Canadian Cannabis Stocks 2017 Outlook - Updated

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Includes: APHA, CGC, LXRP, NXTTF, OGRMF, RDDTF
by: Ted Ohashi
Summary

In the second quarter, the Canadian cannabis stocks as measured by the Let's Toke Business Marijuana Composite Index declined 15.5% suffering from investor fatigue.

The quarter ended with eleven consecutive weeks of LTB MC Index declines. But as I illustrate, the market action does not seem to reflect urgent investor selling.

Reasons relate to delay in passing The Cannabis Act, failure to address taxation and dispensing, a sloppy MedReleaf IPO, a Cannabis Wheaton financing fiasco and hold periods ending on earlier placements.

My proprietary charts support the view that Licensed Producers are attractively positioned and microcaps are attractive but need to be closely monitored.

The risk in bad markets is investors who put their toe in the water are afraid they will take a bath. I urge investors to exercise portfolio patience. There is still lots of room on the upside for Canadian cannabis stocks.

Summary: the cannabis stocks have been overtaken by investor fatigue: too many financings, too many negative developments such as the Medreleaf (OTCPK:MEDFF) IPO and the Cannabis Wheaton underwriting fiasco, too many product recalls and delays in legalization regulations to name but a few. Our assessment tells us the market blahs are likely to last a while longer now that parliament has taken off for the summer probably dragging investors with them.

We think activity could pick up in mid-August as the market begins to anticipate a resumption of activity post-Labor Day. I also don’t think the 11 consecutive weeks of marijuana stock price declines has to continue indefinitely. It does mean the declining market lacks momentum and the trend isn’t likely to change for a few more weeks.

Here is my update for Canadian cannabis stocks for the balance of 2017 and beyond. (see Canadian Cannabis Stocks 2017 Outlook)

It is useful to begin with a look at the large cap market indexes because the broader market trends influence all common stocks in general. In Toronto, the markets weakened after an uptick in the first three months of the year. In the second quarter, overall stock prices were weak especially after late April. The TSX Composite posted a loss of -2.4%, which totally wiped out the small gain in the first quarter leaving the index -0.7% in the year to date.

In the U.S., stocks continued to advance with the Dow Jones recording a +3.3% advance extending the 4.6% gain witnessed in the first three months of the year. Although elected officials (mostly the Democrats) seem to abhor President Trump’s politically incorrect approach to the White House and unconventional approach to communication using Twitter, investors continue to love it. The ‘Trump Bump’ on Wall Street remained alive and well.

The weak close to the first quarter in the marijuana stock group continued in the second quarter. The Let’s Toke Business Marijuana Composite Index recorded a -15.5% drop in the April to June period and is down -16.1% for the year to date.

Regular readers are well aware of the change as I noted on April 21, 2017 that the marijuana group had turned down following the tabling of “The Cannabis Act” and I alerted everyone on May 5, 2017 that both the LTB Composite and the LTB Momentum indexes were now in downtrends. I have consistently expressed a cautionary tone since then.

The following charts demonstrate the reversal in momentum coincident with the correction in stock prices. The top chart below shows the abrupt change in momentum in the short run. This tends to confirm the old stock market adage “… an ebb tide lowers all boats.” In other words, when the general stock price trend is downwards, most stocks go down in sympathy. The lower chart below shows just how “… irrationally exuberant…” cannabis stocks had become in 2013 and early 2014 and how long it is taking to wring the excessive optimism out of the market.

Readers know I continued to express a mood of restraint toward the cannabis group through most of the quarter and still do at present. However, I think it is important to emphasize I have not turned negative on the group. I believe the very high growth rates projected for the industry over the next 3–5 years are realistic so investor optimism is warranted and will return.

The best metaphor at this time is probably my report on Medreleaf [TSX: LEAF] (see Is the Medreleaf IPO a Disaster Waiting to Happen?). I felt for a number of reasons, the Medreleaf IPO could be bad news for investor confidence and this was subsequently confirmed. Despite being one of the leading Licensed Producers in Canada, LEAF shares were underwritten at a price of $9.50 and opened at $7.51 (-20.9%) and traded as low as $6.81 (-28.3%) in its first day on the TSX. It has never closed above the new issue price and recently closed at $8.60, down -9.5% from its new issue price.

At the same time, I remain convinced the negative reaction to LEAF will be short-lived. Initially, I was only concerned about the structure of the IPO. Similarly with the cannabis stocks overall. I have advised caution on the group since late April 2017 and my concerns have been borne out. But I still like the group and urge investors not to abandon their portfolio positions.

Here are two charts that reveal what is going on behind the scenes:

This chart illustrates how the current quarter ended. The last eleven weeks were a string of consecutive declines in the LTB Marijuana Composite Index. This is the longest period of uninterrupted declines since I began calculating the index in 2014. I have been following the old adage that goes back to the days of stock ticker machines on Wall Street that says, “Don’t fight the tape.” In other words, the market is in a downtrend as I have warned since April and we should not ignore that fact.

