Even if we don't enter a bear market anytime soon, you should have a game plan for how to make the most of one. And, if you're heavily invested in cannabis stocks, you'll need to be ready to adjust your fair-weather strategy significantly when the bears come out of hibernation.
It's hard to go wrong by purchasing shares of high-quality and stridently expanding companies. But, in the marijuana industry, rapid growth can cover up a lot of issues that a market downturn could easily reveal. Let's investigate why that's the case so that you'll be better equipped to protect your portfolio.
Valuation is key, but don't forget profitability, either
If you typically favor small competitors with quickly ramping revenue, a falling market should refocus your attention on valuation. Accurately valued businesses with sustainable profit margins and diversified sources of income are likely to be safer during a downturn than unprofitable companies with overly optimistic valuations.
For example, Scotts Miracle Gro (SMG -0.17%) sells gardening equipment and fertilizers to consumers as well as marijuana businesses, meaning that its revenue is diversified. Furthermore, it's profitable, pays a dividend, and has a trailing price-to-earnings (P/E) ratio near 14.3. That means buyers are willing to pay slightly less than the market's average P/E of nearly 16 for its shares.
In other words, if a bear market is driving investors away from speculative or overvalued stocks, it's unlikely to be driving them away from Scotts. And, because it pays a dividend, dips in Scotts' share price will raise the dividend yield, which is currently around 1.79%, thereby enticing new buyers and moderating the impact of the fall.
In contrast, companies like Sundial Growers (SNDL -4.96%) are likely to suffer significantly in a falling market. Aside from being unprofitable, its price-to-sales (P/S) ratio of nearly 20 is sky-high, especially in comparison to profitable and faster-growing pure-play companies like Trulieve Cannabis, (TCNNF -11.94%) which has a P/S of around 4.6. When the entire market faces downward pressure on prices, investors will find fewer reasons to liquidate their Trulieve shares in comparison to their shares of Sundial.
Therefore, stick with cannabis stocks that aren't overvalued or struggling to report consistent earnings. Of course, that's good advice for investing in many other types of stocks, but the issue of profitability is especially important in the context of the marijuana industry for reasons that I'll discuss in the next section.
Avoid meme stocks to avoid dilution
Buying shares of potentially overvalued cannabis meme stocks is riskier than ever in a bear market. When investors are making a flight-to-quality, meme stocks rarely make the cut for what counts as "quality," and that can quickly cause problems.
Robinhood favorites like Sundial Growers benefit from their time in the limelight by issuing massive amounts of new stock when retail traders boost the price of its shares. For Sundial, this strategy enabled it to diversify its business into cannabis investment banking, which might allow it to make a turnaround.
Still, when the retail investor mania recedes, or when the ambient market sentiment is negative, meme stocks may struggle to issue new shares at an attractive price. If the companies need cash for operations and they can't secure loans or other forms of traditional financing -- which is a very common problem for marijuana businesses of all sizes -- they might be out of luck.
As a result, shareholders will see their equity get diluted, and the company won't necessarily be able to get much money for the trouble. Profitable marijuana businesses likely won't have that problem. If you want to avoid this outcome, simply don't invest in the latest marijuana stock that retail investors are obsessing over.
Solid stocks are worth buying regardless of the market
For appropriately valued and healthy cannabis companies like Trulieve or Scotts Miracle-Gro, a bear market doesn't change much of anything.
Because they aren't reliant on external financing or issuing new shares to make cash, their core business activities won't be affected even if their stock price does drop. And, since their valuations are reasonable right now, they aren't likely to be on the chopping blocks of skittish or pessimistic investors.
So, if you think there will be bearish sentiment for the foreseeable future, invest in quality cannabis stocks that don't need to have their price supported by an army of retail traders or their cash flows supplemented by new share issuance. Even if you're wrong about where the market's going, you'll be giving your portfolio a better chance to grow anyway.