Cannabis investors who are looking for the sector to rally in 2020 could be in for a big disappointment. In 2019, the Horizons Marijuana Life Sciences ETF fell by 39%, and there were cannabis stocks that did much, much worse. Although valuations may appear to be low, especially compared to where they were at a year ago, that doesn't mean that they're cheap or worth investing in today. There are three reasons why investors shouldn't expect a big recovery from pot stocks in 2020:
1. Valuations remain high
It may be hard to accept the notion that stocks that have plummeted more than 60% in value are still expensive, but investors shouldn't be quick to scoff at that. HEXO (NYSE:HEXO) is a prime example of a stock that's fallen heavily and that may still be too expensive. It was one of those underperforming pot stocks that fell a whopping 70% in 2019, far below the Life Sciences ETF and what its peers averaged. While the temptation may be to point to HEXO's low price-to-book multiple of 0.7 and say that it's a cheap buy, it's just not that simple. Writedowns aren't uncommon in the industry and the value of what's on the books for many of these cannabis companies can be questionable at best.
Last month, HEXO released its year-end results. Not only did the company have fair-value gains on inventory and biological assets, but it also incurred an impairment loss totaling 19 million Canadian dollars during the year. The amount of noise on the company's financials makes it difficult to assess what the true value of HEXO's assets are today, and so if the stock is trading below book value, that may not necessarily mean that it's undervalued. Aurora Cannabis, for instance, trades at just 0.6 times its book value and investors aren't rushing out to buy shares of the company, either.
Pot stocks have been overvalued for so long and by so much that it's hard to tell what a reasonable multiple looks like anymore. HEXO's price-to-sales multiple of nine looks like it's a steal of a deal compared to its peers -- Aurora trades at nearly 10 times its sales -- but once you look at other growth stocks, that isn't the case. Amazon.com, a stock that's no stranger to high valuations, trades at only 3.5 times its sales.
HEXO is much cheaper than it was a year ago, but that's not much of a benchmark for investors to use.
2. Vaping concerns could undermine valuations and sales numbers this year
Perhaps the most important consideration for investors to factor in today is the impact that vaping-related illnesses will have on the industry this year. Not only do problems relating to vaping make vapes more dangerous, but they could impact the growth potential for many pot stocks, and hence the multiples that investors are willing to pay for them.
The cannabis 2.0 market, which features ingestible and edible products, is now legal and Canada and vapes are a big part of that new segment. Professional services company Deloitte estimates that the entire cannabis 2.0 segment in Canada will be worth CA$2.7 billion annually. That could give the industry a big boost given that Deloitte's estimate for the medical and recreational pot market, excluding cannabis 2.0, is worth anywhere from CA$2.6 billion to CA$6.13 billion. While Deloitte didn't isolate a number specifically related to vaping, numbers from multiple states in the U.S. suggest that vape sales can make up between 20% to 30% of the total market for recreational pot.
Cannabis 2.0 sales will play a significant role in the industry's growth, but vaping-related illnesses could weigh down those results this year. And HEXO knows all too well how disappointing sales results can negatively impact a stock's price.
3. Different kinds of supply issues may arise in 2020
Since Canada legalized recreational marijuana on Oct. 17, 2018, one of the biggest problems has been that there was not enough supply in the industry. However, with more producers coming on line and existing ones adding to their capacity, there could be downward pressure on prices and that could make turning a profit even more difficult this year.
Analyst Matt Bottomley at Canaccord Genuity believes that pot prices could drop sharply: "I suspect it'll be a race to the bottom with price because everyone now has more than enough supply." If that happens, losses could get even bigger and companies may see their margins worsen rather than improve, even as new edible and ingestible products hit store shelves.
What does this mean for investors?
As bad as 2019 was for the cannabis industry, there's no guarantee at all that this year will be any better for Canadian marijuana stocks. Investors need to be careful in deciding which pot stocks to invest in as 2020 could be another challenging year. These companies are already in bad shape and burning through lots of cash. Although they've declined in value, if their results don't improve, there's no reason they can't continue to fall further down in price.
Investors should carefully assess the financial health of a cannabis company as well as evaluate how likely it is to post a profit this year before deciding whether to invest in it.