With the regulators at the Federal Reserve opting to try to control high inflation by making it more expensive for companies to borrow money for the better part of a year now, it's a hard time to be a growth investor. Uncertainty surrounding the Fed's interest rate hikes is hitting the market like a truck, making the rapidly expanding businesses of yesteryear into the bugbears of portfolios today.
Cannabis stocks are among the harder hit -- but it isn't as though the industry was in top shape before inflation reared its head either. Many players were and are unprofitable, and quarter after quarter of revenue growth is no longer a sure thing.
With that backdrop in mind, is now a good time to be buying marijuana companies with the hopes of a rally down the line, or is the Federal Reserve going to ensure that investors will lose their shirts? Let's investigate.
More damage is likely, but the Fed isn't the only force to blame
As exemplified by the sharp fall of the cannabis industry-tracking AdvisorShares Pure U.S. Cannabis ETF, (MSOS -4.54%) the past year hasn't been a great time to be invested in marijuana stocks. Take a look at this chart, which depicts industry leaders like Cresco Labs (CRLBF -5.34%) and Canopy Growth (CGC -3.01%).
Note that the Fed started to hike interest rates (and thereby make it more expensive for businesses to take out debt) in March 2022. As you can see, cannabis stocks were trending downward in the months before that, perhaps as a result of investors anticipating action to control inflation. But there's more to the story than the market dumping growth stocks on the assumption that raising fresh capital would soon be significantly more expensive than in the past.
For instance, both Cresco Labs and Canopy Growth are unprofitable. Over the last year, neither made much in the way of progress with improving their quarterly gross margins despite management's efforts to do so by selling higher-margin products instead of lower-margin ones.
To make matters worse, Canopy Growth's quarterly revenue actually dropped by more than 22.9% in the last 12 months, and Cresco's was flat.
In other words, there's more than one reason that could explain the downward trajectory of their stocks. And without either a return to robust top-line growth, or wider margins supported by trimming costs or switching to a higher-value product mix, there's not much hope for anything fundamental to change, regardless of what the Fed does.
The question is whether there's still a long-term thesis for investing in either pair, given that they'll have a harder time borrowing money to finance whatever operational changes they need to make to succeed.
It's a good time for buying greedily if you're planning to buy quality
The bottom line is that neither Canopy Growth nor Cresco Labs are in a strong enough financial position to believe that they'll be good investments anytime soon. They're both losing cash every quarter, and their debt loads are starting to look larger than desirable. Any pivoting will probably involve cutting production, which will drive revenue (and share prices) further downward.
Still, there are indeed other opportunities for smart investors who are willing to take risks on cannabis stocks. Remember, there are two parts to the story of why the stocks are declining: The Federal Reserve hiking interest rates, and the performance of public marijuana businesses today and in the future.
Therefore, if you can identify a cannabis company that's growing and profitable, and its stock is getting demolished by a falling market nonetheless, it might be a good candidate for a bargain buy that'll pay off later.
For example, Trulieve Cannabis' (TCNNF -6.26%) stock is down by 60.3% this year, but its quarterly earnings before interest, taxes, depreciation, and amortization (EBITDA) is up by 273.5% despite falling into unprofitability in the second quarter. Likewise, its revenue is still growing quite quickly, and its gross margin is widening too. Of course, there's more to Trulieve's story, but the point is that it's a much better candidate for investors to take a chance on right now than Canopy or Cresco.
So, if you want to take this opportunity to scoop up a bunch of cannabis stocks, be sure to focus on businesses that are less likely to need to borrow money in the near future. Similarly, the chances of a healthy company continuing to be healthy are higher than the chances of a less-healthy company returning to high performance, which means that now isn't the best time to gamble on operators that can't turn a profit.
In 10 years, people who made fruitful investments in cannabis stocks today will likely be better off. But there's no guarantee that the industry's weaker players will be around at all, so don't bet the house either way.
