Before you get sucked into reading more of my blather, take a moment and read the Wall Street Journal if you’ve got a copy nearby or an online subscription — not the whole thing, but read Christopher Mims’ column The World Isn’t as Bad as Your Wired Brain Tells You. It’s an unusually brief and clear piece about a few of the biases and irrational thought processes that addle most of us… Availability Bias, Extremety Bias and Confirmation Bias go a long way toward explaining why newsletter pitchmen are so successful at getting us to sign up for their get-rich-quick ideas or scare us into hiding in the basement, why patently absurd conspiracy theories are so rapidly adopted as “real” online, and why everything in media, from Facebook to the great MSNBC/Fox News shouting match, is designed to show us more of what we already have a tendency to agree with. Probably the best thing for our democracy would be if we all agree to stay off of Twitter and Facebook for six months and read only thoughtful and edited journalism and communicate with other people only in person.
Except for Stock Gumshoe, of course, you should keep reading our stuff. Every day. And telling your friends. And clicking on all the dumb ads on our pages so we can finally get that solid gold bathtub I’ve had my eye on.
And the other thing I think you should read this week is a bit more challenging, and older, but I find it illuminating — Ben Hunt’s Epsilon Theory is one of the more thoughtful publications I read, mostly because of his ability to dive deep and explain both the human (and market) need for narratives that drive things, and the way those narratives are formed over time. This older piece wasn’t really about that, though: I recently went back and read his piece on Magical Thinking from 2016… it’s really pointed at the Federal Reserve and the Taylor Rule and the populist movements as a reflection of human irrationality, turning an idea or a formula into a belief system, but I think it’s a good reminder to us all to step back from belief and focus on real life sometimes.
So that’s two new perspectives for you for some long weekend reading — if you’re like me, you’ll get sucked into Ben Hunt’s writing and read Epsilon Theory for a few hours… but whatever it is you do, hopefully we can all open our minds a bit and turn off CNBC and the social media echo chambers and do some thinking for a few days.
What, then, comes to mind as we finish the last week of summer — or at least, the Gumshoe definition of summer? (we usually slow down publication in July and August and ramp back up in September, so I’ll be coming at you just about every day again starting next week… exhausting us both.)
Well, I thought I’d spend a few minutes responding to and opining on marijuana stocks, courtesy of a Banyan Hill ad focused on that market and the deluge of varying questions I’ve gotten about pot stocks in general… then I’ll update you on what happened in the Real Money Portfolio this week.
So… Marijuana first.
The ad that caught my eye was a “presentation” called “Marijuana’s US Tipping Point” by Matt Badiali and Jeff Yastine, pitching Badiali’s Real Wealth Strategist (which, similar to some recent offerings I’ve looked at from other Agora publishers, is a low-cost subscription that both renews at higher prices and includes a “free trial” of a newsletter you didn’t ask for, in this case The Bauman Letter, that they’ll automatically start charging you for after a few months… so if you don’t do anything, your $79 sub to Real Wealth Strategist soon becomes a recurring $176 a year, or whatever they choose to charge in the future).
The ad is all about “how you could turn a $50 starting stake into an early retirement by riding medical marijuana’s wave of legalization,” and that’s a fairly typical promise for all kinds of newsletters, built on this mythical idea that you can somehow ladder your windfall investments — turning $50 into $500 in some hot penny stock, then that $500 into $12,000 by picking another extraordinary winner, then betting that $12,000 to win $40,000, and pretty soon you’ve got a couple million dollars and can retire! Yay!
Assuming, of course, that your children didn’t have you committed for doing something as irresponsible as “doubling down” on every single risky penny stock speculation you make (since, as you probably figured by now, just one 90% drop as you’re building on those imagined profits causes this mythical tower to crumble all the way back down… and there’s always a 90% drop at some point when you’re betting on speculative manias). Conjuring up these kinds of historical “possible” profits from serial penny stock speculations is fun and easy since past stock windfalls are easy to find… in real life, with real money, it would be like playing Jenga after drinking 75 cups of coffee.
Indeed, when these Banyan Hill ads talk about returns they use this same notion of serial victories and “cumulative returns,” imagining that having two gains of 200% each doesn’t just result in a gain of 200% for your two-stock portfolio, which would be the rational person’s way of thinking about a collection of investment ideas, but that you gain 400% because you can somehow stack them magically on top of each other and earn cumulative returns. He talks about winning positions in a portfolio of ten stocks during the last mining bull market (Badiali used to edit a mining-focused newsletter for Stansberry, and before that an oil newsletter), with the best being a 300%+ return, and the total gain for those ideas is not, they claim, the average of the stocks… but the sum of the performance, so somehow a group of stocks, the best of which returned 300% or so, generates 2,672% gains. That’s stupid, and a really unhelpful way to think about your investments, but, well, a lot of people don’t do well in math class and get sucked into those big numbers.
