When it comes to pot stocks, be greedy when others are fearful.
- Cannabis stocks have been heavily hit the past 6 weeks, and have underperformed the broader market
- This is a seasonal decline that has historical validation
- The US market was overextended driven by a flurry of recent M&A deals, and so a correction was inevitable
- This presents a great opportunity to initiate a position or to dollar-average down
Blood on the dance floor
That would be the best way to describe the performance of cannabis stocks in general over the past couple of weeks. Starting the year with a bang, and being nearly 60% up in the first quarter, the downturn from there has been steep and incessant. I have explained many times that cannabis stocks have a larger Beta than ordinary stocks.
A Beta coefficient is a measure of the volatility, or systematic risk, of an individual stock in comparison to the unsystematic risk of the entire market.
In layman's terms, this means that cannabis stocks are more volatile than the broader market. So, when times are good and the markets are rising, one could expect cannabis stocks to rise even higher. The opposite, however, is also the case. In this case, when the markets are going down, one should expect cannabis stocks to decline significantly more, and this has certainly been the case.
One of the industry benchmarks is the largest cannabis-centric ETF, the Horizons Marijuana Life Sciences ETF (with over $1.3 billion funds under management), and its performance against the S&P500 Index is shown above. As you can see, the ETF has considerably underperformed the S&P500 and this is a clear display of the beta coefficient in action.
Tis the season to be anything but jolly
This downturn is not out of the ordinary, in fact, quite the opposite. Cannabis stocks have traditionally not performed well during the North American summer season. This is clearly demonstrated if one considers the Global Cannabis Index over the past 3 years.
As can be seen, the May to August period is associated with falling prices and a downtrend trend. Our thesis is that the cannabis industry has been and will continue to be, in a bull market and this is depicted by the black trend line. Pot stocks are volatile, and there will be times of great peaks and troughs. Investors need to enter the market eyes wide shut, and to both understand and expect this. However, the long term outlook is still a bull-market one.
May to Date
As previously mentioned, cannabis stocks surged in the first quarter of the year, with some of the companies over 100% up year to date. This kind of growth was never going to be sustainable and a correction was always going to happen. However, the strength of the correction has surprised many of the cannabis experts and the markets in general.
Not all of this can be attributed to the industry itself. Broader markets have also been under pressure with Trump fighting trade wars with China (and now potentially Mexico) via his Twitter artillery. General unease over a potential global recession and the confusion around Brexit have all contributed to underlying market sentiment of negativity, and this has weighed heavily on pot stocks.
Most of the stocks performed terribly in May, with the US stocks underperforming their Canadian counterparts.
We have long been of the opinion that investors should allocate a larger proportion of their cannabis assets towards the US market whilst simultaneously reducing their exposure to the Canadian producers. We expected the US stocks, driven by the positive changing legislative environment, to outperform Canada. But to date, this has not been the case.
The market has been in a relentless downturn since the beginning of May and this may continue for some time. The US stocks have definitely been impacted more than their Canadian peers, and one of the reasons for this is the fact that the US stocks ran up so much higher in Q1. Driven by significant M&A activity such as Cresco Labs acquisition of Origin House and Curaleaf's acquisition of Cura Partners, investors saw massive movement and gains from these deals and the rising tide lifted all ships.
However, since then, the deals have been slower to close than initially announced due to the ongoing investigations by the US anti-trust authorities. Although there is very little risk of these deals not going through, the lag on the deal has placed additional pressure on the stocks and this has itself contributed in dragging the market down with it, as investors await further news and/or catalysts.
Some stocks have added further fuel to the fire and caused themselves even more damage. CannTrust's disastrous capital raising round placed immense pressure on the stock as investors voted with their sell orders. Hexo delivered stagnant quarter-on-quarter growth, with poor gross margins, while MedMen delivered another quarter associated with a massive cash burn, albeit with significant revenue growth. iAnthus meanwhile had the double whammy of MPX Biocuetical shareholders selling down (which is very common post a merger) and then the recent repricing of staff options, that really irked investors – with the stock down almost 15% in the past week alone.
For further comparison, consider the chart above. It shows a comparison of the newly-listed Horizons U.S. Marijuana ETF against it's older sibling, the HMMJ. Note that the HMUS ETF has lost 20% of its value May to date, while the HMMJ (which has no US cannabis holdings), has only lost about 8% over the same timeframe.
Birdy Num Num
As we have shown above, historically, the cannabis industry has shown great periods of volatility with the North American summer months typically associated with downward pressure on stock prices. However, we view this recent correction as favourable for a number of reasons.
Firstly, after such strong performance in the first part of the year, a correction like this was both needed and inevitable. But it provides a great opportunity for investors looking to gain entry into the market and initiate positions, and of course, for investors looking to dollar-average down some of their existing positions.
Finally, the cannabis industry is fuelled by M&A catalysts that drive stocks prices in the affected companies and lift the market as a whole. We see future M&A activity to be centred predominantly in the US, and these events could create very favourable opportunities for investors.
There is no doubt that there is pressure on the markets at present and much uncertainty has caused investors to fear and flee. We are reminded by what the great Oracle of Omaha – Warren Buffet – believes, which is be greedy when others are fearful and fearful when others are greedy.
The market is fearful right now, and that creates a buying opportunity. We remain firm in our view and belief that the US companies possess greater growth potential over the coming 24 months. The companies that have strong fundamentals, good traction in market, and are well capitalised, offer investors a greater than average opportunity to bank significant gains in the future.
No doubt there's blood on the dance floor right now, but no need to leave the party just yet.
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