Cannabis stocks can’t turn huge revenue growth into huge profits
- U.S. President Joe Biden announced sweeping measures that many believe clears the path toward national marijuana legalization, and the ETFMG Alternative Harvest ETF rose 20% as a result.
- At valuations this depressed, the stocks are due for a big, multi-day, perhaps even multi-week bounce on good news.
- But given product commoditization and lack of profitability, we do not believe the coming bounce in cannabis stocks is sustainable.
While the market suffered yet another selloff yesterday, cannabis stocks staged one of their biggest single-day rallies ever.
U.S. President Joe Biden announced sweeping measures that many believe clears the path toward national marijuana legalization. And the ETFMG Alternative Harvest ETF (MJ) rose 20% yesterday as a result.
The pop in cannabis stocks is a much-needed reprieve for pot bulls. The industry has felt relentless selling pressure over the past several months – years, in fact. But unfortunately, I don’t think it’s going to last.
What Did Biden Do?
Yesterday, U.S. President Joe Biden announced pardons for all federal offenders convicted of simple marijuana possession. He then urged governors across the country to follow suit with pardons for state and local offenders.
The move will pardon more than 6,500 individuals across the U.S. with prior convictions for possession. If governors follow suit, the pardons will likely extend to tens of thousands of individuals nationwide.
In addition, President Biden also instructed Secretary of Health and Human Services Xavier Becerra and Attorney General Merrick Garland to begin an urgent review of marijuana’s federal classification as a Schedule-1 drug.
Political analysts have posited that the moves are the biggest step yet toward eventual federal legalization.
We agree. By the end of this decade – possibly sooner – cannabis will be legal across the entire United States.
But that doesn’t necessarily mean cannabis stocks are a great buy for the long haul…
Cannabis Stocks Are Cheap Enough for a Big Short-Term Bounce
To be clear, we do think pot stocks will bounce here, and the reasoning is pretty simple. They’re too cheap not to.
The industry’s biggest names – like Canopy Growth (CGC) and Tilray (TLRY) – are trading at 4X to 6X EV/Sales multiples. Those mark near all-time-low valuation multiples for the stocks.
At valuations this depressed, the stocks are due for a big, multi-day, perhaps even multi-week bounce on good news.
We received that good news yesterday. Now we get the multi-day/week rally. Watch out for a near-term breakout in cannabis stocks!
Fundamentals Remain Broken
In a multi-month, multi-quarter, and multi-year window, we do not believe the coming bounce in cannabis stocks is sustainable.
The aforementioned legal developments are a tailwind for cannabis demand. But demand has never really been the problem for cannabis stocks. Generally speaking, these companies have been able to retain fairly robust sales growth over the past several years.
Yet, their stocks have been crushed. Why? Profitability.
Take a look at the following chart. The cannabis majors have been successful in growing revenues at a steady pace. But they have not been successful in turning that revenue growth into profits. Profit margins and cash flows remain negative. And there is no improvement in the trend. A lot of these companies are losing more money today than when they were significantly smaller a few years ago!
We believe this lack of profitability is thanks to widespread product commoditization in the cannabis industry.
For most consumers, weed is weed is weed. They can’t tell the difference, and they don’t really care to begin with. Those who do care have already found their favorite brand and will probably stick with it. That means that the resulting competitive landscape is one where the cheapest supplier will sell the most weed.
In an environment like that, it’s almost impossible to drive positive operating leverage. Suppliers are perpetually undercutting one another on pricing.
We do not see any easy or quick fix on the horizon for this commoditization problem. Therefore, we think the profit outlook for cannabis firms is very cloudy. Until that clears up, cannabis stocks will likely remain under pressure.
The Final Word on Cannabis Stocks
Not all hypergrowth investments are created equal.
Sure, by definition, all hypergrowth investments are stocks that are growing very quickly. But good hypergrowth investments are the ones that can turn that rapid growth into huge profits and cash flows.
Cannabis stocks are bad hypergrowth investments. They do not turn huge revenue growth into huge profits.
This post originally appeared at InvestorPlace.