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My 2018 Prediction for Canada’s Cannabis Sector

Boy, what a ride 2017 was for most Canadian cannabis equities.

With nearly everything cannabis-related seeing massive increases during the tail-end of 2017 relating to continued exuberance (or perhaps irrational exuberance) related to the upcoming legalization of pot in mid-2018, the increase in market valuations for Canopy Growth Corp. (TSX:WEED), Aurora Cannabis Inc. (TSX:ACB)Aphria Inc. (TSX:APH), and Medreleaf Corp. (TSX:LEAF), among others listed on the TSX and TSX Venture exchanges, has been truly remarkable.

As fellow Fool analyst Joe Frenette has recently pointed out, while the Bitcoin frenzy may be cooling this holiday season, cannabis remains the hot sector for many investors seeking a get-rich-quick option in a sea of overvalued securities on the TSX.

While the thesis that cannabis companies are likely to outperform Bitcoin and other blockchain-related cryptocurrencies in 2018 may pan out in 2018, I stand firm on my previous analysis, citing cannabis as yet another bubble investors should be wary of in the year to come for a number of reasons.

Irrational exuberance is exactly that: irrational

A number of respected, high-profile analysts, such as Chris Damas and Barry Schwartz, who cover the Canadian cannabis sector, have pointed to the sky-high fundamental risks investors are making by piling their retirement savings into cannabis companies at current levels.

Mr. Shwartz has recently gone on record, calling cannabis investing a nearly surefire way to “lose all of your money,” citing key risk factors I have harped on for some time now. The majority of the concerns analysts such as Mr. Shwartz and others share on the cannabis sector is related to the demand side of the equation, noting that the market analysis done relating to the consumption of marijuana by new users is highly questionable, with the vast majority of consumption likely to take place by high-volume users who currently enjoy access to medical marijuana in the current semi-legalized Canadian medical marijuana-distribution system.

I suggest all Foolish readers also refer to the research report released by Mr. Damas for more clarity on the supply-side fundamentals of the Canadian cannabis sector; whether a supply glut will truly rear its ugly head in 2018 or beyond remains to be seen; however, it is true that despite consolidation taking place among many of the large Canadian players, the increase in production capacity set to come online is likely to result in lower long-term profit margins for producers.

Cannabis securities difficult to short

Another key facet which analysts have pointed to as a driver of valuation growth among many of Canada’s largest cannabis companies is the reality that shorting Canadian cannabis stocks remains difficult and very expensive to do. With the majority of shares for many of the newly minted TSX equities held by investors who got in via private placements, large chunks of stock are not available to be borrowed, leading to a situation where investors are largely only able to bet on the upside of the sector, leading to a potential lack of price discovery, which is present in most other actively traded sectors today.

Bottom line

While cannabis valuations may continue to rise pre-legalization in early 2018, I expect investors will come to their senses and begin taking profits off the table following legalization as valuations normalize.

The problem is, for valuations to normalize, a significant correction is in order.

Stay Foolish, my friends.

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Fool contributor Chris MacDonald holds no positions in any stocks mentioned in this article.

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