Last week, marijuana stocks briefly shot higher in response to the U.S. House of Representatives Judiciary Committee's 24 to 10 vote on Wednesday to decriminalize marijuana at the federal level, expunge federal convictions, and enable states to craft their own laws regarding cannabis. Canada's two biggest marijuana companies in terms of production capacity and market share -- Aurora Cannabis (ACB +3.54%) and Canopy Growth (NYSE: CGC) -- both gained around 33% over the course of a couple of days.
Then reality set in.
Given that the Republican-controlled Senate appears highly unlikely to even bring the bill up for a vote, stocks in the cannabis industry ended the week on a sour note. Specifically, Aurora's shares dropped by 13.5% on Friday, while Canopy's slipped by 9.3%. That's not a surprising outcome, given that the U.S. is widely considered to be the most-valuable cannabis market in the world.
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Can these two titans of the fledgling marijuana industry regain their mojo this week?
More downside and disappointment to come
Even though Aurora and Canopy have both shed around half of their value over the past 12 months, the stark reality is that these two top pot stocks are still grossly overvalued. There are three solid reasons behind this argument.
First, while the legal cannabis business does have a healthcare aspect to it, these companies are arguably best-viewed as consumer packaged goods plays. And that's a serious problem from a valuation standpoint. The average price-to-sales ratio for consumer packaged goods stocks has historically sat at around 2.5. Presently, Aurora's stock is trading at 12.8 times sales, and Canopy's shares are trading at a jaw-dropping 24.7 times 12-month trailing sales. What's more, these valuations would still be in nosebleed territory even against the benchmark of the premium-laden healthcare sector, where the average price-to-sales ratio has consistently hovered around 5.
Second, Cannabis 2.0 simply won't be the boon most investors are hoping for in 2020. Pot investors have been clinging to the hope that the legalization of edibles, beverages and vape pens in Canada will cause sales to skyrocket in the back half of next year. Aurora and Canopy, however, already appear to be bracing themselves for a letdown. Long story short, this second wave of legalization will probably be subject to the exact same supply constraints and unfavorable market dynamics that are currently hurting dried flower sales.
Lastly, the painfully slow rollout of retail locations in Canada is a major logistical issue that won't be solved overnight. It's likely to persist well into 2020 and perhaps even into 2021. Although that's an unfortunate headwind, investors should bear in mind that legal marijuana is a brand-new industry, emerging from decades of negative press, law-enforcement actions, and misinformation. It will take time to work out all the kinks.
How bad could things get for Aurora and Canopy in 2020?
Aurora and Canopy should be fine over the long haul. Both companies have well-established product portfolios and ever-expanding international footprints, and the U.S. should eventually legalize pot nationwide. Meanwhile, though, these stocks will probably continue to revert to the mean from a valuation standpoint.
The key takeaway is that Aurora and Canopy could easily drop by another 50% from current levels -- that is, if the market decides to hold them to the prevailing valuation benchmarks of the consumer packaged goods space. That might sound overly bearish, but the fact of the matter is that the market got way ahead of its skis on cannabis stocks in the lead up to the legalization of adult-use marijuana in Canada. Now, the market is tasked with revaluing these equities in light of their less-than-stellar fundamentals and shaky near-term outlook.
