With the total return of AdvisorShares Pure US Cannabis ETF falling by 27% during the last 12 months, badly underperforming the wider market's growth of 22%, cannabis stocks are still hurting, continuing their years-long losing streak. With lingering issues with operational efficiency, a brutal bear market for stocks in 2022, and historical turbulence in the market for marijuana, investors in the industry are probably somewhere between losing what's left of their patience and pleading for salvation.
Will shareholders get much-needed relief in 2024, marking the comeback of the marijuana industry as a whole, or is there more pain in store? The future is uncertain, but having a game plan for how to invest will make it easier to navigate whatever happens next.
North American companies and markets are crawling closer to turning the corner
To make money, vertically integrated cannabis companies need to cultivate marijuana, harvest it, process or manufacture it into the desired retail forms, distribute those products to outlets, and then draw consumers in via advertising. If consumers want more of those products, prices rise. But if there is a large volume of products and an insufficient number of buyers, prices fall, typically taking out the profit margins of producers in the process. And that's exactly what has plagued the North American cannabis industry over the last few years.
While prices per unit of cannabis are still well below their levels in yesteryear, there are signs that a recovery is underway, at least in Canada. Demand isn't necessarily growing, but manufacturers have trimmed their supply capacity and reduced their overhead significantly to rightsize their operations relative to demand. Over the past year, the trailing-12-month operating margins of companies like Tilray Brands, Aurora Cannabis, and Canopy Growth have started to slowly improve, though all three are still losing more money.
Nonetheless, by the end of the 2024, Aurora Cannabis anticipates that it will be producing free cash flow (FCF), or what's left of cash flow after capital expenditures and other business investments. Tilray is also signaling that in its fiscal 2024, which is already underway, it should be generating positive FCF on an adjusted basis. Another piece of good news is that the two companies are back to adding to their top lines year over year, meaning that they have a real chance of breaking the trend of stagnant or declining revenue, which was a feature of the last two years. So the coming quarters could well be characterized by their reaping the benefits of operational improvements and recovering demand. And with a major catalyst like cannabis legalization potentially in play, it's even possible that the U.S.-based businesses might soar soon enough as well.
Valuations are looking attractive, but it might not be enough
Aside from a few of the big Canadian companies potentially turning a corner and generating profits or cash flow, valuation is another sign that cannabis stocks are ripe for a comeback. Right now, the broad market's price-to-sales (P/S) ratio is 2.5. Check out this chart:
Data source: YCharts
As you can see, valuations aren't nearly as high as they were before, and now there might be bargains afoot for enterprising stock buyers. That could be a driver for rising share prices, especially when considering the other positive dynamics at play. But it isn't exactly a guarantee that 2024 will be a great year for cannabis stocks, because there isn't one.
A few critical barriers remain in the way of the cannabis industry's return to good times for shareholders. The most obvious obstacle is marijuana prohibition, which continues to be the law at the federal level of the U.S. in addition to ban lingering for longer than anticipated in the European Union. An additional and closely related challenge is lack of access to capital and traditional banking services. If cannabis banking legislation being considered by Congress is enacted in 2024, it could be a huge boon that sparks the industry's revitalization in the U.S. On the other hand, similar bills have failed in the past without much fanfare, so it might take a few more attempts.
So should you invest in a basket of cannabis stocks in advance of 2024? Probably not. Though there's a real chance of a revival next year, the risk of investors experiencing more of the same is too high right now to bother making more than one investment. Stick to individual businesses that are on track to be profitable soon, and only consider them if the rest of your portfolio is already adequately diversified because they remain quite risky, and are not appropriate for most investors. Then, if you do decided to buy, be ready to hold your shares for years, just in case that's how long it takes.
