Never Get High on Your Own Supply

bubble-4

Overview of the Cannabis Industry

While the cannabis industry is still in it’s infancy, it has attracted an astronomical amount of investment capital. Many companies originally focused on the development of medical grade Marijuana have turned their focus to the recreational market. With Justin Trudeau’s commitment to legalizing marijuana for recreational use throughout Canada, and 28 US states legalizing the once illicit substance, investment capital has been flowing into the industry in a seemingly endless supply.

Estimates indicate that the market for recreational marijuana in Canada will be roughly 23 billion dollars, while the US market could be as large as 22 billion by the year 2020. With all this room for potential growth, there is little wonder why the space has attracted the eye of investors.

However, as often happens in the stock market, what starts off as a good idea quickly leads to excess and irrational exuberance.

Irrational Exuberance, what is it and how does it apply to the cannabis industry?

Irrational Exuberance are the two words stock market bulls loath to here above all others, but what does it mean?

Irrational exuberance is a phrase used by the then-Federal Reserve Board chairman, Alan Greenspan, in a speech given at the American Enterprise Institute during the Dot-com bubble of the 1990s. The phrase was interpreted as a warning that the market was heavily overvalued.

You are probably asking yourself how this happens. The main reason is what is known as the herding effect. When stocks in a particular industry go up strongly, fund managers who own these stocks look like geniuses and attract more money for their fund, while those who don’t look foolish. Even if they know the market sector to be overpriced, many managers will buy these stocks in order to save face. This is a reaffirming cycle that continues until it ends in an inevitable  and violent collapse.

How does this apply to the cannabis industry? While the average P/E (price/earnings) ratio for stocks in the S&P 500 is around 22, the average P/E for stocks in the cannabis is roughly 74. This number is understated slightly, as it does not include the numerous  companies which have yet to record positive earnings, but still have market valuations north of 1 billion dollars. In the last month alone these stocks have risen by an average of 18%, based on little to no change in their recorded earnings.

Lets take a look at how much one of these companies would have to grow to justify their current valuations. Given the fact that these companies are creating a product with minimal differentiation between competitors, I will generously assume a net margin of 3%. The average P/E for an established company is typically south of 10, so again this number serves as a generous estimate. This means that for a company to justify a 1 billion dollar evaluation, it would have to grow it sales to roughly 5 billion dollars. While one or two companies may achieve this feat over a number of years, the growth of these companies has already been discounted in their current evaluation, and so they must beat this 5 billion dollar marker by a significant amount if the investor hopes to receive satisfactory returns.

As for the majority of the companies who fail to achieve this exponential revenue growth, there stock price is doomed to collapse to a tiny fraction of it’s current value.

Comparison to internet stocks in the late 1990’s

A similar phenomena occurred with the internet stocks in the late 1990’s. Any stock with .com in its name was being given a billion plus dollar evaluation with no earnings. Any analyst could see that these stocks were over valued, but they kept on going up. Analyst who stuck with fundamental evaluations  and gave these stocks sell ratings looked like fools as the stock price proceeded to double. Everyone and their mother was buying these stocks and P/E ratios of over 100 became the norm. This continued until the early 2000’s, when the stock prices began to collapse. Many of these companies went bankrupt, and the majority of those that survived have yet to top their 1999 highs to this day. Only a handful of companies, such as Amazon and Microsoft, proved to be successful investments. Though these companies too saw a significant decline in the fallout of the bubble crashing.

nasdaq-bubble

Above is a graph of the nasdaq composite index (which is comprised primarily of internet stocks) during the boom and bust of the dot.com era.

The similarities to the current state of the cannabis industry is glaring, and the end results will likely be the same. There will be a handful of big winners, and an enormous amount of big losers. A crash is all but inevitable, and it is likely that even the winners will get hit when the bubble is burst. If your hope is to try and pick out the winners, I would suggest waiting for the bubble to burst before you do so. If you wish to try and ride the wave of irrational exuberance, do so at your own risk…But beware that a crash is coming and it will be as quick as it is devastating.

Investors in the cannabis industry are riding a high right now, but it is only a matter of time before they are forced to sober up.

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