It’s just a few days until pot becomes legal, and the question on everyone’s mind is, “How high can cannabis stocks go?”
As the late summer rally showed us, cannabis stocks can go pretty high — like, $15 billion market cap high. But with most cannabis stocks cooling off in the past few weeks, we can see clearly that no rally is forever.
One of the culprits behind the cooling off’ we’ve seen in cannabis stocks recently is the profitability question. Put simply, very few cannabis companies are actually profitable in net income terms. If we exclude unrealized investment gains from the equation, almost none of them are. While the profitability issues in the cannabis sector mainly come from high investment costs that will presumably taper off at some point, it remains to be seen how profitable these companies will be when the earnings floodgates finally burst open.
Many are hoping that legalization will be the “saviour” of the cannabis industry that finally makes pot stocks profitable after years of growing losses. While this is certainly possible, I wouldn’t count on it. To understand why, we need to look at the cannabis industry as a whole.
A competitive landscape
The Canadian cannabis industry is a competitive space. There are over half a dozen publicly traded cannabis companies in Canada, all of them competing for the same recreational cannabis supply contracts and prescription cannabis sales. While these companies can differentiate themselves somewhat with their international strategies, on the domestic front they are basically interchangeable commodity suppliers.
This means that, in the long run, these companies are likely to start competing on price points, as happened in Colorado when cannabis was legalized there. Add into the equation even more price pressure from black market vendors, who will cut prices to remain relevant in the legal cannabis era, and you’ve got a recipe for falling prices.
While I think it’s likely that pot prices will fall when cannabis becomes legal this week, it’s not inevitable. What is inevitable is many cannabis companies’ expenses continuing to grow for the foreseeable future.
Take Canopy Growth (TSX:WEED)(NYSE:CGC) for example. Canopy wants to be the number one cannabis producer in all of the 11 international markets it operates in. This will require massive infrastructure investments, which the company is financing largely from the proceeds of the Constellation Brands deal.
The infrastructure involved in building up a globally dominant cannabis company is substantial, with grow sites, transportation, and storage infrastructure being only the tip of the iceberg. In order to become consistently profitable, Canopy will need to earn a significantly positive ROI on all of these infrastructure investments — and it’s not guaranteed that they will. Sudden government action against cannabis in any of the countries Canopy is investing in could make some of the company’s investments go to naught. For these and other reasons, pot companies like Canopy may have a rocky road to profitability ahead of them.
When you buy heavily cyclical stocks at low prices… and then hold the shares until the cycle reaches its peak… you can make a very healthy profit.
Every investor knows that. But many struggle to identify the best opportunities.
Except The Motley Fool may have a plan to solve that problem! Our in-house analyst team has poured thousands of hours into their proprietary research – and this is the result.
Our top advisor Iain Butler has just identified his #1 stock to buy in 2018 (and beyond).
The last time this stock went from the low point of its cycle to the peak… shares shot from $12 to $40 inside of 4 years. That’s an 300%-plus return. And if you missed out on that ride, today might just be your second chance.
Fool contributor Andrew Button has no position in any of the stocks mentioned.