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Pot stocks flashing warning signs as investors drive valuations back to January peak

Several days of frenzied trading have driven marijuana-stock valuations back to near the record highs set at the start of this year, setting the stage for what could be another brutal sell-off once the enthusiasm subsides.

Even usually optimistic sell-side analysts are signalling that the biggest pot stock of them all – Canopy Growth Corp. – may be due for a pull back.

The cannabis industry was trading at 21 times projected 2019 earnings before interest, taxes, depreciation and amortization (EBITDA) as of Friday, according to Echelon Wealth Partners. That marked a steep increase from 14.8 a week earlier. Those valuations stretched even further on Monday, when pot stocks surged yet again.

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The industry’s valuation is near a high set in January, according to Echelon, after which a prolonged slump knocked off billions in company value. The latest rally is raising concerns that history is about to repeat itself.

Barry Schwartz, chief investment officer and portfolio manager at Baskin Wealth Management, called the valuations of some Canadian cannabis companies “unbelievable."

“At the end of the day, these companies have to make money," he said Monday in an interview on BNN Bloomberg TV. “God knows when that’s going to happen.”

But for now, the rally lives on. Aurora Cannabis Inc. rose Monday by 7.7 per cent. Aphria Inc. and Canopy finished the day up 6.9 per cent and 2.4 per cent, respectively.

The recent surge was sparked when U.S. alcohol giant Constellation Brands Inc. announced a $5-billion investment in Canopy on Aug. 15. Since then, Canopy shares have skyrocketed 87 per cent, while speculation of further deal-making has lifted the industry.

More alcoholic beverage companies are likely to strike deals with Canadian marijuana producers, Cowen & Co. analyst Vivien Azer said Monday in a note.

One such attractive partner for an alcohol company is Tilray Inc., Ms. Azer said, which spiked 22 per cent on Monday. It has a broad portfolio of consumer brands, many of which are commercially available in the United States, she said. Tilray, which Cowen took public in July, now has a market value of almost US$5-billion.

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“We expect more alcoholic beverage companies to announce deals with Canadian LPs [licensed producers] over the course of the year,” Ms. Azer said in the note.

Canopy, with a market capitalization of more than $13-billion, holds a dubious distinction: it now has the worst return potential of any company on Canada’s benchmark stock index.

The analyst consensus 12-month price target for Canopy shares is $48.64, which implies a potential drop of 17 per cent over the next year, based on Bloomberg data as of end of day Friday. Among the 246 companies on the S&P/TSX Composite, Canopy’s return potential is worst by a margin of 13 percentage points.

By the same metric, the outlook looks considerably rosier for Canopy’s chief rivals. Aphria has a return potential of 53 per cent over the next 12 months, while Aurora clocks in at 22 per cent. Aphria has been on a tear of late, climbing 31 per cent since Thursday’s close.

Analysts have been an optimistic bunch on Canopy. Ten analysts actively cover the company. As of their latest published research, eight had “buy” recommendations and one “hold.”

Echelon’s Russell Stanley is the lone analyst with a “sell” recommendation on the stock, along with the lowest price target at $34.50 a share. In a note to clients, he said the Constellation investment was a “very strong endorsement for Canopy,” but that “valuation concerns continue.”

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Indeed, Canopy’s valuation is especially frothy, relative to its peers.

The company is trading at 137 times projected EBITDA, the loftiest multiple of the 23 companies tracked by Echelon. The next highest is Emblem Corp. at 81 times projected EBITDA.

It’s entirely possible Canopy will prove analysts wrong. For one, analyst targets are often wildly inaccurate. Moreover, any number of market conditions could change over the next year, giving yet another boost to Canada’s nascent marijuana industry.

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