Investors who bought Canopy Growth Corp. (TSX:CGC) at its peak last week are getting a nasty lesson on the risks connected to chasing a stock that has a $2 billion dollar valuation but barely generates enough quarterly revenue to buy a high-end house in Toronto.
What’s going on?
Canopy is probably the hottest stock around Canadian water coolers these days.
The cannabis producer blew through the $2 billion valuation mark November 16 and briefly hit $17 per share before investors decided to lock in some juicy profits. The stock traded for just $4 at the beginning of October.
Most of the run-up in the share price is connected to expectations that Canada will have a legal recreational pot market by 2018. The recent votes by U.S. states to allow the sale of cannabis have bolstered hopes of a speedy Canadian approval process.
At the moment, Canopy is Canada’s market leader in the medical marijuana segment and is expanding its reach overseas to countries like Germany and Brazil.
Why is the stock falling?
Any sane investors sitting on the sidelines watching the Canopy show could see the current pullback coming.
When the stock topped out on November 16, it had to be halted a number of times for volatility on the way up as well as on the way back down. When the dust finally settled, an astounding 24 million shares had changed hands, and investors who bought the stock at the opening bell were looking at a 15% haircut.
Bottom feeders picked up Canopy for about $10 per share that day, and unlucky buyers paid more than $17.
When you have a stock moving that much in a single session, it is time to step back and clear your head. Traders love this stuff, but it can be toxic for investors.
Speed bumps coming?
The federal government set up a task force this summer to study the best way forward on making the sale of recreational marijuana legal in Canada.
The recommendations are expected at the end of November and will be used as the starting point to draft legislation, which will ideally be ready by the spring of 2017.
In a perfect investor world, the government will have all its ducks lined up by the end of next year, and Canopy will begin to dominate the estimated $10 billion Canadian marijuana market beginning in early 2018.
If that were guaranteed, the current valuation might be warranted, but difficult issues need to be sorted out, and the market might be underestimating how long the process will take.
Think about it.
Who gets to sell the product? Where will it be sold? Who will pay for the manpower needed to ensure sellers are legit, and the product is coming from licensed suppliers?
Do provinces or communities have a say on where, or if, cannabis can be sold? How much tax will be charged? Where does the tax revenue go?
These questions are just the the tip of the iceberg, and the Liberal government knows it has to get this right.
Cannabis smokers are certainly behind the project, but I suspect a large part of the voting public is a bit nervous about the potential impact to local communities.
If public concern starts to heat up, the legalization process could come to a quick halt, and that won’t be good for Canopy’s shareholders.
Should you buy?
The stock remains volatile, easily moving 10-15% in inter-day trading. That’s a recipe for bad news if you are an investor rather than a trader.
With Q3 revenue of just $8.5 million, Canopy simply doesn’t warrant the current valuation of $1.5 billion. In fact, a 50-70% plunge in the stock is certainly possible in the near term.
I would steer clear of this name until the government has a firm launch date in place for the recreational marijuana market.
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Fool contributor Andrew Walker has no position in any stocks mentioned.