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2 Signs That the Cannabis Bubble Has Burst

By David Jagielski - Oct 31, 2019 at 4:05PM

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Investors aren't showing the same excitement for the industry as they have in the past.

Pot stocks have been struggling this year, and there's little reason to believe there will be a recovery happening anytime soon. Cannabis companies ballooned to significant valuations and, although it seemed inevitable that a correction would take place, their values continued to skyrocket. Now, however, there's growing evidence to support the idea that the cannabis bubble has in fact burst. Below are two reasons why there's little doubt that attitudes on the industry have changed.

1. Investors have adjusted their expectations

Sales growth used to be able to drive share prices up in the cannabis industry, but that's not the case anymore. This is a development that's been evident for months now, especially with marijuana stocks cratering this year. One of the better examples of this is Aurora Cannabis (ACB -4.62%):

ACB PS Ratio (TTM) Chart

ACB PS Ratio (TTM) data by YCharts

Even though the company has been achieving great sales growth now that the marijuana industry is open for business in Canada, that hasn't been enough to keep the stock from falling as investors have been paying less per dollar of revenue. Multiples of more than 100 times sales were ridiculous, but that didn't stop investors from buying shares in Aurora. However, from the chart above, it's clear that toward the end of 2018 when there was a big downturn in the markets, investors had adjusted how much they were willing to pay for a stock like Aurora that had little to offer besides sales growth.

While sales growth is important, so too is generating cash and being profitable. And with concerns of a recession on the rise this year, it's perhaps not surprising that investors have opted to go for safer, more value-oriented investments, which Aurora clearly isn't. While the excitement might return to the industry if legalization takes place in the U.S., it's unlikely that these astronomical valuations will be the norm again.

Cannabis greenhouse

Image Source: Getty Images.

2. Less activity when it comes to mergers and acquisitions

A year ago, rumors swirled that Aurora was in talks with Coca-Cola about a possible beverage deal, although nothing ended up materializing. Even bringing on big-name investor Nelson Peltz as a strategic advisor hasn't led to any significant partnerships or deals for Aurora -- certainly, nothing that has been able to get investors out of their seats.

However, it's hard to blame companies in other industries from not wanting to get involved in cannabis.

For one, the illegality of marijuana in the U.S. still presents a big risk that large corporations may not want to take or expose their brands to. And secondly, given the headaches that Constellation Brands (STZ 0.29%) has endured with its pot investment weighing down its financials, companies aren't going to be lining up to worsen their bottom lines while having to spend money to help keep cannabis companies operating. The once-exciting new industry to invest in is looking a lot more burdensome today.

Until cannabis companies prove to be more self-sufficient, there may not be as many deals being made. While there may be more modest deals like the one involving Canopy Growth (CGC -6.16%) and Biosteel, it may be a while before there's a groundbreaking deal that has a real impact on the industry. The level of risk, unfortunately, has become too big to ignore, especially amid all the negative press surrounding the industry this year. Concerns around vaping-related deaths being linked to cannabis products and the scandal surrounding CannTrust growing pot illegally has given investors many reasons to think twice about what's been a very volatile industry of late. 

What does this mean for investors?

For investors, the takeaway here is not to buy shares of marijuana stocks simply because they've dropped in value. While it may seem unlikely that Aurora and Canopy Growth could fall further in price, that could very well be a reality. The more that investors turn away from stocks with high valuations and more to price-conscious investments, the less demand there will be for shares of expensive pot stocks. 

However, there are still good options out there, as Charlotte's Web (CWBHF -10.13%) has been able to consistently post a profit and could be an alternative for cannabis investors looking for a better value buy. And by being focused on hemp, it's also not exposed to the risks related to vaping marijuana. Investors simply need to be more careful in deciding which cannabis stocks to invest in and focus on those that have some solid, tangible results behind them, rather than just promises of future growth.

David Jagielski has no position in any of the stocks mentioned. The Motley Fool recommends CannTrust Holdings Inc, Charlotte's Web, and Constellation Brands. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Canopy Growth Stock Quote
Canopy Growth
$3.81 (-6.16%) $0.25
Aurora Cannabis Stock Quote
Aurora Cannabis
$1.65 (-4.62%) $0.08
Charlotte's Web Holdings, Inc. Stock Quote
Charlotte's Web Holdings, Inc.
$0.68 (-10.13%) $0.08
The Coca-Cola Company Stock Quote
The Coca-Cola Company
$65.22 (0.52%) $0.34
Constellation Brands, Inc. Stock Quote
Constellation Brands, Inc.
$250.87 (0.29%) $0.72
CannTrust Holdings Inc. Stock Quote
CannTrust Holdings Inc.
$0.00 (0.00%) $0.00

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

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