Bottom feeders are moving into Canada’s marijuana sector, buying beaten-up stocks after a brutal six-month sell-off. Who can blame them? For investors who ignored the sector when the stocks were rallying to record highs on frothy expectations, perhaps now is the time to give pot stocks another look.
The reason: While stock valuations and investor sentiment have changed, the cannabis market hasn’t.
Let’s start with the changes by looking at Canopy Growth Corp. – the blue-chip market leader and the company that was the first to attract institutional money when Constellation Brands Inc. bought an initial stake in October, 2017.
Canopy shares hit a record high of $73.75 on Oct. 15, 2018, in the days leading up to cannabis legalization in Canada. Since then, the shares have fallen more than 73 per cent, and the biggest losses have occurred over the past six months.
In late April, the collective wisdom of the stock market valued the cannabis producer at $24-billion, based on the total value of its outstanding shares. Today, that value has withered to less than $7-billion.
Why? The company’s fiscal second-quarter results, released last week, confirmed some long-simmering doubts over the cannabis sector’s performance: Canopy’s sales fell 15 per cent from the previous three months amid a slow rollout of retail stores in Ontario, persistent competition from the black market and unsold oil and capsules.
More broadly, the sector is struggling with dwindling cash, expensive financing arrangements and shareholder dilution.
Apart from Canopy, Aphria Inc. shares have fallen 59 per cent since April and Aurora Cannabis Inc. shares are down 76 per cent since March. If this was a speculative bubble, it is now popping.
But some stocks enjoyed a nice bounce on Tuesday. The Horizons Marijuana Life Sciences ETF, an exchange-traded fund that provides exposure to the sector through dozens of pot stocks, increased 4.9 per cent, suggesting that some investors see value in stocks that have fallen to two-year lows. Canopy shares closed at $20.31, up $1.53, or 8.2 per cent.
These investors may be on to something, for a few reasons.
First, sentiment toward cannabis stocks has clearly shifted.
Trading volume for Canopy was just 173 million shares in the three months ended Sept. 30, down considerably from 2018 when quarterly trading volume easily topped 500 million shares.
In another sign of withering sentiment, analysts are slashing their target prices on Canopy’s share price – to $29 from an average of $78 in June, according to Bloomberg.
Perhaps demoralized retail investors have lost interest in the stock. Institutional investors are another story, though. A look at Canopy’s biggest 20 investors shows that these savvy money managers have increased their holdings, on a net basis, by more than five million shares since the end of September.
Second, stock valuations are down sharply.
Cannabis producers aren’t exactly gushing profits, so typical price-to-earnings ratios don’t apply to the sector. But looking again at Canopy, the stock’s price-to-book ratio has fallen to 1.29 from 3.2 in the previous quarter, according to Bloomberg. The stock’s price-to-sales ratio has fallen to 19.3 from 57.9 in the previous quarter.
Is the stock cheap? Well, no. But the lower valuations feed into the third reason for buying cannabis stocks when they’re down: The initial attraction to the sector was that these companies were supplying a newly legalized product, ensuring strong growth ahead.
Canopy’s disappointing quarterly results suggest that this strong growth is merely delayed, not dead – and Canopy is in a good position relative to its rivals during this period of uncertainty, given its large size and stronger financial position, with about $2-billion in cash.
“With so many names in the sector starved for capital, and facing increasingly onerous terms to receive it, Canopy’s balance sheet will continue to serve as a differentiator for many quarters to come,” John Zamparo, an analyst at CIBC World Markets, said in a recent note.
Perhaps that’s why institutional investors are staying put and bargain hunters are moving in.