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Here's Why Marijuana Stocks Deserve Coal in Their Stockings This Year

By Sean Williams – Updated Dec 13, 2018 at 8:38AM

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Pot stock investors would have had a great year, if not for this.

The marijuana industry has seemingly knocked down one barrier after another in 2018.

Arguably no event was bigger than the legalization of recreational marijuana in Canada on Oct. 17. Not only does lifting nine decades of prohibition in our neighbor to the north open the door for billions of dollars in added annual sales once the industry is running on all cylinders, but it provides legitimacy that the pot industry is here to stay.

Meanwhile, a handful of U.S. states wound up legalizing cannabis in some capacity this year. During the midterm elections, residents in Missouri and Utah voted to approve medical marijuana initiatives in their respective states, bringing the total number of legalized states to 32. Voters in Michigan also approved a recreational weed measure during midterms, which followed Vermont's legislative approval of adult-use weed in January. In total, 10 states have given the green light to recreational pot.

A cannabis leaf lying atop a hundred dollar bill, with Ben Franklin's eyes poking out between the leaves.

Image source: Getty Images.

Despite gaining legitimacy, pot stocks have performed miserably in 2018

These events, along with many of the largest cannabis deals in history and uplistings and initial public offerings galore, would have most folks believing that marijuana stocks had a great year. But this hasn't been the case.

Through Dec. 11, 2018, the first publicly traded marijuana ETF, the Horizons Marijuana Life Sciences ETF, had lost nearly 32% in 2018. Mind you, the stock market hasn't exactly had a banner year, but this is a more-than-30-percentage-point underperformance to the broad-based S&P 500.

Why the underperformance, you ask? Part of the blame could be cast on pot stocks delivering unimpressive earnings reports last month. To be fair, sales associated with the October legalization of recreational pot in Canada haven't yet been accounted for. We'll begin to see that revenue reflected in the operating results of cannabis growers beginning in January and February. But, on the sole basis of operating performance, seven of the largest marijuana growers lost nearly $300 million on a combined basis in the latest quarter. That's not very appealing to fundamentally focused investors.

Red tape may be playing a role as well. Health Canada has been struggling to review a backlog of cultivation applications and sale permits. Typically, these applications take months, to more than a year, to review. This is impeding the ability of growers to plant cannabis and harvest it for sale, which is perpetuating the supply shortage in more than half of Canada's provinces and territories.

A close-up of lumps of coal being placed inside of a Christmas stocking.

Image source: Getty Images.

Marijuana stocks have sabotaged their shareholders this year

However, the real reason marijuana stocks deserve a lump of coal in their stockings this year is their rampant share-based dilution.

As a reminder, pot stocks haven't had the easiest access to non-dilutive forms of capital. Banks haven't been willing to lend for fear of facing financial and/or criminal penalties, leaving most publicly traded marijuana stocks to turn to their only source of readily available capital: bought-deal offerings.

A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors in exchange for capital. Regardless of the instrument these pot stocks chose, the end result is the same: an increase in a company's outstanding share count. Common stock sales provide an immediate increase in share count, whereas convertible debentures, stock options, and warrants can boost a company's share count over many years. As this share count rises, it becomes incrementally harder for public companies to generate a meaningful per-share profit. And, let's not forget, it also weighs on the value of existing shares.

The fact of the matter is that marijuana stocks would have had a reasonably good year if not for excessive dilution.

A frustrated stock trader grasping his head while looking at losses on six computer monitors.

Image source: Getty Images.

Two prime offenders

For example, Auxly Cannabis Group (CBWTF -6.43%) has seen its market cap grow by nearly 30% since the year began, through Dec. 11, 2018. Auxly has added grow facilities, struck additional royalty partnerships, and created a vertically integrated business up and down the cannabis supply chain. And yet, its share price has lost almost 58% year to date. Why? Look no further than share-based dilution.

Since none of Auxly Cannabis Group's production partners are even expected to produce any significant amount of cannabis until next year, the company has been reliant on selling its stock in order to generate capital for acquisitions and royalty deals. As a result of Auxly's ballooning share count, investors have taken it on the chin. Clearly, value has been assigned to these acquisitions and deals in the form of a higher market cap, but investors have nonetheless been punished by Auxly's grow-at-any-cost approach.

Aurora Cannabis (ACB -0.20%), the grower with the highest projected annual peak production, has done the same to investors. Despite growing its market cap by 85% in 2018, the company's share price has fallen 22%.

Aurora Cannabis has been acquisition hungry this year, gobbling up CanniMed Therapeutics in May, MedReleaf in July, and ICC Labs within the past few weeks. These buyouts have clearly translated into added value for a company that could push for 700,000 kilograms in annual output, if not more, at peak production capacity. Yet, Aurora's share count may balloon past 1 billion following its ICC Labs purchase and when other aspects of prior bought-deal offerings (e.g., stock options) are accounted for.

Until marijuana stocks significantly reduce the pace at which they're diluting their shares, this could continue to be a problem.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool recommends Auxly Cannabis Group. The Motley Fool has a disclosure policy.

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