They say the darkest hour is the one just before dawn. Well, let’s hope that dawn will be upon us, and soon, as it is pretty dark out there.

The last couple of weeks have been some of the worst I have experienced in my short time (just under 2 years) in this industry. Although the general stock market has been in a sharp decline over the past couple of weeks, the Cannabis Industry seems to have been hit much, much harder.

Let’s consider first the broader market. As most of you know, I do not look at the broader market very often and am almost entirely cannabis centric in my research and knowledge.

However, when the markets are falling around you, as they currently are, it’s hard to ignore. In an article posted by MarketWatch this week, they note a nearing “death cross” for the S&P 500, which highlights the stock market is in tatters.

A death cross is what chart watchers refer to as the point where the 50-day — a short-term trend tracker — crosses below the 200-day, which is used to define the longer-term trend. Many believe the cross marks the point where a shorter-term decline graduates to a longer-term downtrend.

 

Source: Yahoo Finance – 50-day in Red and 200-day in orange.

 

But as MarketWatch’s Tomi Kilgore writes, the ominous formation is also a sign of how viciously equity markets have unraveled in the past several weeks. More than half of the S&P 500’s 11 sectors have seen death crosses, and a chunk of the index’s constituents are in bear markets, having declined at least 20% from a recent peak.

They say a rising tide lifts all ships, and this is true, but so is the inverse. The lowering tide has dragged all ships down with it, and pot stocks are no exception. The overall Global Cannabis Index has declined by 31% over the past 30 days.

Digging deeper, the Canadian LP Index declined 32% in the same time period, whilst the US Cannabis Index is down 35% over the past 30 days. These are big numbers.

It can clearly be seen that Cannabis has been pulled down with the overall market but by a far greater amount.  There are a couple of reasons that could be responsible for this.

 

Tax-loss Selling

Tax loss selling is simply a tax strategy to minimise capital gains from other sources. It can include things like mutual funds, stocks, and property.

Consider an easy example.

You bought 149 shares of Aphria on January 3, 2018, for $15.10 per share. At the same time, you also bought 1000 shares of CannaRoyalty (now Origin House) for $2.25 a share. You now own $2,250 of each stock, for a portfolio total of $5,000. 

As at the time of writing, Aphria trades at $7.55 (see more on Aphria below) and Origin House trades at $6.29. You thus have a gain of $4,404 on Origin House, and a loss on Aphria of $1,125.

Thus, to take the tax loss, you could sell all of your Aphria stock and half of your Origin House stock. Your net gain is $1,077 (this is all you would pay tax on) and your portfolio balance would be $7415 (with taxable income of only $1,077 and not $2,415).

 

Jeff Sessions, then Attorney-General, ripped up the Cole Memo on 5 January 2018

On January 5 this year, then Attorney-General Jess Sessions tore up the Cole Memo (the Obama administration’s protection preventing Federal interference with States that had legalised Cannabis) and the market went into a massive sell-off.

However, this sell-off was on the back of what was called the “Cally Rally” (California’s legalisation of recreational Cannabis on January 1, 2018). Stocks went hyperbolic from ~8 December through to the 4th January, with many seeing gains of up to 200% during this period.

Thus, the Jeff Sessions Ice Bucket sell-off would have triggered significant tax gains for many investors. And now is the most logical time to offset against those. Although this sounds trivial, do not in any way underestimate tax loss selling’s impact on the market (especially this year given the rise and fall of the general markets – as mentioned above).

 

Earnings Season

Traditionally, the month of November signals the deadline for companies to report on their earnings. Earnings season in the Cannabis Industry has been pretty much the same story every year for the past couple of years.

Little to no revenue, coupled with growth being funded by significant cash burn. The stocks are valued on their future sales and growth potential (especially Canadian recreational legalisation).

With Canada’s legalisation on 17th October this year, analysts were expecting significantly higher earnings results. I just don’t understand that. I have written many times that the Canadian recreational legalisation was going to be a disaster come Day 1. Canada was never going to be ready.

There was no way that supply was going to be met, which in turn meant that all of the Province’s initial orders were going to be short. Which in turn meant that the recreational supply was going to be sold out, and quickly.

To compound the matter, most of the Provinces opened with very, very few dispensaries, with Ontario launching with none and going online only. They just weren’t ready. Permits, fit outs, hiring, trainign and regulations, all needed to be done in an impossibly short timeframe.

And of course, the demand was insatiable with over 150,000 orders coming through the Ontario Online Store in the first hour, and so much so, that Quebec had to close the stores from Mondays to Wednesdays in order to try and recoup supply.

However, there must have been many in the market that either did not know or understand this or simply chose to ignore it. The big Canadian LP’s were expected to produce massive revenue results, but most delivered significantly less.

To compound matters, some of them showed significant cash burn although to be fair, this was as a result of massive infrastructure and land grab growth. These poor results further weakened the stocks and added fuel to the selling fire.

Source: Company Filings

 

And finally, one shouldn’t underestimate the ‘herd mentality’. After the sensational crash and burn of the crypto stocks this year, many young and aggressive retail investors have thrown in the towel and run for the hills. 

 

The correct correction

When you talk about Pot Stocks, the first thing most people say is how “overvalued they all are”. In fairness, this was and is to a certain degree, still true. Most Cannabis Stocks made new all-time highs post the Cally Rally, with January 3 marking the high water mark for most of 2018.

Some of the stocks went on to make all-time highs post the announcement of the Canopy-Constellation II deal, with some of them seeing gains of over 100% in the 3 weeks following the announcement.

As an example, Aphria was trading for $9.64 on August 13 and peaked at $21.70 on September 10 (a gain of 125%).

The Global Cannabis Index peaked on September 22, and since then is 42% down. Its 2018 high was on January 4 and is now 61% down since then. There has been an almighty correction. And if we are honest with ourselves, one that was both needed and required.