So what are the actual stocks they’re hinting at for this marijuana revolution? Let’s take a bit of a look… here’s the first one:
“It’s a $6 billion company with 700 employees spanning the globe. It has production facilities in Denmark, Spain, Brazil, Chile and Australia.
“It already makes some of the most in-demand marijuana products … from soft gel capsules, to oils, creams and more. And as medical marijuana becomes legalized, it is in position to roll-out its products in all 50 states.
“According to my 10x Blueprint, and all the research my team and I have done … it’s crystal clear that this company is a screaming BUY right now.”
And some more clues on this one:
“This company is ‘positioned’ perfectly. They produce marijuana for both medical and recreational use, with nearly 70,000 patients already relying on its products. It’s predicted the number of patients could swell to 450,000… that’s a potential 543% surge.
“For my ‘people’ filter: There’s a solid management team in charge, too. The founder has held key leadership roles at several different corporations. The president has two law degrees, and has provided legal, political and strategic advice to international corporate clients. And the Senior Vice President started an e-commerce firm at the young age of 13.”
That’s giant Canopy Growth (WEED.TO, CGC), which I mentioned a few times over the past couple years as the company I’d be most willing to dabble in in marijuana because of its leading size and potential brand power (their first brand, Tweed, got a lot of attention in the early days)… though, sadly, I’ve never actually owned the shares. It was a $6 billion company a month or two ago, but surged recently on the back of the news that Constellation Brands (STZ) is taking a much larger stake in the company and looking to develop marijuana-derived beverages for the mass market (Constellation’s an alcohol company, their most valuable asset is Corona beer). And yes, they have had revenue growth approaching 39,000% over the past three years, though that’s because their revenue was close to zero three years ago.
The recent surge has really come on the combination of legalization confirmation and the ongoing “buy-in” by the beverage companies — Constellation really set the stage with their purchase, which could give them more than half the company (at a cost of billions of dollars) if they exercise all their options over the next few years, but then the story immediately turned to “who’s next” as Molson Coors (TAP) bought into a joint venture with Hydropothecary for cannabis-infused beverages, Pepsi and Anheuser Busch are constantly rumored to be looking at one Canadian pot stock or another and, most visibly, international liquor giant Diageo (DEO) has said that they’re negotiating with several major players to possibly invest with as they work on cannabis-infused beverages. Even Heineken, through its Lagunitas subsidiary, has a weed-infused seltzer for sale in California. I have no idea whether THC beverages will end up being big business, or even whether anyone likes them, but it’s possible and none of the big players want to miss out if that market ends up exploding.
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What’s his “Marijuana Investment No. 2?” Here are the clues:
“Shares trade for less than $7…
“Six international operations from Israel to Australia…
“First pure marijuana comapny to trade on the Nasdaq, attracting attention from big investors.”
They also throw the clue that “Constellation Brands paid $190 million for a 10% stake in the company” in there, but that’s probably just an error — that’s a reference to Constellation’s first investment in Canopy Growth, and we already know Canopy was “Marijuana Investment No. 1” in this same ad. So this is clearly Cronos Group (CRON), which is mostly a Canadian investor in grow operations but does also have assets in half a dozen other countries. Shares were less than $7 before the “which beer company will buy a pot stock next” sweepstakes began a little while back, then they doubled recently before coming back down to about $10. That pullback in the past few days was because of Citron Research’s short attack on the stock, which is centered on their report Cronos: The Dark Side of The Cannabis Space that puts a $3.50 target on the shares. That’s not a bearish statement on the marijuana business more broadly, though they do mention the possible oversupply in Canada, it’s more about the lack of disclosure and the very small “real” business that’s actually happening within Cronos’ various subsidiaries.
So that’s number two — how about another?
Marijuana Investment No. 3 is a “picks and shovels” play on marijuana, which they say has “multiple subsidiaries which supply much needed products to the marijuana market,” including hydroponic equipment and services. That’s not a lot of clues.
So this could be a general services company, like General Cannabis (CANN), which provides security and consulting services and facility planning, or a retailer and distributor like GrowGeneration (GRWG), though they’re more focused on the retail experience than on big growers, or even the oft-cited Scotts Miracle-Gro (SMG), which has been pushing into the marijuana business and building a meaningful segment in hydroponics… but none is a perfect fit for that. Given the lack of specifics, you can probably make any services company you like fit that clue… though none of them have jumped out to me as appealing just yet.
