Big things are happening with the marijuana industry in 2018. Since the beginning of the year:
- GW Pharmaceuticals (NASDAQ:GWPH) became the first cannabinoid drug developer to receive approval for a cannabis-derived drug from the Food and Drug Administration.
- Vermont made history by becoming the first U.S. state to legalize the use of recreational marijuana entirely through the legislative process (i.e., without going to vote on a ballot).
- Multiple over-the-counter-listed pot stocks uplisted to more reputable U.S. exchanges, such as the New York Stock Exchange and Nasdaq.
- Canada became the first industrialized country in the world to legalize adult-use marijuana, opening the door for what could be $5 billion or more in added annual sales, once the industry is ramped up.
And these are just a handful of the major marijuana events that've occurred this year. It's these events, and the expectation of rapid sales and profit growth, that have pushed marijuana stocks considerably higher in recent months and years.
History suggests that the marijuana bubble will burst
However, history has shown that all "next big thing" investments struggle to hold their astronomical gains over the long run. Whether we're talking about the internet, business-to-business commerce, the decoding of the human genome, 3D printing, or blockchain technology, the bubble has burst all the same.
Now, this isn't to say that there haven't been great companies to emerge from these industries. But it does suggest that marijuana stocks, like other rapidly growing industries that have emerged over the last quarter century, are likely to deflate -- and investors know this.
Although incredibly risky, pessimists have been more than willing short sell marijuana stocks. In other words, bet on a decline in pot stock prices. Short-selling is particularly risky because gains are capped at 100% (a stock can't drop below $0), whereas losses can be infinite. As the icing on the cake, short-sellers are borrowing shares from their brokerage, meaning they're paying an annual interest rate on what they borrow. For some highly volatile marijuana stocks, this APR is a double- or even triple-digit percentage.
Short-sellers are concentrating their efforts on these six pot stocks
But what's really interesting about investors' pessimism is that it's being almost entirely concentrated in a half-dozen marijuana stocks.
In a research note published by S3 Partners last week, courtesy of Investopedia, the top 20 marijuana stocks in terms of short interest on the U.S. and Canadian exchanges have combined for $2.867 billion in bets made against the industry. Adding both the U.S. and Canadian listings, the following six marijuana stocks account for 90% ($2.58 billion) of this short interest.
- Canopy Growth Corp. (NYSE:CGC): $957 million
- Aurora Cannabis (NYSE:ACB): $655 million
- GW Pharmaceuticals: $315 million
- Tilray (NASDAQ:TLRY): $306 million
- Cronos Group (NASDAQ:CRON): $273 million
- Aphria (NASDAQOTH:APHQF): $107 million
I concur that most of these short-sell bets make a lot of sense.
Betting against these cannabis stocks makes sense
For example, Aurora Cannabis, though forecast to lead the industry in peak annual production (570,000 kilograms-plus per year), is going to have to do more than simply grow a lot of weed in order to differentiate its business. It's been acquiring businesses like it's going out of style and, in the process, has ballooned its outstanding share count. By the time Aurora completes its acquisition of ICC Labs, it could have around 1 billion shares outstanding. This'll make it very difficult for Aurora Cannabis to generate a meaningful per-share profit.
Cronos Group is another pot stock that simply may not be worth its weight in peak production. Only recently did Cronos begin construction on a joint-venture facility that'll yield 70,000 kilograms when fully operational. With this facility unlikely to be hitting its stride until 2020, Cronos Group is being valued as an industry leader with what could be just 70,000 kilograms to 80,000 kilograms of combined annual production.
Tilray, too, deserves some attention from short-sellers. Although this a business model I can appreciate, given its focus on high-margin medical cannabis patients, there's no logical way to defend a share price north of $100 (let alone the $300 it hit on an intraday basis back in September). Tilray is going to be spending heavily to boost capacity, ensuring that losses continue for the near future. Furthermore, it's still quite a ways away from becoming a top-tier producer.
Lastly, I can fully understand pessimists betting against GW Pharmaceuticals. Even though GW"s lead drug, Epidiolex, is in the driver's seat for two rare types of childhood-onset epilepsy, there's competition on the immediate horizon. It's unclear whether GW Pharmaceuticals' lofty valuation will be justified given the approval of a single cannabidiol-based drug.
Will these shorts pay off?
On the other hand, it remains to be seen if it's wise to bet against Canopy Growth or Aphria.
Canopy Growth Corp., while pricey, has what's arguably the best sales channels and most-recognized brand (Tweed) throughout Canada. It also has the backing of Corona and Modelo beer producer Constellation Brands, which announced a $3.8 billion investment in Canopy Growth in mid-August. Constellation has now poured more than $4 billion into Canopy Growth, which is good for a 38% equity stake. With tangible backing from a brand-name alcohol producer, short-sellers could be playing with fire.
Then there's Aphria, which is considerably less expensive than its peers based on its forward price-to-earnings ratio. Aphria doesn't yet have a major partner in the beverage, tobacco, or pharmaceutical industry, but it is expected to be Canada's third-largest producer by annual yield (255,000 kilograms). Roughly 10% of its production will be focused on high-margin concentrates, which could be yet another dangling carrot for a larger partner.
While these two could certainly head lower, the pessimist's case is a lot murkier.