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This Report Should Have Cannabis Investors Worried

Photo: Plantlady223. Licence: https://creativecommons.org/licenses/by-sa/4.0/ Source: https://commons.wikimedia.org/wiki/File:Young_cannabis_plant_in_the_vegetative_stage_01.jpg

Much of the hype around pot stocks and the basis for their high valuations has been centred around the growth that is expected in the industry. However, a recent report from Statistics Canada suggests the industry may not be all that big.

The black market for cannabis in 2015 was estimated to be worth $6.2 billion, which is less than the wine market. Although the wine industry is worth an estimated $7 billion, other than Andrew Peller Ltd, which doesn’t have a big market cap by any means, there aren’t many big wine companies listed on the TSX.

Why does this matter?

Given that Canopy Growth Corp  (TSX:WEED) already has a market cap of $4.4 billion by itself, and Aurora Cannabis Inc  (TSX:ACB) is valued at over $3.2 billion, these two companies combined are already valued higher than the entire industry.

Aphria Inc adds another $2.3 billion to the pool, and there are still many other cannabis stocks on the TSX, with more pot companies likely to be listed as we approach the legalization date.

This is just further proof that these stocks are too highly valued and that the market is simply not big enough for all of these companies to experience the significant growth that would be needed to justify their valuations.

Where will the growth come from?

Certainly there is no guarantee that the $6.2 billion figure is correct, as by definition it would be difficult to ascertain the size of a black market. However, even if the industry were $8 billion or $9 billion, that’s still less than the market cap of the aforementioned three companies.

The assumption for investors is that legalizing marijuana will create new demand and build on existing users. However, I’m skeptical that this will be the case. I’ve never smoked pot in my life and I can’t image I ever will regardless of whether it is legal or not.

While the legalization may tempt some to try cannabis, it’s hard to see how that would drive significant growth in the industry. After all, I’ve yet to come across someone who wanted to smoke pot and didn’t because it was illegal to do so.

Edibles could offer another avenue for growth – but will it be enough?

While regular pot smoking might not offer significant growth opportunities, if edible marijuana is legalized,that could certainly increase the size of the industry.

However, the high valuations that cannabis stocks trade at suggest that the growth would have to be exponential for these companies not to be overvalued.

What should investors do?

At the current valuations, it’s hard to miss the pot bubble that is forming. Although the share prices may very well continue to rise, stocks are getting very expensive given the limited amount of sales and the lack of profits that have been generated thus far.

There is a lot of optimism that is fueling cannabis companies. At this point it’s hard to view pot stocks as being anything more than a speculative buy. There could be some upside in the short term, but beyond that, investors are exposing themselves to significant risk.

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Fool contributor David Jagielski has no position in any stocks mentioned.

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