“The fourth stock is a company diving head first into the industry. They are providing the capital and expertise for marijuana companies to become successful. In exchange for the funding, this company gets as much as one-third of the revenue from each company it supports. And you can get in for less than $2 a share.”
This must be Auxly Cannabis (XLY.V, CBWTF), which I’ve written about a bunch of times — mostly under the heading, “I love the idea of this business model, but boy, I wish this was a better company at a cheaper price.” That’s a purported “streaming” and “royalty” company in the marijuana space in Canada, but their early deals were essentially heavy bets on both huge demand increases for marijuana, and huge yield increases at their partner companies based on their advice and input, and, perhaps more importantly, on what looked to me like very high per-ounce prices for the finished product. Maybe it will work out, maybe not, but it strikes me that they’re betting heavily on this being a huge market where most of the producers “win.” I covered Auxly in more detail just last month when it was being promoted as the “Royal Gold of Marijuana” if you want more of my chatter on the topic.
“The fifth stock is a biopharmaceutical company. They produce pills from the marijuana plant to help patients deal with the treatment and symptoms of their illnesses. It’s a $4.2 billion company, which could soon go up once the FDA votes on a promising drug they produce… which I think is all but guaranteed.”
That’s very likely to be GW Pharmaceuticals (GWPH), the largest of the real pharmaceutical companies that builds drugs based on compounds in marijuana. That’s very distinct from a “medical marijuana” company, they’re not selling weed to help with nausea from chemotherapy or pain relief or glaucoma, they’re selling real, clinical trial-passing drugs whose active ingredients are derived from specialty hybridized marijuana plants — most recently, they got approval to market Epidiolex for the treatment of seizures in some patients.
So in reality, the marijuana connection is not terribly meaningful — their drugs will rise or fall on their own, and be priced in some way that’s completely disconnected from the raw material, and their fate will depend on the market for their current and future drugs. The only thing that will help, I suppose, is that loosening the regulatory noose for marijuana will make it easier for them to run the business — it would be less onerous to work with marijuana in the lab, for example, if it were downgraded from being a Schedule 1 drug in the US. Then again, if it’s just the active compounds in marijuana that are making the drug work, well, legal recreational pot means that some possible patients might just toke up instead of taking the controlled and monitored dose given by the drug — some folks don’t want the extra “feature” of feeling high, but not everyone avoids that.
I don’t have any particular qualms about GW Pharmaceuticals, I just don’t call it a marijuana stock… and I don’t invest in clinical stage biotechs and drug developers in general, given the imagination you need to have to forecast their profits a few years out, so I haven’t dipped my toes in the GWPH waters, though it has probably been the most-teased stock in the “pot stock” ads over the past five years.
So where am I left after all that? Well, in truth, I think the whole industry is wildly crazy — it’s a relatively high gross margin business so far, mostly on the medical side, though pricing is highly regulated in Canada and we’re not sure what the price of “regular” marijuana will end up being or what the markups will be for edibles and special strains and whatever beverages they may develop… and the existing Canadian medical marijuana sales, at least, are pretty trivial in size in Canada… over the past year Canopy Growth has seen revenue increase by 70%, to just under $70 million for the past twelve months. That’s patently absurd for a $9 billion consumer product/healthcare company unless the growth is going to be truly ludicrous… so it’s obviously all about how recreational pot takes off when the first sales begin to happen in Canada in mid-October (all the laws have been passed, they’re just getting the final systems in place).
What’s the dream? That marijuana becomes the next major legal recreational drug for Canadians (and soon after, for Americans), and that the profits earned from it over the next few years justify the incredible investments that have been made in building up a massive grow capacity over the past year or two.
That recreational market lets you dream about much larger scale production — forecasts I’ve seen are for Canadians buying $5 billion worth of pot per year as it’s legalized, and that seems to be a pretty widely-cited number. By comparison, Canadians spent about $9 billion on beer last year, and about $22.5 billion on alcohol in total. Molson Coors and Anheuser-Busch InBev between them, the two biggest beer businesses in Canada, hit about $4 billion in Canadian sales last year (in US$). So if Canadians start to spend as much on Canopy’s brands of legal marijuana as they do on Molson and Bud Lite put together, a number that averages out to a little less than $500 per person, that could put Canopy’s revenue at $4 billion. If Canopy gets half of at smaller but still insanely huge $5 billion market, that would be, through simple math, $2.5 billion in revenue.
