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Part of cannabis and investing

There may be no other sector with higher investor interest than cannabis.

Once a batch of small, highly risky stocks that traded on obscure exchanges, cannabis shares are reaching a new level of maturity. The first wave of publicly traded marijuana companies found a home on the Toronto Stock Exchange and other Canadian markets, since the United States’ federal drug laws had mostly dissuaded companies from listing on that country’s stock exchanges.

That’s changing, owing to the success of Tilray Inc., a B.C. cannabis company that went directly to the Nasdaq stock exchange and saw it shares zoom from US$17 to a high of US$300 in a wild first few months of trading.

Tilray, Canopy Growth Corp. and Aurora Cannabis Inc. have all crossed the $10 billion threshold in market capitalization, with Tilray worth more than many S&P/TSX 60 companies at its September, 2018 high prices.

Canopy can be thanked for much of the 2018’s run in cannabis shares. On August 14, the company announced its partner, global spirits company Constellation Brands Inc., would make a $5 billion investment that will eventually give it control of Canopy. That validation launched many other pot stocks into the stratosphere, as investors sought the next cannabis company to partner with a big-name beverage concern.

There’s an entire index of cannabis stocks, the North American Marijuana Index. The TSX-listed Horizons Marijuana Life Sciences Index ETF Fund, which crossed $1 billion in assets this year, uses the index as a basis for its fund. It doesn’t, however, include Canadian companies that cannot list on the TSX because of that exchange’s prohibition on companies that operated in the United States in apparent violation of the country’s federal drug laws.

Canada’s historic decision to legalize the drug for recreational use, as of Oct. 17, has created a new market in a country of more than 30 million people. The shares are still highly volatile, best suited for investors with a high tolerance for risk, but they’re rapidly becoming mainstream investments.

Here’s what you need to know about investing in cannabis.

Canadian exchanges: The place for pot stocks

When Canada passed legislation in June to legalize marijuana use, there were seven billion-dollar cannabis stocks; six of them traded on the Toronto Stock Exchange. As legalization dawned in October, the billion-dollar club had grown to 13, with ten choosing Canadian exchanges for their primary listings. (The list includes The Scotts Miracle-Gro Co., a fertilizer company founded in Ohio in 1868.)

MedMen Enterprises Inc., which calls itself “the largest weed company in the United States,” listed on the Canadian Securities Exchange at the end of May. It topped $2 billion in market value by October. CEO Adam Bierman said “we have to end Prohibition first” before considering a listing on the New York Stock Exchange or Nasdaq Stock Market. The Canadian Securities Exchange, which bills itself as “the Exchange for Entrepreneurs,” has more than 350 stocks, with cannabis companies accounting for its most valuable listings.

The big players

Health Canada has awarded 113 cannabis licences, as of July 18. Sixty-one are for production sites in Ontario and the rest dispersed across the country. Canopy Growth Corp. of Smiths Falls, Ont., is the largest company, boasting the most growing facilities, the biggest market capitalization and the highest medical sales to date. Its chief rivals include Alberta-based Aurora Cannabis Inc. and Aphria Inc. of Leamington, Ont.

For its part, Aurora has grown mostly through acquisition, using its shares to ink blockbuster deals. In 2018, it purchased industry pioneer CanniMed Therapeutics Inc. and agreed to buy MedReleaf Corp., which has cornered the veterans market. These companies have been the early leaders of Canada’s nascent medical cannabis regime. But with the legalization of recreational use, a much bigger market is up for grabs and it remains to be seen who will win that game.

What separates the largest players from the rest is their massive scale of production and a plan to export their weed into new medical markets around the world, such as to Europe and Australia. The next tier of players includes Cronos Group Inc. and CannTrust Holdings Inc. of Ontario, Quebec’s The Hydropothecary Corp. and Organigram Holdings Inc. of New Brunswick.

Behind the numbers

Investors need to take a deeper dive into cannabis earnings than they might expect. As Canadian-listed companies, many use International Financial Reporting Standards, which have particular rules about agricultural assets. Part of those standards call for companies to revalue biological assets, such as trees and marijuana plants, every quarter. The change in value appears near the top of the income statement, where the company’s operational numbers appear. But these gains and losses in the value of unharvested plants bear no relation to what was actually produced and sold in the quarter.

So, investors interested in the quarter’s cannabis commerce will need, typically, to remove those unrealized gains or losses so as not to be misled by net income — or a net loss — that includes those quarterly changes.

Valuing the stocks

At this stage of the industry, traditional valuation metrics are almost worthless in assessing pot stocks — unless you argue, as many do, that they point to a speculative bubble in the shares. As legalization loomed in October the price-to-sales ratio for the S&P/TSX Composite was about three, according to S&P Global Market Intelligence. By contrast, the median price-to-sales ratio of the 62 stocks in the North American Marijuana Index was 47. And few of the companies were reporting any kind of profits that would make calculating a price-to-earnings ratio possible. Analysts who follow the industry say that Canadian producers that are already up, running and licensed to sell are the leaders, while smaller companies that aren’t yet licensed are akin to a lottery ticket.

The bet against

The enthusiasm comes despite serious questions about just how profitable these companies can become under legalization. There’s intense interest in the stocks from short sellers, who profit when stocks decline, not rise. IHS Markit says 2.44 million shares of cannabis stocks were being shorted as of Sept. 24 (the week after wild, euphoric trading in Tilray shares). For many, the short case is that investors are getting ahead of themselves, bidding up nearly every company in the industry as if it will become one of the top two or three players in a mature cannabis space. Short selling, however, can help investors who hold the stocks and hope for gains: As a well-shorted stock rises meaningfully, turning the trade into a loser, a short seller often decides to unwind a short position by purchasing the shares on the open market. That drives the price even higher and creates what’s called a “short squeeze.”

With files from Christina Pellegrini

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