But the next chart shows why I am not overly concerned:

This graph compares the current correction on the top with the previous two longest consecutive stretch of losses lasting seven weeks each in 2014 below. The current pattern seems less a correction driven by selling caused by an urgent desire to liquidate and more a case of a market that is biding its time. This is understandable given a delay in passing the legalization bill in Canada. This market has actually weathered a couple of storms that might have resulted in a greater correction in a less resilient market. For example:

  1. In April 2017, the Government presented its marijuana legalization documents and in May 2017, tabled Bill C-45, The Cannabis Act and Bill C-46, a bill to revamp laws related to impaired driving. As the parliamentary summer recess approached in late June, it became increasingly apparent the Government would not press the Cannabis Act before the break and C-46 was priority. As a result debate and passage of the Cannabis Act has been delayed to September.
  2. Bill C-45 failed to clarify key issues such as taxation, dispensing of cannabis and provincial differences. This leaves operators and investors in a state of uncertainty. Although the Licensed Producers don’t like the uncertainty, it is something investors passionately detest.
  3. The Medreleaf Initial Public Offering was a rather sloppy affair and when the stock opened down sharply, a nervous market would have reacted more severely.
  4. The Cannabis Wheaton underwriting fiasco might have been more unsettling if the underlying market fundamentals were not as strong.
  5. The large number of newly issued private placement shares that became free trading in the first half of 2017 might have sapped more strength from a weaker market.
  6. A number of higher profile product recalls occurred as the industry attempted to adjust to new testing standards established by Health Canada. It started at the end of 2016 with Mettrum and Organigram recalls triggering closer scrutiny on the part of the regulator. The industry will adjust to such changes but it also has to compete with underground grow ops that don’t have to comply with standards and pay taxes.
  7. In November 2016, California, Massachusetts, Nevada and Maine approved recreational marijuana and Florida, North Dakota, Arkansas and Montana passed medical marijuana measures. With California being a larger marijuana market than Canada, these additional approvals are providing investors with a further expanded list of investment opportunities.
  8. According to colleague Anthony Cataldo, there are now 226 marijuana companies (read full article here). We also reported the number of Licensed Producers in Canada now stands at 50 and recently there was one week in which five new licenses were granted. This means the supply of marijuana companies for investors to choose from is growing rapidly.

Finally, here is a look at the longer-term Let’s Toke Business Marijuana Composite Index to give us some perspective on these points.

As this chart illustrates, the long-term trend is intact. All markets go through periods of above trend performance followed by weeks of below trend results. We have just transitioned from above trend to below trend. We will now likely spend some weeks below trend but it should not be that long until a recovery gets underway. What seems to make sense looking ahead is a market that will be much healthier by September with a change in trend starting over the summer.

So looking ahead, I see a continuation of a generally dull market but not necessarily in the form of consecutive weeks of declines in the index, which now stand at 11. My forecast is that for at least several more weeks, there will not be a change in the overall trend of the Let’s Toke Business Marijuana Composite Index.

Next we examine the Licensed Producer (LP) subset. The number of components of this sector of the marijuana industry have increased dramatically in recent months. At the end of 2017, there were nine companies in this index. At the end of the first quarter of 2017, that had increased to 10 even after Canopy Growth acquired Mettrum and currently there are 16 LPs.

As I noted recently, the proposed Cannabis Act favors the already licensed producers (see Under the Cannabis Act - the Rich Get Richer). Popular recent trends include financing, planned expansion of growing facilities and international diversification. These are opportunities that only existing LPs enjoy.

The next two charts plot the LTB Licensed Producer Index relative to the Marijuana Composite Index over the past year, and, three and one half years. When these charts rise to the right, it means the License Producer stocks are outperforming the average marijuana stock and that has been the case.

As is evident, the LP Index has outperformed the LTB Marijuana Composite Index with some consistency over one and three and one half years. These companies appeal to investors because:

  1. The public LPs are generally the most advanced in terms of attaining revenue and profitability. Many of these companies have grown and harvested many crops and have an established customer base for their products.
  2. Most of the public LPs are well funded with war chests in the hundreds of millions of dollars, in some cases. In other words, they have balance sheet strength to go along with substantial revenues on their income statements.
  3. They have the advantage of having branded over several years. This means within Canada or in international markets, they are established corporate brands and this gives them a significant advantage over lesser known competitors.
  4. When recreational legalization is approved in Canada and other significant markets such as the U.S., Europe and Australia, the LPs are the companies best situated to take advantage. They can market cannabis products, expertise and financial strength internationally.
  5. From an investment risk perspective, these companies offer comparative quality and safety in a young and still growing industry.

