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Canopy Growth Corp.: Where There’s Smoke, There’s Fire

Canopy Growth Corp. (TSX:CGC) has been one of the best picks on the TSX this year. The stock just keeps rising higher, but despite all of the tailwinds, if one piece of bad news comes out, it could trigger a horrible crash.

Investors must consider the bearish case when investing in a stock. Optimism is at an all-time high thanks to non-stop positive news on Canopy as well as the marijuana industry as a whole. It’s clear that investors want a piece of this hot market, which is ready to take off, but before you get excited, let’s take a lesson from the book of Warren Buffett.

Be careful when following the herd

As Warren Buffett used to say, “…be fearful when others are greedy, and greedy when others are fearful.” While followers of Buffett usually take this advice on the buy-side, it’s also terrific advice for the sell-side.

With investor optimism at all-time highs, Canopy may actually be a terrible investment right now because investors in the stock have become greedy. The stock has soared over 250% in a year, and it keeps climbing higher, but while most investors are greedy, you should be scared–really scared! This is the kind of stock that would give Warren Buffett nightmares!

Sure, the marijuana market is going to be a huge opportunity, and you could make a great deal of money by investing in marijuana stocks, but if that’s the only reason why you’re buying Canopy at current levels, then you need to rethink your strategy.

Don’t forget about the valuation

Canopy is a great business. The management team is building a terrific brand for themselves. They have Snoop Dogg on board, and that’s going to be a fantastic marketing campaign.

The business is great, but what about valuation? Even if it’s the best stock in the world, you still have to consider value if you’re going to make any money in the markets; otherwise, you’re just speculating.

The stock has an absurd price-to-book ratio of nine and a price-to-sales ratio of 56.9, which is ridiculously expensive. If you buy the stock at current levels, you’re paying a gigantic premium, and you have no margin of safety.

If you’re willing to pay a massive premium for shares of Canopy, then you’ve got to accept the fact that the stock could correct by as much as 50% or more. If you can honestly stomach a crash of that magnitude, then go ahead and invest in the stock. Simply put, it’s not a stock for investors with a weak stomach.

If you buy shares at these prices, then you’re making a bet that Canopy will be a leader in the marijuana industry, and that it will have more successful partnerships in the next few years. The valuation may not be fully realized until pot is legalized, and there could be a rocky road ahead as the sell-offs will be just as big as the gains. If you’re going to buy, buy the dips. Don’t buy it at all-time highs.

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Fool contributor Joey Frenette has no position in any stocks mentioned.

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