Over the past week, the federal government finally approved the use of marijuana for legal use. Many investors were relieved, as there have a been a few roadblocks in the process. However, this news did not lead to any substantial increase in the overall prices of marijuana stocks.
The most followed exchange-traded fund (ETF) HORIZNS MARIJUNA LF CL A UNT ETF (TSX:HMMJ), which tracks the marijuana industry advanced by close to 7% for the week, but did end on a downtrend. Essentially the rose is off the bloom, and why not? The industry has now put the most major piece of good news in the rearview mirror and may now be facing the realities of real competition.
As marijuana use is becoming mainstream, there will inevitably be a greater number of operations trying to follow in the footsteps of industry leaders such as Canopy Growth Corp. (TSX:WEED)(NYSE:CGC)m which at a price of $43 per share has increased substantially based on “potential” and not much more. Once buyers establish their favourite brand and the euphoria of “trying it out” wears off for many consumers, the revenues may not be there to substantiate a high valuation. At the current price, the company trades at close to 100 times revenues (assuming we annualized the current quarter’s revenues).
In spite of a positive bottom line, the company continues to operate at negative cash flow, as the reported revenues are derived through “the change in value” of the assets. What this really means is that the marijuana that’s been grown is worth more than the cost of growing it. This means that we have a short selling opportunity on our hands.
Fellow competitor Aphria Inc. (TSX:APH) on the other hand, trades at a price under $13 per share and carries a multiple that is closer to 50 times revenues. The same problem of cash flows persists at this company, however. When considering the bottom line, the amounts reported remain insignificant until the company actually begins reporting positive cash flow.
So how do investors make a profit?
As both of these names operate in the same industry (and are impacted by similar factors), investors are best to enter into a long/short position in the hopes that Canopy Growth Corp. is outperformed by smaller rival Aphria Inc. In the event that the entire industry takes a dive, the only requirement is that Canopy Growth Corp. decline by more than Aphria Inc. In the events of an increase in value, we hope that Aphria leads the pack.
The ideal situation for investors who long Aphria Inc would be a large increase in value while shares of Canopy Growth Corp. decline in tandem. This would offer an opportunity to make money under both circumstances. The danger however, is that each name moves in the opposite direction, leading to large losses – but that’s just the fun of investing!
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Fool contributor RyanGoldsman has no position in any of the stocks mentioned.