Please ensure Javascript is enabled for purposes of website accessibility

The 2 "G's" Absolutely Killing Pot Stocks Recently

By Sean Williams – Sep 17, 2019 at 6:21AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

These two issues are fixable, but it's not going to happen overnight.

For years, investors have been told the tale that marijuana stocks might be one of the greatest growth stories over the next decade. And based on the sales data we have, that very much looks like the case. Between 2014 and 2018, the duo of Arcview Market Research and BDS Analytics found that global legal weed sales more than tripled to $10.9 billion. Estimates on Wall Street opine that worldwide sales could gallop to as high as $200 billion a year by the end of the next decade.

Yet, if you take a closer look at the performance of marijuana stocks since the end of March, it's been abysmal. Inclusive of dividends paid, the Horizons Marijuana Life Sciences ETF, the first-ever tradable exchange-traded fund focused on cannabis, has shed 30% since the end of March.

While there are obviously a number of factors that can be blamed for this subpar performance, many of them point back to the two "G's": governance and greed.

A judge's gavel next to a handful of dried cannabis buds.

Image source: Getty Images.

Stringent governance has been challenging

Tight federal, state, and/or local regulations are difficult for an industry used to operating in the black market for decades to get used to -- and we've seen these struggles play out both in Canada and in the United States.

In Canada, for example, dried flower supply issues have been persistent since day one of recreational pot sales on Oct. 17, 2018. Sure, some of this blame can be placed on growers that began expanding their capacity later than expected. However, the bulk of these supply problems can be traced back to governance issues.

Health Canada, the regulatory agency tasked with overseeing the Canadian weed industry, began this year with more than 800 cultivation, processing, and sales license applications on its desk for review. This is why, on average, it's taking many months, if not more than a year, to approve growing or sale licenses. Even though Health Canada announced policy changes designed to help it work through its backlog, it'll still take numerous quarters before the agency makes sizable headway. This means continued supply concerns for dried flower, as well as with derivative pot products, which are set to begin hitting dispensary shelves by mid-December.

To add to the above point, we've also witnessed regulatory hurdles in select provinces. Ontario, for instance, has been particularly slow to open physical dispensary locations, which has meant considerably lower-than-expected sales in the province.

We're also seeing governance issues come into play in the United States, albeit to a slightly lesser degree than in Canada. In California, the state has been slow to approve dispensary store licenses. More important, municipalities have been given the option to allow or deny cannabis retailers. According to the Los Angeles Times, a meager 18.5% of California's 482 cities are allowing marijuana to be sold in dispensaries. That's created an open invitation for illicit producers to set up shop throughout the rest of the state.

A clear jar packed with cannabis buds that's lying atop a small pile of cash.

Image source: Getty Images.

Greed, vis-a-vis high tax rates, has been a killer

But don't place all of the blame simply on tight industry regulations throughout North America. High tax rates, especially in certain U.S. markets, deserve credit for pressuring cannabis stocks.

Once again, California is a front-and-center culprit. Although it's the largest cannabis market in the world, and is estimated to account for almost a quarter of the $30.1 billion in licensed-store sales by 2024, according to Arcview and BDS Analytics, its tax rates on legal weed are outrageous.

California's cannabis consumers are currently paying for a laundry list of expenses that includes:

  • State sales tax
  • Local sales tax
  • The excise tax of 15% added to cannabis sales
  • A wholesale tax on cannabis leaves or flower
  • The laboratory testing confirming the quality of the product
  • Other regulatory costs, including seed-to-sale governance and tracking

Long story short, estimates range, depending on the locale and the magnitude of other expenses that aren't listed as taxes, from a tax rate of anywhere from somewhere in the 40% range to as high as 77% on legal marijuana in California. This means that black-market marijuana can run circles around legal-channel cannabis on price -- and that's exactly what's happened. This year, 74% of pot sold in the Golden State is likely to avoid taxation since it'll come from the illicit market.

Canada's excise tax rate of roughly 10% is considerably lower than most legal weed markets in the U.S., and has, therefore, been less exposed to greed concerns. Nonetheless, supply shortages and modest price undercutting of the legal market has opened the door to Canada's black market.

A magnifying glass being held above a potted cannabis plant.

Image source: Getty Images.

Brand-name pot stocks are suffering

These governance and greed concerns are both fixable, but it's going to take quite a bit of time to tackle these issues. In the meantime, pot stocks with the richest valuations are liable to feel the most pain from the industry failing to live up to near-term expectations -- namely, pot stocks like Canopy Growth (CGC 0.36%) and Aurora Cannabis (ACB -0.40%), which are valued at aggressive multiples of fiscal 2020 sales despite the fact that both will likely lose money next year.

Canopy Growth is particularly exposed here, given its ballooning losses and top-level turnover. In early July, company visionary and now-former co-CEO Bruce Linton was shown the door, leaving investors to wonder who'll lead Canopy Growth's strategy moving forward. Linton's "expand first, ask question later" strategy has put the company in line to gobble up significant market share when supply issues are resolved in Canada. However, this aggressive acquisition and expansion strategy, along with Linton's robust share-based compensation offered to employees, might make Canopy one of the last major growers to turn a recurring profit.

Meanwhile, Aurora Cannabis' fiscal fourth-quarter report alludes that the company has done everything it can from a production perspective to get more marijuana to market. Nevertheless, Aurora's report notes that there are conditions beyond the company's control when it comes to the country's supply challenges. Making matters worse, Aurora's early year prediction of fourth-quarter positive recurring EBITDA didn't come to fruition, and the company is still lugging around 3.17 billion Canadian dollars in goodwill, which heightens the likelihood of an eventual writedown.

Long story short, brand-name cannabis stocks may offer long-term promise, but they're very avoidable for the moment while governance and greed issues are being sorted out.

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

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Canopy Growth Stock Quote
Canopy Growth
$2.79 (0.36%) $0.01
Aurora Cannabis Stock Quote
Aurora Cannabis
$1.25 (-0.40%) $0.01

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/30/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.