As a result, I continue to favor the LPs such as Aphria (APHQF), Canopy Growth (TWMJF) and Organigram (OTCQX:OGRMF) and plan to expand the list of recommended LPs over the next few months.

Another subset within the industry is the LTB Low-Priced Stock Index. This index is a mandate for the smaller, less developed companies that combine higher risk with higher potential reward. The next two charts show this index made up of companies with stock prices below $0.10 per share. These charts are intended to reflect the more speculative group of Canadian marijuana stocks.

The charts demonstrate the higher risk/higher return nature of smaller cap companies. In the past twelve months, the index rose 36.4% from low to high and declined 24.4% from high to low. In the past three and one-half years, the index rose over 500% from low to high. When investing in small cap companies in this sector, you must follow each carefully.

It is typical in most cycles such as this cannabis cycle for the majority of small and microcap companies to go up in smoke when the cycle ends. In the ‘dot com boom and bust’ from approximately 1997 to 2001, for the example, many of the small cap participants went out of business. Even some of the successful survivors such as Cisco (NASDAQ:CSCO) declined over 90% before recovering.

Over the longer term, the Low-Priced Marijuana Index has outperformed the average cannabis stock by a wide margin. Again this reflects the higher risk/higher reward nature of the stocks. This characteristic is not restricted to the cannabis stocks. In the history of stock trading it has always been so. The message is you cannot focus only on the potential reward. You should not ignore the stock risk and your personal financial risk.

I am not concerned this cycle is over and as a result I believe the smaller cap companies still offer substantial potential returns. But if you invest in small cap marijuana companies, remember to watch them closely. If you took a “flyer” on one or two of these companies, this might be a good time to consider upgrading your small cap holdings. I have been recommending Lexaria (OTCQX:LXRP), Namaste Technologies (OTCQB:NXTTF) and Radient Technologies (OTC:RDDTF), which I think are three probable small cap survivors. I think stocks such as these will offer a similar level of potential return with a more manageable level of risk.

If this is where the rubber meets the road, then the Canadian cannabis stocks have clearly been on the skids. With the LTB Marijuana Composite finishing the quarter with eleven consecutive weekly declines and being flattish in the first half while several world markets showed strength, the one-year return on the cannabis group has fallen into the mid-range the world market indexes we follow. I believe this is an anomalous situation and the Canadian cannabis group will reassert its strength in the second half of 2017.

Even so the Canadian cannabis group outperformed the average Canadian stock by a significant margin. On the basis of this data, a Canadian portfolio that was 20% diversified into marijuana stocks would have raised its return to 10.0% in the previous twelve months while a typical U.S. portfolio return would have decreased slightly to 18.8% in the past year.

Based on these returns, a $25,000 Canadian portfolio growing at 7.9% per annum would amount to $114,385 in twenty years but with 20% diversification into cannabis stocks resulting in an assumed growth rate of 10.0% per annum, it would become $168,188 - an increase of $53,803.

Summary & Conclusion:

  1. The marijuana stocks continued to consolidate during the second quarter of 2017 resulting in a -16.1% return in the first half. I outlined several reasons underlying the decline but it all adds up to investor fatigue. I have been advising caution for several weeks and think the cannabis group will remain sluggish in the short term.
  2. The political scenario toward cannabis in the United States remains dominated by Jeff Sessions, who has been pushing back on marijuana and shows no signs of rescheduling cannabis. So the complications south of the border are likely to continue. There is some possibility that Sessions will be deposed but I do not see that as a high probability at this time and until something changes, I remain more inclined to favor Canadian operators.
  3. The Licensed Producers (LPs) continue to forge ahead extending their advantage in the Canadian industry. As a group, the LPs have outperformed the average cannabis stock. As mentioned above I favor OGRMF, TWMJF and Aphria. Of these three, I have posted a basic report and updates on OGRMF (Why Organigram Merits a "Must Buy" Rating) and Canopy Growth (Canopy Growth - a Cannabis ETF Surrogate?) on Seeking Alpha. I am currently looking at other LPs that may be group leaders over the next one to three years.
  4. For the more venturesome, I expect the low priced, higher risk marijuana stocks to perform exceptionally well in the foreseeable future. In looking at this group, investors need to be more cautious. Recently, the microcap group has not been able to escape the general malaise in cannabis stocks, so an opportunity exists to upgrade holdings. Our picks are LXRP, NXTTF and RDDTF. On my Seeking Alpha blog, I have posted a basic report and updates on LXRP (Before You Can Sell LXRP High, You Must First Buy It Low) and NXTTF (NXTTF - It's Time to Fill Your Boots).
  5. The main mistake to avoid at times like these is throwing in the towel. One of the mainstays of successful investors is the old adage, “Buy low, sell high.” Selling Canadian cannabis stocks now is more akin to selling low and not generally a profitable strategy. Now is the time to exercise portfolio patience.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.