The first step to making money by investing in stocks is to keep the money you already have. That's particularly true when it comes to the marijuana sector, where -- regrettably -- there's an abundance of bad options from which to choose.
Thankfully, the cannabis industry is maturing, but there are already a few common traits among the weakest performers. Aside from general red flags like indebtedness and unprofitability, be sure to pay attention to these three calling cards for cannabis stocks that'll hurt your portfolio's value.
1. Overbuilt cultivation and manufacturing capacity
When cannabis businesses work to get bigger, it's obvious that they need to have enough marijuana to meet demand. But one of the industry's most common stumbling points is to anticipate more demand than actually exists in the market.
Time and time again, companies have made massive investments in greenhouses or other cultivation facilities to increase production capacity in anticipation of revenue that never seems to materialize. Then, when the overhead costs become too great a drag on the bottom line for too long, management dolefully announces that the extra capacity needs to be turned off, like when Aurora Cannabis (ACB -1.32%) closed one of its facilities and reduced the output of another by 75% late last year.
As an investor, it's difficult to judge whether a company's plans to build out new cultivation space are going to be fruitful. Thankfully, you can easily screen out the businesses that have already stumbled by expanding beyond what's supported by demand. If an unprofitable company's cost of goods sold (COGS) eats up a stubbornly high percentage of quarterly revenue, it's a sign there's inefficiency afoot. For example, in the third fiscal quarter of 2021, Aurora Cannabis had a cost of sales of $127.54 million and total net revenue of only $55.16 million. Management attributed this to the detrimental effect of unused capacity.
2. Targeting the least lucrative product segments
Raw materials and simple products sell for less per unit than more complex products that require substantial processing. In the cannabis industry, that means products like vaporizers, oils, edibles, skin creams, and beverages have more attractive margins than bulk dried marijuana flower.
Furthermore, these complex items are less likely to experience competition from illegal products, as they tend to require specialized industrial equipment to make. That doesn't necessarily mean that it's always easier to make a profit on sales of each unit, but it does ensure that competitors will need to spend more up front to purchase the right hardware before they can start to compete for market share.
So, it makes sense to avoid companies that focus on selling cannabis flower unless they have proven that they can consistently do so profitably at scale. Be aware that unprofitable companies like Aurora Cannabis and Cronos Group can compete in lucrative segments and still fall victim to low average selling prices. There's a difference between competing in a product segment and deriving a large proportion of total revenue from it.
3. Habitual accounting concessions
I'm of the general opinion that the stronger a company's earnings are, the less explanation its financial results need to wow investors. Many cannabis companies are not profitable -- sometimes for reasons management can't control, like changes in the price of bulk cannabis. That means they can't report positive values for their earnings before interest, taxes, depreciation, and amortization (EBITDA), but they still want to report some financial metric that is trending in the right direction. Thus, the concept of "adjusted" EBITDA was born (or so I imagine).
In short, many marijuana cultivators like Aurora Cannabis and Cronos Group recalculate their EBITDA to account for fluctuations in the market price of cannabis and one-off expenditures, then report the resulting value as adjusted EBITDA.
There's nothing wrong with providing alternative metrics for investors to use to evaluate a stock. On the other hand, the healthiest cannabis companies don't need to repackage their earnings results to look appealing, so it's probably good to tread carefully around the ones that do.