The cannabis industry has taken investors on a roller coaster ride over the past couple of years. And while some investors earned terrific profits, many incurred significant losses. Finding a middle ground can be difficult, but there are ways cannabis investors can protect themselves and minimize their level of risk to the industry while still taking advantage of its attractive growth opportunities. Below are three things cannabis investors should strive to do in 2020 when investing in pot stocks:
1. Consider valuation multiples
One of the most obvious signs of problems for the cannabis industry was how high valuations had become. Earlier this year, Canadian marijuana producer Canopy Growth (CGC -1.69%) had a market cap of $17 billion. To put that into perspective, cannabis research company BDS Analytics projected the entire marijuana industry in Canada to be worth just $5.2 billion, and that figure wouldn't be reached until 2024. Although the company was growing its presence outside of Canada, that would remain the largest market the company could access until the U.S. legalizes pot, which could be years away.
For the top cannabis stock in Canada to have a higher valuation than the entire industry in the country was absurd, but investors kept on buying based on the hype. That's why the correction that Canopy Growth and other pot stocks went on in 2019 wasn't as shocking as it was overdue.
What investors can do to protect themselves is consider valuations and multiples before buying a stock. In particular, the price-to-sales (P/S) ratio can be an effective way to gauge how expensive one stock is in relation to another. Cannabis producer Cronos Group trades at more than 88 times its sales. By comparison, Facebook, one of the top tech stocks in the world, has a P/S of less than 10. Currently, Canopy Growth is at a multiple of 28. While that's still high compared to Facebook, it's much more modest than Cronos' astronomical value.
At the very least, factoring in something like P/S when comparing pot stocks allows investors to quickly assess which ones are cheaper buys relative to their peers. Plus, since many marijuana companies aren't profitable, using the more common price-to-earnings (P/E) multiple isn't helpful.
2. Focus on operating income rather than net income
Investors probably shouldn't use P/E for cannabis stocks anyway, even if it were available for comparison purposes. That's because revaluation gains and other income can inflate earnings numbers. While it sounds good to hear that a company has posted a profit for the quarter, investors should always try to drill deeper into the results.
One way to do that is by stopping at the operating income line rather than net income. While this will include the impact from adjustments that may happen to the cost of goods sold, operating income ignores investment gains, foreign exchange, and any other non-operating items that can skew net income. It's not a perfect solution, but it gives investors a better starting point than net income, making it easier to compare quarterly reports.
3. Pay close attention to the statement of cash flow
Even if a company records a profit and doesn't get any help from gains or other income, that may not necessarily be the most important number investors should look at. Cash is at a premium in the industry and in order to keep growing, companies need to be generating positive free cash flow. If they're not, it can lead to a company issuing more shares, which results in shareholder dilution.
Canopy Growth's free cash flow over the past 12 months has been a negative 1.5 billion Canadian dollars. Although the company has more than CA$1.1 billion in cash on its books and big investor Constellation Brands to help it out, it's a problem that Canopy Growth needs to fix sooner rather than later. Otherwise, the business won't be sustainable.
Finding a cannabis stock with good free cash flow will minimize the risk of shareholders seeing their investments diluted. Strong free cash flow is also indicative of a company that's well-run and that's in a good position to continue growing.
Investors need to do their own due diligence
Investing in marijuana companiesis risky and it's going to remain that way as the industry continues to grow. However, cannabis investors can protect themselves and their portfolios by doing their own analysis before making any investment decisions, and that can include evaluating a stock's current valuation and the strength of its financials. While you may miss out on some potential gains by exercising caution, you'll also minimize the risk that you incur devastating losses.