 

Source: New Cannabis Ventures

 

Now let’s build on this. As I recently wrote, the political winds of change are blowing favourably through the US. There is much noise of the potential for the STATES Act to pass and be signed in by Trump by Q3 of 2019.

This would essentially make the protections offered via the Cole Memo, law, stabilising the political environment for cannabis companies operating in state-legal environments. It may also have an impact on banking regulations, which currently are very unfavourable to cannabis companies.

And of course, you have Canada. Make no mistake, this is a big market, with the massive shortages and lack of retail being very much a short-term issue. In the longer term, supply will exponentially increase, and with the “real legalisation” (the legalisation of recreational extracts and edibles) looking to go live by October 2019, the Canadian market will see huge growth.

This will, in turn, result in massive revenue growth for the leading Canadian LP’s. And with it, real value for shareholders. This is a startup industry. My experience of founding and building startups has given me great insight into what to expect and the kind of growth that should be expected before industry-leading results can be attained.  It is rare that a startup gets it right from the get go.

 

If you arent embarressed by your first product to market, you launched to late.

 – Reid Hoffman (LinkedIn Founder)

 

This is a startup industry. The 5 largest economies in the world still have not legalised cannabis (at the federal level) for medicinal use, never mind recreational. The industry has a long, long way to go, and many mistakes will be made along the way. But for the savvy investor, there are significant gains to be had. 

This is now an outstanding time to be looking to take positions for the medium to long-term timeframes. Prices are now where they were around October 2017 (just before the first Canopy-Constellation deal). But this support line is different. This time, it starts with a legal Canada, and a rapidly growing US market, as well as 5 additional countries that have legalised for medicinal usage since then.

These positions might be in the form of dollar averaging down, or as an entry point for taking positions in new stocks. And if you are completely invested and are currently underwater, relax. If you are a Green Fund member you will know, that we are in this for the long run, and in the long run (provided you’ve picked right) you will be a winner.

 

The Paper Portfolio

At the time of writing, the Global Cannabis Index is 49.6% down year to date (YTD), and the Horizons Marijuana Life Sciences Index (our benchmark) is 22.2% down YTD.

 

The Green Fund is currently 33.20% up YTD with our cash balance accounting for 8.23% of the portfolio. I will be looking to add both Charlotte’s Web and Truelieve to the portfolio, and I will write up on both of those stocks in the coming weeks.

 

The Short Sellers

And finally, let me end off by addressing the chaos that is currently surrounding Aphria, Scythian Biosciences, and Liberty Health Sciences.

The scandal started with a Hindenburg Investment Research report that claimed that Aphria’s recent C$280m Latin American (LATAM) acquisitions appear to be largely worthless.

They went on to present documentation suggesting that Aphria insiders were likely undisclosed beneficiaries of the deals (via Scythian Biosciences), and had diverted upwards of C$700m via such transactions (~50% of Aphria’s total net assets).

In addition, they suggested that Aphria’s cannabis was of low quality, with sources describing facilities infested with bugs, stricken with mould, and having failed audit inspections.

A damming “short sell report” claiming that Aphria is “uninvestable” and, that with a slew of highly questionable transactions, negative operating cash flow, and a low-quality product, ultimately see no credible path forward for the company.

 

 

The stock crashed. Down 32% in one day, with the short-sellers making millions and millions and millions. Was this just a damaging report, malicious and greedy in its intent as Aphria claimed in a super-bland, vanilla response?

Did they overpay?

For sure they did. No more than Canopy and others have paid to enter the South American, Australian and European markets. This is a dog-eat-dog land grab for world domination in the fastest growing industry on the planet. They are all paying massive sums for the right political connections and the right licenses.

What they are not buying are well run, sophisticated operations (for the most part) as the industry is simply too nascent in these markets.

Then, Hindenburg went on to release another damming short sell report, this time on Liberty Health Sciences, noting that there had been shell entries created to siphon returns on property deals pertaining to their cultivation centres.

Once again, a certain Andy DeFrencesco seemed to be at the center of the action. 

 

Source: Andy DeFrancesco’s private Instagram account

 

He is responsible for putting all three companies together and being integral in their listings and M&A from there.  He is also very connected with Vic Neufeld (Aphiria’s CEO) who is looking more and more greedy as the stories break.

Aphria has been a founding share in the Green Fund’s Paper Portfolio. It is found in almost every major Index’s holdings and is rated a Speculative Buy by many of the most respectable rating agencies, with a target price of between CAD$18 and CAD$24.

Their market cap has been cut from ~$4bn to just under $2bn and the fact remains that there is still serious commercial value in their Canadian holdings, facilities, and operations. Remember they are the 3rd largest producer of Cannabis (behind both Canopy and Aurora) and have supply agreements with every Province.

Even if one was to write off all of their LATAM assets, they still currently trade at less than 2X tangible book value, and do not seem to have any liquidity issues. I honestly believe that Vic Nuefeld is going to have to go, and with him, a management reshuffle.

 

Source: Aphria Company Documentation

 

I also think this brings to light just how “startup” a lot of these Cannabis companies are. Aphria has 4 insiders (the top row above) on a board of 6. That’s simply not good enough.

As Aphria have always stated, “we have a good thing growing”, and to be honest, I still believe this to be true.  This is, in my opinion, an exceptional time to be taking an initial entry position, and a great opportunity to Dollar average down. Yes, there’s smoke, which no doubt means there’s fire. But a fire sale is not necessarily required here.

Sit tight guys. Now is not the time to panic.

 

Disclosure:

I/we have long positions in Aphria, Canopy, CannTrust, Aurora, and Liberty Health Sciences. I have no plans to initiate any new positions or sell any positions, within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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