Cannabis Stocks: Not A Dot-Com Bubble...Yet

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Includes: ACB, APHA, B, CGC, EMHTF, LXRP, NXTTF, OGRMF, ORCL, RDDTF, SNNVF, STZ
by: Ted Ohashi

Summary

The cannabis stocks have been on a tear and people are worried there is too much speculation in the market. Investors are afraid to buy and scared to sell.

I have gone back and looked at the Dot-Com Bubble. It was longer and stronger than this cannabis cycle and the end of that cycle featured many high-profit opportunities.

The current cannabis cycle has entered a higher risk stage that should see greater price volatility both up and down. But I don't think the bull market is over. Yet.

In this stage of the cannabis stock market cycle there are certain investment disciplines that should be used to manage risk in portfolios.

I have also updated my list of stocks with adjusted opinions based on recent market developments.

The cannabis stocks are above many blue sky highs at all-time record levels. Some cannabis shares are up five to tenfold since November 2017 and the underperformers are scorned for only producing more than four years of "normal" returns in less than four months. California has gone legal, Canada is about to go legal, Attorney General Jeff Sessions recently rescinded the Cole Memorandum, the marijuana stock market is bouncing daily like a monkey on a trampoline, new Exchange Traded Funds are mindlessly pouring their shareholder's capital into the cannabis stocks, the Toronto Stock Exchange has to deal with a non-compliant Aphria listing, Canadian Licensed Producers are dumping shares on investors while they extract hundreds of millions of dollars from investor coffers to fund growth and the Canadian Securities Administrators are reconsidering their position that full risk disclosure is enough warning for cannabis stockholders. Meanwhile, investors want to know if it's too late to buy or too early to sell. Many investors are afraid to buy and scared to sell.

I will try to explain what I think investors should do to successfully invest in cannabis stocks today.

Let's begin with a look at the general case. This is a logarithmic chart of the Dow Jones Average from 1896 to the present. A few facts are evident:

  1. The chart rises to the right. This means, in the long run, the investment return from stocks is positive.
  2. The slope of the chart is fairly steady as it rises to the right which means, on a logarithmic chart, the rate of change in prices has some stability over the long-term ≈ 9% per annum.
  3. From the beginning of stock market trading in the U.S. and Canada, stock prices have moved up and down in what investors have come to refer to as cycles.
  4. When prices are moving up, it is called a bull market and investor sentiment is said to be bullish. When prices trend down it is called a bear market and investor psychology is said to be bearish.
  5. Warren Buffett, probably the most successful investor of our time said in his letter to shareholders in 1994, "Stock prices will continue to fluctuate - sometimes sharply…." As this was borrowed from a quote attributed to another great investor, J.P. Morgan, over six decades earlier, I guess they are both right - stock prices will continue to fluctuate.

Generally speaking, the value of a country's stock market reflects the growth in the underlying economy. Investors know this and their investment decisions are impacted accordingly. Stocks go up and down because in theory, investors try to track "fair value" for the market based on a "bottom up" approach, that is, by buying individual stocks. Stocks move in cycles because investors tend to bid prices up above fair value in their optimism and drive stock prices down below fair value in their pessimism. When the market gets above the so-called fair value, the main driver is emotion. Market experts refer to this emotion as greed. Greed based on not wanting to miss out on the high profits being generated by the market. When the market falls below fair value the main driver is also emotion but, in this case, market pundits call it fear. This refers to the fear of losing their money.

So investors full of optimism and greed tend to drive stock prices too high. On the other hand, when investors are motivated by pessimism and fear, stock prices can fall too low. So now we can interpret what Warren Buffett means when he advises being "Fearful when others are greedy and greedy when others are fearful." Buffett means when people are greedy, the market is probably too high so be careful. Conversely, if everyone is fearful, the market is likely below fair value so invest aggressively.

But nothing is as easy as it sounds. It is difficult to know when investors are predominantly greedy or fearful. Also, because the greed and fear are emotion-based, there is no telling how long it can go on. In my experience, these price trends up and down endure for much longer than anyone thinks. A good recent example is the U.S. stock market. Various writers on Seeking Alpha have been saying American stocks are overpriced for well over a year. Despite all this negativity, the Dow Jones Average has gone virtually straight up all of 2017 and so far in 2018.

Going from the general to the specific, over the years I have seen subsets of stocks go through their own cycles as the cannabis stocks have done over the past few years. In the past, there have been gold cycles, lithium markets and graphite plays to name but a few.

The one market event I think is most comparable to the current cannabis cycle was the high tech cycle often called the "dot-com" cycle that is also known as the "tech bubble," "the Internet bubble" and the "Information Technology bubble." It was driven by the growth in personal computers and more and more people connecting to what was called the World Wide Web. The number of U.S. households owning a computer went from one in six in 1990 to over one in three by 1997. (It's almost nine in ten today). So the excitement involved the growth of the Internet, email, e-marketing and business efficiencies.

