Aswath Damodaran has just released his latest video in which he discusses the businesses that are involved in the marijuana market and the three choices that investors have when assessing their investment choices in this space saying:
“If the marijuana market is likely to grow strongly, it should be a good market to operate a business in, right? Not all big businesses are profitable or value creating, since for a big business to be value creating, it has to come with competitive advantages or barriers to entry. If you are an investor in this space, you also have to start thinking about how companies will set themselves apart from each other, once the business matures. To see how companies in this business will evolve, it is important that you separate the recreational from the medical cannabis businesses, since each will face different challenges.”
Here is an excerpt from the video:
So, should you invest in this business or stay away until it becomes more mature? While there is an argument for waiting, if you are risk averse, it will also mean that you will lose out on the biggest rewards. If you are exploring your options today, you have to start by assessing your investment choices and pick the one that you are most comfortable with.
The Investment Landscape
This is a young and evolving business, with the Canadian legalization drawing more firms into the market. Not only are the companies on the list of public companies in the sector recent listings, but almost all of them have small revenues and big losses. While that, by itself, is likely to drive away old time value investors, it is worth noting that at a this early stage in the business life cycle, these losses are a feature, not a bug. Looking at just the top 10 companies, in terms of market cap, on the cannabis business, here is what I see:
|Largest Publicly Traded Cannabis Companies- October 2018|
Note that the biggest company on the list is Tilray, a company that went publicly only a few months ago, with revenues that barely register ($28 million) and operating losses. Tilray made the news right after its IPO, with its stock price increasing ten-fold in the weeks after, before losing almost half of its value in the weeks after. Canopy Growth, the largest and most established company on this list, has the highest revenues at $68 million. More generally, Canadian companies dominate the list and all of them trade at astronomical multiples of book value.
As new companies flock into the market, the list of publicly traded companies is only going to get longer, and at least for the foreseeable future, most of them will continue to lose money. Adding to the chaos, existing companies that have logical reasons to enter this business (tobacco & alcohol in the recreational and pharmaceuticals in the medical) but have held back will enter, as the stigma of being in the business fades, and with it, the federal handicaps imposed for being in the business. Put simply, this business, like many other young and potentially big markets, seems to be in the throes of what I called the big market delusion in a post that I had about online advertising companies a few years ago.
Trading and Investing
Like all young businesses, this segment is currently dominated by trading and pricing, not investing and valuation. Put differently, companies are being priced based upon the size of the potential market and incremental information. Put simply, small and seemingly insignificant news stories will cause big swings in stock prices. Thus, there is no fundamental rationale you can give for why Tilray’s stock has behaved the way it has since it’s IPO. It is driven by mood and momentum. If you are a good trader, this is a great time to play the game, since you can use your skills at detecting momentum shifts to make money as the stock goes up and again as it goes down. Since I am a terrible trader, I will leave it up to you to decide whether you want to play the game.
If you are an investor, you want to invest on the expectation that there is more value in these companies than you are paying up front, for your equity stake. As I see it, here are your choices:
- The Concentrated Pick: Pick a stock or two that you believe is most suited to succeed in the business, as it matures. Thus, if you believe that the business is going to get commoditized and that the winner will be the one with the lowest costs, you should target a company like Canopy Growth, a company that seems to be pushing towards making itself the low-cost leader in the growth end of the business. If, in contrast, you believe that this is a business where branding and marketing will set you apart, you should focus on a company that is building itself up through marketing and celebrity endorsements. To succeed at this strategy, you have to be right on both your macro assessment and your company pick, but if you are, this approach has the potential to have the biggest payoff.
- Spread your bets: If your views about how the business will evolve are diffuse, but you do believe that there will be strong overall revenue growth and ultimate profitability, you can buy a portfolio of marijuana stocks. In fact, there is an ETF (MJ) composed primarily of cannabis-related stocks, with a modest expense ratio; its ten biggest holdings are all marijuana stocks, comprising 62% of the portfolio. The upside is that you just have to be right, on average, for this strategy to pay off, but the downside is that these companies are all richly priced, given the overall optimism about the market today. You also have to worry that the ultimate winner may not be on the list of stocks that are listed today, but a new entrant who has not shown up yet. If you are willing to wait for a correction, and there will be one, you may be able to get into the ETF at a much more reasonable price.
- The Indirect Play: Watch for established players to also jump in, with tobacco and alcohol stocks entering the recreational weed business, and pharmaceutical companies the medical weed business. You may get a better payoff investing in these established companies, many of which are priced for low growth and declining margins. One example is Scott’s Miracle-Gro, for instance, which has a growing weed subsidiary called Hawthorne Gardening. Another is GW Pharmaceuticals that has cannabis-based drugs in production for epilepsy and MS.
It may be indication of my age, but I really don’t have a strong enough handle on this market and what makes it tick to make an early bet on competitive advantages. So, I will pass on picking the one or two winners in the market. Given how euphoric investors have been since the legalization of weed in Canada in pushing up cannabis stock prices, I think this is the wrong time to buy the ETF, especially since sector is going to draw in new players. That leaves me with the third and final choice, which is to invest in a company that is not viewed as being in the business but has a significant stake in it nevertheless. At current stock prices, neither Scott Miracle-Gro nor GW Pharmaceuticals looks like a good bet (I valued Scott Miracle-Gro at about $55, below its current stock price of $70.), but I think that my choices will get richer in the years to come. I can wait, and while I do, I think I will take another walk on the boardwalk!
You can watch the full video here:
You can read the original article here – Aswath Damodaran, High and higher: The Money in Marijuana!
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