The marijuana industry has had nothing short of an incredible year. We've witnessed continued expansion in the United States, marveled at the consistent uplisting of cannabis stocks to more reputable exchanges from the over-the-counter (OTC) exchange in the U.S., and more recently watched as Canada tore down barriers by becoming the first industrialized country to legalize recreational marijuana.
A marijuana bear market? You'd better believe it
Yet, for all the pot industry has done this year, and for investors since the beginning of 2016, it hasn't been enough to ebb the recent slide in marijuana stocks.
On Oct. 15, 2018, just two days before the proverbial green flag waved in Canada, the Horizons Marijuana Life Sciences Index ETF (HMLSF 0.51%), the very first cannabis ETF to debut in Canada and make its way to the OTC boards in the U.S., closed at $20.06. During the following session, on Oct. 16, it would hit an all-time intraday high of $20.86. And ever since, it's been a train wreck.
In the week following Oct. 15, the Horizons Marijuana Life Sciences ETF would proceed to lose 22% of its value. From intraday peak to intraday trough between Oct. 16 and Oct. 25, the ETF shed 32% of its value. In other words, it took just a week to completely derail the cannabis rally and push pot stocks firmly into bear market territory (traditionally defined as a decline of 20% or more from a recent high).
Why are marijuana stocks suddenly going up in smoke? It's probably a combination of the following factors.
Here's why pot stocks are plunging
First, we're moving beyond the point where promises matter. For the past couple of years, marijuana stocks have dazzled investors with robust peak production estimates and acquisitions. However, with adult-use marijuana now legal in Canada, investors are going to be looking for tangible results, rather than promises. For the time being, pretty much every marijuana stock is losing money on an operating basis, which makes the industry avoidable from a fundamental perspective.
Second, investors are realizing that it's going to take years before marijuana growers are operating at peak potential. For instance, Aurora Cannabis (ACB 0.82%), Canopy Growth Corp. (CGC 6.59%), Aphria (NASDAQOTH: APHQF), and The Green Organic Dutchman (TGOD.F) are expected to produce 570,000, 500,000, 255,000, and 195,000 kilograms, respectively, when fully up to speed. Yet, their current run rate is 45,000 kilograms for Aurora Cannabis, about 40,000 kilograms for Canopy Growth (extrapolated annually from its latest quarterly report), 35,000 kilograms for Aphria, and zilch for The Green Organic Dutchman, which won't even have a harvest till next year. Combined, that's less than 10% of their projected aggregate peak output.
Third, most of the high-margin product that's expected to drive margins isn't on the table yet. With the exception of cannabis oils, no other alternative pot products are currently allowed to be sold, including vapes, edibles, concentrates, and infused beverages. Though it's widely expected by the industry and investors that Parliament will review and legalize new options for consumption in 2019, this isn't a given. And as long as these alternative cannabis products stay off dispensary shelves, marijuana stocks like Aurora, Canopy, Aphria, and The Green Organic Dutchman could be prone to the adverse effects of dried cannabis commoditization.
Finally, and building on the previous point, there's the real possibility of cannabis oversupply wreaking havoc on margins. In the U.S., we've witnessed numerous instances of oversupply weighing down the per-gram price of dried flower, and Canadian growers could deal with many of the same issues.
How do marijuana stocks rebound from here?
If pot stocks are going to somehow right the ship after a miserable past two weeks, they'll need to start with the signing of long-term supply deals and the forging of brand-name partnerships. In this regard, Canopy Growth has the inside edge.
According to Canopy's first-quarter operating results, released in mid-August, the company had more than 67,000 kilograms of annualized supply agreements with Canadian provinces and territories, which is more than any other grower on an annualized basis. These deals create predictable cash flow and less chance of Canopy Growth being hammered by dried flower commoditization.
Canopy Growth also received a monster investment of $3.8 billion from Modelo and Corona beer maker Constellation Brands on Aug. 15. More than just a partnerships, Constellation is vested in the growth of Canopy's business, as well as bringing new products, such as cannabidiol-infused beverages, to market when legal.
We'll also need to see marijuana stocks making genuine strides to reduce their operating losses. Mind you, fair-value adjustments have helped companies like Aphria turn a quarterly profit. However, investors are wising up and looking at these companies strictly on an operating basis. They'll want to see improved operating efficiency, falling per-gram growing costs, and shrinking per-share losses.
In other words, investors want to see this industry mature. But, frankly, that could take some time.