So if you want to imagine that future, which would be incredible growth from the $70 million they pulled in over the past year from the medical marijuana business (as they’ve been expanding production and stockpiling product for eventual recreational legalization), what would that company be worth then? They’d have to dramatically ramp up production, as they’re doing, and I don’t know what that eventual capital cost would total, but if we assume that someday in the future they’re on a sustainable sales level in the billions, and have a similar gross margin to what they have right now, which around 40% happens to be similar to the gross margin for Molson Coors (though lower than the 60%+ of Anheuser Busch), then what would the company be worth? If it’s valued like Molson Coors at that time, investors will be sorely disappointed — TAP has gross margins of 43% and revenue of $11 billion, and trades at 1.3X sales for a market cap of $14.5 billion. Canopy has a $9 billion market cap now, and no one is in these shares hoping for a 50% gain over the next few years — the dreams are much larger than that.
Anheuser Busch is much more profitable, and much larger, with revenue of $43 billion and a price/sales ratio of 4.3 for a $191 billion market cap. And Constellation Brands is stronger still, with revenue of $7.7 billion and a p/s ratio of 5.4 for a market cap of $40 billion, thanks to their big overpriced Mexican beer hits (led by Corona). So that’s the range at which some big alcoholic beverage companies trade, somewhere between 1.3X sales and 5.4X sales. If we slot Canopy Growth in there near the top at, say, 5X sales, and assume that the Canadian marijuana market ends up being as big as the Canadian beer market, with Canopy taking close to half of that market on the strength of their brands and distribution power, then maybe Canopy Growth should be worth $20 billion when that happens.
It’s valued at $9 billion now, with a mere whisper of those sales, so that tells me that investors are already anticipating incredible revenue growth. We’ll leave aside ideas like profit margin and earnings, because no one cares about those if they think they’re getting in early on a multi-year period of massive sales growth, or if big multinationals decide that the regulatory environment is now friendly enough and clear enough that they can start to buy up the pioneers, as Constellation is arguably doing with Canopy.
So you can imagine a world in which the current valuations for some of the leading Canadian pot names are rational, if optimistic… but for me, that world is a lot further away than investors are guessing right now, and I don’t think there’s a high probability that Canopy is going to go from $70 million in sales to $2 billion in sales over the first year or two of recreational legalization, let alone $4 billion… which means I can’t convince myself to buy the stock.
That means I’ve been missing out on a lot of the marijuana fun in the investing world, and of course I regret that, but the numbers just don’t make enough sense to me and I don’t expect the crazy moves of the past few weeks to be sustainable.
That doesn’t mean I’m right, to be clear. I’ve been wrong on the pot stocks in the past, and I could be wrong this time, too. My primary concern is that these companies are being traded by people who assume not only that the market for marijuana will be huge and growing, but also that a growing commodity market will generate higher prices and strong profit margins, which is hard to imagine (particularly because the primary rationale for legalization is to crush the black market, which won’t happen if legal prices are twice as high as black market prices). But I’m also having trouble with the daydreams of massive wealth explosions, because marijuana cultivation and sales doesn’t strike me as a business where margins are going to improve dramatically. Unlike crazy software and other tech stocks, these are mostly farming and consumer products companies that have real input costs for every sale, and that will be spending like crazy on marketing (assuming they’re allowed to).
So that’s my fuddy-duddiness on the marijuana business, which would probably be enough to get me fired by any big newsletter publisher — the newsletters know damn well that they have to sell the people what they want, and what the people wanted was bitcoin a year ago and is marijuana today, with winds that shift all the time, so mining stock analysts are becoming bitcoin gurus and marijuana stock experts and coming up with on-trend recommendations as fast as they can, at the risk of being ignored if they don’t come up with their “top five marijuana stocks to buy.” This is a fashion business, the attempt to find out which pot stock will be most fashionable with investors.
My fear for current speculators in Canopy Growth and Aurora and the other large players is that they might end up owning a fairly boring producer of a legal product whose market size and growth after the first couple years can’t hope to match the investor expectations, given the massive market cap those companies carry today, which could lead to a declining share price. That doesn’t mean I think Canopy will go out of business tomorrow, or that Canadian marijuana will be a bust in general — I expect it will probably be a successful industry, and that Canopy will be one of the relative winners, thanks in no small part to their large backing from Constellation, and maybe the share price will go up another 500% from here… I just don’t see any reason why it should, and I can’t stomach betting on it. The possible range of outcomes is just too wide.
For another point of comparison and perspective, if you’re looking for some skepticism to counter your own “just buy pot stocks!” internal hype machine, think about California — that’s the largest current legal pot market in the world, following legalization of recreational pot last year, and California has almost exactly the same population as Canada (though a much larger GDP, and somewhat higher average household income). So far, the last estimate I saw indicated that California was on pace to have marijuana sales of about $2 billion in this first year, far less than had been anticipated a couple years ago. Part of that’s due to local headaches with getting dispensaries open, which we’re also seeing here in Massachusetts, and maybe those hiccups won’t come for Canada in the same way, but part of i