But, What About Weed Stocks?

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Weed Stocks

For those who know me or listen to the podcast know my firm stance on weed stocks and their current valuation in the market. As an investor, it is your job to leave emotions at the door and analyze companies in a reasonable and quantitative manner. I will dive into their growth prospects with legalization happening across Canada federally and why despite their explosive growth, I will be sitting on the sidelines. I will explain how their explosive growth is promising, but investors must be aware of the drawdown potential with their high flying valuation.

“As a bull market continues, almost anything you buy goes up. It makes you feel that investing in stocks is a very easy and safe and that you're a financial genius.”

- Ron Chernow

Retail Investors

Before I talk numbers with the two most dominant players in the industry, I want to point out the valuation and hype of these stocks and their price performance is due to retail investors. As seen as the quote above, retail investors ride the hype train. With downside risk to the extreme and a long running bull-market, retail investors have never experienced or tend to forget what happens when the tide comes in.

Growth

Canopy Growth Corp (WEED) has posted an outrageously impressive over 80% top line revenue growth over the last twelve months. They have boosted revenue from 2 M (million) to 78 M in the last four years. This growth is impressive and I am not here to discredit that in any way. The point is to understand that you are purchasing a piece of an incredible business… but at what price?

Valuation

Since weed stocks are pre-earnings growth companies, we need to understand their growth from the top line revenue. What this means is that these companies are currently unprofitable. Investors hope to get in early for their profitability in the future. This already groups the stock into a category of companies Stratosphere Investing does not invest in. With thousands of fantastic businesses out there, I am happy to bet on the currently profitable ones.

Canopy Growth Corp, ticker WEED, currently holds the largest valuation in the industry. The market is currently valuing the company at 15.3 B (billion) in market capitalization.

“Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1. Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market.”

- Warren Buffett

Price to Sales & Price to Book Ratios

To get some context on how the two largest players are valued, we will use the price to sales ratio. Understood easily, Price to Sales is their current valuation (price) divided by revenue. Price to Book is their current price divided by their book value which can be thought of as their “net worth”.

Canopy Growth Corp (WEED):

P/S: 178x

P/B: 22.5x

Aurora Cannabis (ACB):

P/S: 187x

P/B: 18.15x

For those unfamiliar with valuation ratios, these are insanely high metrics, thus indicating that they are over-valued. Investors will say “you cannot use traditional metrics to value these companies”. This is generally when over-optimism is present in a bull-market and to be cautious. Don’t forget, every company’s share performance is proportional to earnings growth over a long enough time period. Don’t assume these companies are somehow unicorns to this simple fact.

The Bottom Line

If investors wish to purchase cannabis stocks and are comfortable with tremendous volatility with potentially vicious drawdowns, then all of the power to them. I hope they are right. These would be fantastic Canadian growth stories. It is the aim of this article to familiarize retail investors with the high-flying valuation and understand how purchase price is incredibly important to long term stock returns.