If you’ve been investing as long as I have been, you know that Wall Street loves a good fad. Now, in many cases, there’s good reason for the hype. We live in exciting times. From 3D printing to VR to surgical robotics, I’ve recommended plenty of companies that are on the cutting edge of technology.
As long as a company has the sales and earnings to back up their popularity, I don’t mind jumping on the bandwagon. That’s why I currently recommend high-multiple stocks like Amazon Inc. (AMZN) and Netflix, Inc. (NFLX).
However, not every fad is backed by fundamentals. The dot-com bubble of the late Nineties was a particularly painful example of this. Since then, we’ve had plenty of smaller bubbles in fad stocks. Tesla (TSLA), with a forward P/E of over 100, comes to mind.
What is more troubling, though, is a potential bubble forming in one of today’s “hottest” sectors. I’m talking about the marijuana craze.
Now, at face value, there’s a lot to be excited about here. We’re in a new era of decriminalization in the U.S. Recreational marijuana is now legal in nine states. Medical marijuana is legal in 30 of the 50 United States. And, with two-thirds of Americans supporting legalization, more states will likely follow.
Meanwhile, our neighbors to the north are leading the legalization charge. In less than a month, Canada will become the second country ever to fully legalize recreational marijuana.
As more states give marijuana the green light, tons of small businesses have been rushing into the market. Even big players like Coca-Cola (KO) have been experimenting, with Coke exploring drinks infused with cannabis oil.
With all of this excitement brewing, it’s small wonder that pot stocks have become hot commodities. Players like Canopy Growth (CGC), Tilray (TLRY) and Aurora Cannabis (ACBFF) have experienced huge growth over the past few months.
However, to all of those who want to know my opinion on these stocks, I advise caution. There is one massive catch to all of this price appreciation.
These stocks aren’t moving higher on the strength of their underlying business fundamentals. They have been driven higher by forced buying pressure from marijuana ETFs. Given that many marijuana stocks are penny stocks, it doesn’t take much buying pressure to cause movement in them.
Unfortunately, this growth isn’t sustainable. Every weekend, when I run our weekly quantitative research, I typically find 14 to 16 Canadian cannabis-related stocks. However, I have yet to find any Canadian cannabis related stock that regularly files quarterly reports. This is a huge problem.
This means that all of those fundamentals that I need to see—sales, earnings, operating margins, return on equity—aren’t there. None of the stocks have the financials for me to even consider buying them.
On top of this, there is little to no analyst coverage. Even one of the bigger, more established companies—Canopy Growth (CGC)—doesn’t have any analyst coverage. So, when you invest in these companies, you’re essentially flying blind.
This isn’t surprising, given that many of these companies only have a handful of employees.
Okay, so I’ve been criticizing Canadian cannabis companies, but what about the budding American industry? Well, there’s a problem with that, too. Your investment options are severely limited in the U.S. That’s because the United States’ tax code prohibits U.S. cannabis producers from expensing normal business expenditures like wages, electricity or rent. So nowadays, most U.S. cannabis businesses are non-profit enterprises.
To summarize thus far, we’re left with a relatively small number of Canadian cannabis producers that don’t have regular financial statements or analyst coverage. But that’s not the only reason why I’m staying away.
The other thing you need to know about this industry is that the Pot ETFs are also engaging in highly irregular activity. A good example of this is ETFMG Alternative Harvest (MJ). These ETFs are pouring money into thinly traded Canadian cannabis stocks. And then, they’re selling their ETF shares at a massive premium.
To put it into perspective, your standard blockchain ETF is going to command a 15% to 20% premium. As for marijuana ETFs, they regularly have a 30% premium. In fact, if you run MJ through Morningstar, it won’t even tell you what the premium is. That is highly irregular. If you’d like to read more about this, I wrote an article on Advisorhub about this very phenomenon: https://advisorhub.com/clients-risk-fleeced-buy-sell-etfs/
I have to tell you that I have never come across an industry where virtually all players refuse to file their quarterly financial statements. That, plus the 30% premium charged by many pot ETFs, doesn’t make me too bullish about the industry right now.
Right now, there is just too much uncertainty in this market, not enough fundamentals, and too many unscrupulous actors. So I don’t recommend any direct marijuana plays. That may change further down the road, but in the meantime, I recommend staying away from the industry entirely.
That’s all for this week. I’ll be back in touch on Monday with the latest upgrades and downgrades in Portfolio Grader.