For years, the marijuana industry has seemingly shown nothing but promise. For investors lucky enough to have bought into the "Big Three" of the cannabis world -- Canopy Growth (CGC 0.77%), Aurora Cannabis (ACB 3.26%), and Cronos Group (CRON) -- at the beginning of 2016, they'd be sitting on quadruple-digit gains as of today.

Mind you, there's a very good reason why investors have been so bullish on the industry, and especially the Big Three. After global weed sales more than tripled between 2014 and 2018 to almost $11 billion, Wall Street analysts called for worldwide cannabis sales to soar to between $50 billion and $200 billion in roughly a decade's time. That's a ton of growth that investors simply can't overlook.

An up-close view of a flowering cannabis plant growing in a hybrid greenhouse.

Image source: Getty Images.

Investors have been infatuated with the Big Three for years

The pedigree of the Big Three also suggests that they have a good shot at gobbling up significant market share.

Both Canopy Growth and Cronos Group have secured large equity investments, making them the respective No.'s 1 and 2 in terms of cash on hand. Canopy's 3.14 billion Canadian dollars and Cronos Group's CA$2.32 billion gives each company ample financial flexibility to push into new markets, develop existing infrastructure, and make acquisitions. Not to mention, Canopy's equity investment from Modelo and Corona beer maker Constellation Brands and Cronos Group's investment from tobacco giant Altria gives each company a time-tested business partner to lean on.

As for Aurora Cannabis, it's made more than a dozen acquisitions since August 2016 and is in line to be Canada's leading producer. Aside from the up to 700,000 kilos the company may produce annually when all 15 of its grow farms are fully operational, Aurora also has a presence in 25 countries, including Canada.

The ability of the Big Three to expand internationally, forge partnerships, build their production portfolio, and gain brand recognition is a major reason these stocks have been so popular.

But that popularity among hedge funds came to a crashing halt during the second quarter.

An illuminated exit sign above a doorway.

Image source: Getty Images.

Hedge funds headed for the exit on big-name pot stocks in Q2

Following the end of every quarter, money management firms with more than $100 million in assets under management have 45 days to file Form 13F with the Securities and Exchange Commission, which details their holdings at the end of the previous quarter. These filings are used by Wall Street professionals and retail investors alike to find out what the brightest investment minds have been up to over the previous couple of months. Even though they're not perfect -- after all, you're being shown holdings that are 45 days old and likely may have changed -- 13Fs are a great way to identify industry, sector, and innovative trends that are gaining or losing steam.

According to data found on 13F aggregator, while institutional investors as a whole added to their positions in the Big Three, hedge funds, which are essentially more aggressively managed investment portfolios, couldn't get to the exit quick enough. During the second quarter, hedge funds reduced their positions in:

  • Aurora Cannabis by 67%
  • Canopy Growth by 32%
  • Cronos Group by 30%

In aggregate, Aurora saw hedge fund ownership reduced by more than 10 million shares, with Canopy Growth and Cronos Group seeing a reduction of more than 1.1 million shares and nearly 1.2 million shares, respectively.

A businessman giving the thumbs-down sign.

Image source: Getty Images.

Here's why the tide has turned on the Big Three

If Canopy, Aurora, and Cronos are set up to succeed, you might be wondering why hedge funds are suddenly heading to the sidelines. I believe the answer is a combination of factors.

First, Canada is contending with supply issues that aren't going to abate anytime soon. Regulatory agency Health Canada has been inundated with licensing applications for cultivation, processing, distribution, and sales. Although the agency did announce changes to its licensing application process, none of these changes should be expected to eliminate this backlog overnight. When combined with existing compliant packaging shortages in Canada, it's easy to see why product shortages have been prevalent.

To build on this point, select provinces have been slow to approve the licensing of physical cannabis stores. Without adequate physical locations, consumers have been left with few choices other than to buy online or wait out the shortage.

Another problem is that the U.S. doesn't look to be anywhere close to legalizing marijuana at the federal level. Even though Canopy and Cronos have begun pushing into the U.S. hemp or cannabidiol markets in order to lay the groundwork for a hopeful legalization of cannabis in the U.S., a Republican-run Senate led by Senate Majority Leader Mitch McConnell (R-Ky.) virtually ensures that no cannabis legislation will see the floor for a vote until 2021, at the earliest. This is a fancy way of saying that the U.S. weed market will remain off-limits for the foreseeable future.

Hedge funds are possibly also turned off by the lack of meat on bones when it comes to the Big Three's operating results. If we were to take out one-time benefits and costs, as well as the revaluation of derivative liabilities, Canopy Growth, Aurora Cannabis, and Cronos Group are all losing quite a bit of money on an operating basis. According to Wall Street, with persistent supply issues in Canada, none of these three companies is expected to deliver a full-year profit in fiscal 2020. Unfortunately for the Big Three, earnings actually matter now.

The writing appears to be on the wall from the hedge fund community: Big-name cannabis companies are off-limits until the industry matures and bottom lines improve.