Several years ago Morgan Stanley did a poll of over 1,000 high-net-worth investors to see if they’d invest in legal cannabis. A full 65% said they were not likely to invest if cannabis were legalized in the next 12 months.
But Matt Bottomley, equity research analyst at Canaccord Genuity in Toronto, doesn’t hear this same level of objection to the industry today, and for good reason. “At the end of the day, I think the U.S. cannabis sector at maturity is probably US$80 billion to US$100 billion in sales,” he says.
The stigma once associated with cannabis has dropped off dramatically, and within the past month states including New York and Virginia, as well as Mexico, have either legalized it or announced plans to do so.
“You’re going to see it slowly, over the next years and decades transition from a more traditional consumer-packaged goods market,” Bottomley says. Presently, leading U.S. companies “are kind of doing everything in every market,” he says—from growing to producing, up to creating edibles and even operating retail in some markets. As legalization expands across the world, big pharma may look to get in on it, changing valuations.
Big-name companies trading in the U.S. such as Canopy and Tilray see their stock prices appreciate when pro-legalization stories hit the news. But because cannabis is still a Schedule I drug, meaning tightly regulated by the government, Bottomley says, “the fundamentals are not necessarily going to flow down to those types of companies.”
Meanwhile, leading American companies like Curaleaf or Trulieve trade on Canadian junior exchanges, less easily accessed by the overall U.S. retail investor market. He thinks there’s a tremendous amount of capital yet to come into this space. Many companies, he adds, are underserved by institutional investors as well.
“Over the long term if you pick the right horses in the sector, there’s still quite a lot of growth to be had.”
Here are three things Bottomley says to keep in mind when investing in the cannabis sector.
Take Stock of Your Risk Profile
Investors entering the cannabis market have to consider their risk thresholds. “All of our buys on cannabis stocks to date are all speculative buys, and we do have holds and sells as well,” Bottomley says.
The sector can be home to wild price swings where for weeks at a time stocks go in one direction, before pivoting and going the other way. If they consider a 2%-to-3% move in a day outside their risk threshold, it might not be for them. Especially because the “wild directions” stocks move in aren’t necessarily tied to company performance.
Bottomley says it also requires a lot of patience. “You really have to be comfortable about where you are on that growth curve and how far ahead of markets opening up—you want to invest your incremental dollar to get ahead of what could eventually be a very large push upward.”
Valuation is Relative
Cannabis is a sector where policy announcements about the future of legalization can cause stocks to move in the same direction, but investors can’t let that alone sway them. Even if every cannabis stock is moving up or down, and the shift seems uniform, Bottomley advises exercising caution.
Not every cannabis company has exposure to the same markets or regions. When looking at companies in the cannabis space, he says it’s necessary to see how they’re situated in markets relative to their peer group.
He offers the example of a Canadian company trading at 30 or 40 times its forward profitability metrics, or Ebitda (short for earnings before interest, taxes, depreciation, and amortization), but that lacks access to the U.S. market or other growth drivers.
“I prefer buying a company that’s trading at a lower multiple than that, but actually has that exposure,” he says. “That’s the first thing that I look at when I’m putting a rating to any of these companies that I cover.”
Understand the Management Team
For Bottomley, management teams and their philosophies are particularly important in the cannabis industry. “We’ve seen a lot of good case studies for huge success stories and a lot of case studies where things haven’t gone so well,” he says.
Prior to Covid-19, Bottomley went on a lot of site visits, meeting management teams. What benefits investors long term, he says, are companies that aren’t too aggressive with mergers and acquisitions, don’t overpay for assets and focus on core markets where they have competencies and market share. But this also means having good infrastructure, like call centers to support patients for medical cannabis companies, or adequate supply for and quantity of retail locations to gain market share.
“Management teams can be fairly aggressive with respect to their messaging,” Bottomley says, “and that’s fine if you can back it up, but I think that’s something investors have to be particularly careful of when they’re choosing which operators they want to back.”