshape how consumers purchase cannabis by making its stores a unique experience, similar to how Apple operates its stores. And more recently, investors have to like the announced acquisition of PharmaCann for $682 million in an all-stock deal. Once that deal is closed, MedMen will have a retail and/or grow-farm presence in 12 U.S. states.
Why I'm not touching it: Although I fully appreciate what the management team is trying to do and I understand MedMen's reasoning for going all-out to acquire privately held PharmaCann, the biggest pill to swallow is that MedMen's costs are going to soar as it opens new locations and digests the largest U.S. cannabis deal to date.
Right now, MedMen has 16 retail locations, which includes a handful of stores in the Las Vegas area that are in development. Prior to its PharmaCann acquisition, the company was looking to roughly triple this footprint by the end of 2020. Now add in PharmaCann and its own expansion plans along with this being an all-stock deal, and MedMen's operating expenses are going to skyrocket. In my view, there's virtually no chance it'll be profitable any time before 2021 -- and that might even be pushing it.
With MedMen so aggressively expanding, there's also a very strong possibility it could look to raise additional capital through a dilutive share offering. This has been a common theme with pot stocks, and my suspicion is MedMen will follow that path, hurting shareholder value in the process.
4. The Green Organic Dutchman
Why investors like The Green Organic Dutchman: Similar to Aurora Cannabis, The Green Organic Dutchman (NASDAQOTH:TGODF) is beloved for its peak production potential. Management has been aggressive on the organic build and partnership front, with TGOD, as the company is also known, looking at an estimated 195,000 kilograms of peak annual production. Based on highly fluid production figures, TGOD looks to be a top-five grower.
Why I'm not touching it: Even though The Green Organic Dutchman is making what I believe is a smart decision to devote about 20% of its aggregate annual production to beverages and edibles, there are a large number of unknowns built into this $1 billion market cap.
Similar to Cronos Group, TGOD is late to the game in its capacity expansion. But whereas Cronos at least already has steady production from Peace Naturals and its Original BC lines, The Green Organic Dutchman won't have its first harvest and sale until sometime during the first half of next year. That's how far behind it is compared to the rest of its peers. I suspect it'll almost assuredly lose out on lucrative supply deals as a result and may continue to hurt shareholders with bought-deal offerings to cover its high expenses in the interim.
Investors probably also are baking too much value into the company's edibles and beverage line. Remember, dried cannabis and oils are all that's legal right now, with nothing more than a word-of-mouth expectation that Parliament will review and expand consumable options for infused beverages, edibles, vapes, and concentrates in 2019. In other words, the company's 287,245-square-foot facility is unlikely to be a near-term needle mover.
Why investors like Tilray: Without beating around the bush, investors (or should I say day traders) like Tilray (NASDAQ:TLRY) because it's been acting like a dot-com stock from 1999. In a few weeks, it ran from $25 a share to $300 a share, then promptly lost two-thirds of its value. Aside from its volatility, Tilray has a well-established line of cannabis products focused on the medical market and has the potential to expand its annual capacity to north of 200,000 kilograms, with ease. It certainly appears to be in line to attract brand-name partnership opportunities from beverage, tobacco, and/or pharmaceutical companies.
Why I'm not touching it: There's no clearer reason not to touch Tilray than its valuation. Sporting a $14 billion market cap, Tilray would have to execute its business strategy flawlessly to maintain this valuation. The problem is, nothing ever goes flawlessly in the business world.
Last quarter, Tilray reported a 95% increase in year-over-year sales, but we're only talking about $9.7 million in aggregate revenue for a $14 billion company. Considering that Tilray is only on track to have around 850,000 square feet of growing capacity complete by the end of this year, it and Aurora will be spending aggressively to expand its growing footprint, like TGOD and Cronos. Translation: Expect losses to continue for at least the next couple of years.
Investors also won't want to overlook the company's lock-up period on Jan. 15, 2019. On this date, the company's float (i.e., number of shares that can be traded) will expand, and insiders will be free to sell. The fact that insiders haven't been able to sell in addition to a relatively small number of shares that can be traded have made Tilray volatile and provided some pep to its step. That'll be ending sooner than you realize.
Even if given free money, I wouldn't want it anywhere near these five popular pot stocks.
Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.