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Why now might be the right time to load up on pot stocks

Some of Aphria's medical marihuana plants grow in their greenhouse in Leamington, Ont.

GEOFF ROBINS/The Globe and Mail

The latest pullback in pot stocks may be a buying opportunity for investors willing to stomach continuing volatility in the sector as Canada gets closer to legalizing recreational marijuana.

Shares of some of Canada's largest licensed marijuana companies such Canopy Growth Corp., Aurora Cannabis Inc., OrganiGram Holdings Inc., CanniMed Therapeutics Inc. and Emerald Health Therapeutics Inc. are down by between about 10 per cent to 30 per cent since April 12, the day before Ottawa tabled its legislation with a self-imposed deadline to legalize pot by July 1, 2018.

Shares of Canopy, Canada's largest producer, are down 15 per cent since April 12 and have lost about half their value since they hit a high of $17.86 in November. Still, the stock is up almost 240 per cent over the past year.

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Shares of Aphria Inc., which hit a high of $8.77 on April 11, have dropped by almost 30 per cent since. Aphria insiders appear to view the pullback as a buying opportunity. At least three insiders have been buying shares in the public market in recent weeks.

The Horizons Medical Marijuana Life Sciences ETF, which went public on April 5, recently started trading below its $10 initial public offering price, moving further away from its high of $12.40 on April 11.

"We do see this in the markets when you have a big event. Once that event passes, a lot of the short-term investors sell their position," says PI Financial analyst Jason Zandberg. "I do see this as a buying opportunity."

Mr. Zandberg believes the recent selling pressure "has probably diminished, but I can see these names trading sideways for a bit."

That's because many key areas of the legalization still need to be worked out, including how pot products will be taxed, advertised and distributed. Ottawa will license marijuana producers and is leaving distribution and sales to the provinces.

Analysts say the next major catalyst that may potentially push up stock prices for publicly listed pot producers could be when the first major province announces how it plans to regulate and distribute recreational marijuana.

"That could remove some uncertainty around how the market will look," says Echelon Wealth Partners analyst Russell Stanley. "I think people need some colour around how this will look as a business by the middle of next year."

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Analysts are also expecting more mergers and acquisitions in the sector, which may drive up valuations. One of the biggest deals in the sector to date was Canopy Growth's recent $430-million takeover of Mettrum Health Corp., for a 42-per-cent premium.

Bruce Campbell, portfolio manager at StoneCastle Investment Management, which owns a handful of cannabis producers, expects companies in the sector to begin trading more independently from here.

"The news to date has been more macro driven," Mr. Campbell says. "Going forward, execution and one-off events will start to matter more. It's not that they haven't already, but if all of a sudden one company comes out producing stronger profits or growth than another, the market will start to sit up and pay attention. That will start to show up in the valuations of the stock and the prices as well."

Ryan Modesto, chief executive officer at independent research company 5i Research, says pot stocks are still expensive, despite the recent pullback. He cautions investors about getting in.

"It's hard to get too excited just because they've moved down," says Mr. Modesto.

He expects competition among producers to be intense, which will drive down margins.

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For perspective, Mr. Modesto says the sector is currently trading at an average of about 13 times enterprise value to sales for the next 12 months, compared with 9.3 times for Facebook Inc., 8.5 for Shopify Inc. and 4.9 times for Google parent Alphabet Inc.

"Those are all higher margin tech companies that typically garner some of the highest valuations and growth in the market compared to a sector that still faces a lot of scrutiny and potential regulatory constraints," Mr. Modesto says.

"Given the fact that we don't really know what the [marijuana] industry is going to look like on the retail side yet, it's a tough space for us to get excited about."

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