Cannabis Stocks 2019 – Macro Economic Headwinds vs. Industry Hockey Stick

Benjamin A. Smith

Undoubtedly, cannabis stocks investors face a very challenging environment in 2019. Up until now, the industry was supported by macro conditions that, more or less, were tremendously accommodative towards risk asset sentiments. But as we can see, the macro economic landscape is shifting, thereby throwing a curveball to a sector about to realize ‘hockey stick’ growth. We attempt to make sense of the cannabis stocks 2019 landscape, where two intense forces are destined to collide head-on.

With major U.S. exchanges entrenched in bear market conditions to close out Q4, cannabis stocks investors face a conundrum they’ve never encountered. Although voracious bear market declines have always been a sector M.O. on both sides of the border, this one is different. Not only has Canadian sector proxy Horizons Marijuana Life Sciences Index ETF (HMMJ) been hit hard, it’s never fallen so steeply before. Since the October 15th close, HMMJ has cratered ↓46.10% (!) despite a plethora of catalysts working in the sector’s favor. Same goes for the U.S. Marijuana Index, which fell ↓36.65% during that stretch. And there’s no sign of a bottom yet.

Some investors will point to sector’s second ‘mania’ phase decline from January-February 2018 (or April, depending upon your view) as evidence that we’re not breaking new ground. Maybe so. But while those sentiments hold merit, it discounts the fact that much has changed during that time.

Back then, Canopy Growth had not received a $5B direct-equity stake—and potential majority ownership—from a global CPG player; back then, the cannabis legalization ball had not spread the way it has today (U.K./South Korea/U.K./Luxembourg/Philippines/several U.S. states/etc.); back then, the Farm Bill passage was just a twinkle in eye of Congressional legislators; back then, Bill C-45 had yet to pass. A strong argument can be made that such weakness shouldn’t be happening now.

That’s not to say that things didn’t get ahead of themselves. Ascribing multi-billion dollar valuations to companies still several quarters away from posting black net income numbers seems insane to many people. As does ascribing 9-figure market caps to the potpourri of smaller licensed producers with suspect lasting power. The messy Canadian adult-use roll-out also hasn’t done the industry any favors, by pushing out revenue and profitability expectations. All are valid considerations for recent outsized weakness.

But the fact remains that while cannabis stocks have always experienced hard draw-downs, today’s historical free-fall—where sector positioning is much better off—is clearly laid at the feet of Mr. Market. Quite simply, broad market bear conditions (S&P 500 and NASDAQ 100 both 20%+ off the highs), combined with cannabis stocks shifting from a ‘what could be’ to ‘show-me’ landscape, has delivered a punishing blow to investors this quarter.

Cannabis Stocks 2019 – A Sector Without Comparable

Perhaps the greatest uncertainty facing cannabis stocks 2019 is that it’s a sector without a comparable heading into world economic slowdown. We can’t really look at other industries during 2000-2001/2007-2009 periods and predict how the sector might act.

For example, I see obvious correlations between cannabis stocks and internet stocks circa 1999. Both had leading participants trade at obscene P/S metrics long before net profitability was realized; both industries were filled with sub-standard companies with no hope of fulfilling proposed business models; both had a disproportionate amount of issues come to market to cash-in on the craze (in Canada, at least). There are many more. Yet, internet companies were still miles away from monetizing the internet to its true potential.

On the day NASDAQ peaked on March 10, 2000, the combined valuation for composite companies was $6.6 trillion, while aggregate e-commerce sales in the U.S. was somewhere around $25-30 billion—about 1% of total domestic retail sales. Cloud computing, internet streaming and social media platforms were either not monetized, or in the very nascent stages of being so. The cannabis sector’s revenue ramp and cross-penetration into ‘sin’ markets, by comparison, will arrive much more quickly.

While cannabis stocks share ‘risky’ characteristics, they also share much commonality with ‘defensive’ beverage CPG companies. Sales are anticipated to remain constant throughout all economic cycles (dried flower, extracts, beverages), as consumers tend to use ‘sin’ products equally in good times and bad. This is a desirable outcome since Big Beverage is considered somewhat insulated from recession—in fact holding up quite well during both the 2001 and 2008-2009 U.S. recessions.

The problem is, cannabis have not yet achieved the scope, global reach, or market penetration characterized by Big Beverage. While sweeping advancement has been made, it’s a huge stretch to characterize the sector as being ‘defensive’ in light of the lack of operational history behind these companies. Assuming cannabis will emulate Big Beverage resilience during poor economic times—and proving as much—are two entirely different conversations.

In time, I believe Big Cannabis will get there. But that’s still a few years away. In the meantime, the cannabis sector will have to settle for partial defense-ability as it hurdles towards its first world slowdown experience.

Final Thoughts

In my view, the overarching narrative in 2019 will be the battle between macro economic weakening and a sector just hitting its stride. On one hand, cannabis stocks remain deeply speculative—especially on the legislative front in many countries; timetables and scope of market penetration are still highly uncertain. On the other hand, cannabis is almost assuredly a defensive consumer packaged good (with medicinal qualities), with revenue curves growing quickly relative to other early-stage growth industries at similar late-stage market cycles (i.e. internet stocks circa 2000).

As such, anyone who claims to know how cannabis stocks will perform in 2019 is full of themselves. Anything can happen here, from further erosion and stagnation to significant upside should markets hold up better than hoped. Much will depend on the severity of global economic weakness that lies ahead, as well as further legislative advances made in endogenous markets—particularly the U.S. as it relates to the States Act. Without passage of the latter, it’s safe to assume cannabis prohibition will remain in place on a federal level.

Either way, I believe investors should roughly treat the cannabis sector as a hybrid between riskier internet stocks (circa 2000) and defensive CPG/beverage conglomerates heading into the new year—under the assumption of pervasive global economic weakness. There’s a lot of money to be made, but choosing correct entry points on the right stocks is imperative. The good news? The market’s steep swoon has taken much sting out of the bear case heading into 2019.

Midas Letter will have more detailed sector predictions before the year is out.

Benjamin A. Smith

Benjamin A. Smith

Ben is a research analyst and capital markets professional with nearly 20 years of experience. His areas of expertise are broad-based, and include extensive knowledge of macro economics, stock/derivative trading, commodity complexes, cryptocurrencies and technical/quant analysis. He also maintains an particular affinity for U.S. politics and the macro-regulatory environment facing...
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