Not so long ago, Wall Street believed that marijuana offered a massive growth opportunity, giving any company related to the space a huge valuation. AFC Gamma (AFCG 1.63%) was one name that tried to capitalize. The catch is that AFC Gamma is a mortgage real estate investment trust (REIT), so it was positioned as a pick-and-shovel company, not a grower. The opportunity management once saw has clearly disappeared. What can you learn from this situation?
Too much excitement
Investors are generally rational over long periods of time while they're prone to being irrational over shorter periods. This is why you see frequent periods in which new investment opportunities, like marijuana, get afforded huge premiums. Essentially, Wall Street is trying to get in on the cheap in the "early" days but ends up pushing things to extreme levels that are unsupportable. It's pretty common, with the end result normally being a shakeout in which weak players get bought out or shut down, leaving the strongest names as the survivors. In the heady days of excess, it's usually pretty hard to pick the long-term winners from the losers.
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When you see a hot new industry, you need to remember this pattern. Similar fallout is also happening in the electric-vehicle niche and in the space exploration sector. It has happened before in the auto sector, biotech sector, internet sector, and on and on. But don't think just about the sector, as there are adjacent spaces that often get dragged in.
That's the situation with AFC Gamma. This company is a mortgage REIT, but its target audience was marijuana companies. The opportunity here was notable, given that marijuana is still illegal at the federal level. That has left most banks on the sidelines, since working with a pot company could open a bank up to legal liabilities. AFC Gamma was happy to step in to issue mortgages for marijuana properties when banks wouldn't.
And then things changed
There's still material long-term growth expected in the marijuana sector. At this point, most states offer some access to marijuana, with an increasing number allowing recreational use. The compound annual growth rate in the recreational space is expected to be as much as 18% per year between 2022 and 2026, with medical use coming in at 7%. Those are not insignificant numbers, though illegal marijuana sales still represent a huge portion of the market. Given the taxes and regulation that legal marijuana faces, this is a material problem for the industry.
In all, however, it isn't surprising that too many marijuana companies jumped into the sector given the rapid growth that was and still is expected. Considering profits are being constrained by things like illegal marijuana sales and competition among legal sellers, there's a shakeout taking place. But for AFC Gamma, the problem is whom to give a loan to and whom to avoid. For the past nine months or so, the company has chosen to avoid everyone and made no new loans.
Meanwhile, it has to deal with the worry that current customers might default on the loans it has provided. At the end of 2022, the company had one loan that wasn't current, representing about 0.9% of its portfolio. That said, between the third and fourth quarters of 2022, it more than doubled its reserves for loan losses to nearly 5%. In other words, management believes things could get worse as the industry shakeout continues. That's a key reason the stock has plunged and the dividend yield is a worryingly high 18%.
Not worth the risk
AFC Gamma reported distributable earnings of $0.62 per share in the fourth quarter and has set the dividend for the first quarter at $0.56 per share. That's a 90% payout ratio, which doesn't leave a lot of room for adversity. And the company's reserve moves suggest it expects some adversity. Meanwhile, the REIT is looking at expanding beyond the marijuana sector, which suggests that even management isn't convinced its original purpose is a long-term winner. Most investors should avoid this high-yield stock today, but it's worth watching the story as it unfolds. This is a nearly textbook case of the Wall Street hype machine and what happens when a company, and investors, get caught up in what almost always turns out to be a story that's too good to be true.