Let's look at the NASDAQ Composite that most closely reflects those high tech start-up companies that dominated the tech bubble:

That bull market began in 1990. It did not start as the Dot-Com bull market but it evolved into it. Here's what happened in the years following the start of the Dot-Com Bull Market:

  1. As stock prices advanced investors began to speculate on how large this phenomenon called the Internet could become. They wondered if people would really use email. This evolved into wondering if people ever would buy goods and services electronically.
  2. On December 5, 1996, Federal Reserve Board Chairman Alan Greenspan gave a televised speech in which he questioned the "irrational exuberance" that seemed to be underlying the advance in stock prices. By then the NASDAQ Index was up fourfold since the bull market began.
  3. I remember Greenspan's comments triggered substantial stock market sell-offs around the world the next day because investors interpreted his words as saying share prices had gone up too much.
  4. The Index reached its peak in July 2000. At the high, the NASDAQ had tripled over almost four years since Greenspan's warning. During this time there were many very successful new issues of companies that planned to participate in the technology revolution.
  5. In less than two years after the peak, the market had fallen almost 75% and most of the companies fuelled by the hopes and dreams of investors had already or were about to disappear into oblivion.
  6. It took almost thirteen years for the NASDAQ Composite Index to reach the high it hit in July 2000.

Next, let's look at a specific example. I have chosen Oracle (NYSE: ORCL) as being representative.

This is the chart for Oracle, Corporation. The chart is plotted using monthly data and so may not precisely agree with the analysis data which is daily and thus more accurate.

  1. At the opening in 1990, ORCL was trading at $.54 per share.
  2. By the time Federal Reserve Board Chairman Alan Greenspan made his "irrational exuberance" speech, ORCL had risen to $4.69 per share, an increase of almost nine-fold.
  3. When the market topped out, ORCL stock was trading at $46.31 per share. In other words, if you had sold on Greenspan's speech, you would have left almost $40 a share on the table. The cost of selling too early was high.
  4. Two years later as the Dot-Com crash bottomed out, ORCL dropped over 80% in price. The price of staying in too long was also very steep.
  5. It would be nearly seventeen years before ORCL stock would trade higher than it did at the top of the cycle in 2000. As a long-term investment, ORCL's term was long. Very long..

Here is what I see as important takeaways from this review of the high-tech cycle:

  1. By the time Greenspan gave his speech, there was reason to be concerned about the markets. The index had risen over 400% and several individual stocks had gone up a lot more. The rising stock market was in the headlines. Investors felt Greenspan was in a position to know if the market was high and about to fall.
  2. After Greenspan issued his warning, the index tripled again over another four years of rising stock prices. During this time, there were substantial investment profits made. Some of the highest flying new issues came to market in this period. If you missed the high-tech cycle after Greenspan's speech, you missed some of the most substantial profit opportunities of the entire cycle.
  3. With the benefit of hindsight, the risk in the market was rising along with stock prices. The peak was getting closer with each passing day, week and month. So as the investment profits were rising, so was the risk of loss. The point of maximum profit potential was also the time of highest investment risk.
  4. This is exactly how it should be because in investing, risk and reward are directly related. There is no such thing as a high-return, low-risk investment. If someone offers you one, don't believe them. They either don't know what they are talking about or they are lying and, in either case, you shouldn't trust them.
  5. The speculative excesses lasted much longer than anyone expected. Just when you thought nothing could be more outrageous, along came another one. I remember a company called e-Toy that was underwritten on the premise they would market toys on the Internet. It soon had a market capitalization higher than Toys 'R US that was the leading toy retailer at the time. It turned out on top of the sales, income and assets, Toys'R'Us had higher Internet sales than e-Toy.
  6. When the decline came, it was vicious. The NASDAQ Index dropped 75%. Remember, if a stock drops 75%, it has to quadruple to get back to even. It's the way arithmetic works. Your $1.00 stock drops to $.25 to produce a 75% loss. But it has to increase fourfold to get back to a dollar. Many stocks disappeared altogether. Even companies like Oracle that struggled and survived needed seventeen years to see its stock trade higher than it had in 2000.
  7. In the case of the high tech bubble, hanging on to your stocks because you believed in the long-term meant waiting over twelve years to break even based on the index. It took some individual stocks such as Oracle even longer. So don't be too cavalier when talking about the long-term. The long-term can be a long time.

The next chart is the S&P/TSX Venture Composite Index covering the period during which Licensed Producers have traded publicly and I began to chart the Let's Toke Business Licensed Producer Index. I selected the TSXV Composite because it probably better reflects the cannabis group just like the NASDAQ better represented the high tech stocks.

There are several dissimilarities between this chart that shows more or less the full cycle for cannabis stocks in Canada and the chart of the NASDAQ Composite Index that shows the full Dot-Com cycle from the beginning to the present. Here are some of the differences:

  1. The length of time in the Dot-Com cycle before Greenspan's "irrational exuberance" speech was six years and there were another four years after until the peak was reached. The cannabis Licensed Producer stocks have been trading for a total of less than four years.
  2. The overall market was up fourfold by the time of Greenspan's speech. The TSX Venture Index about flat since the cannabis stocks have been trading. In other words, there hasn't been as much tailwind to propel the cannabis stocks.
  3. The NASDAQ Composite Index was greatly influenced by the Dot-Com and Hi-Tech stocks. The cannabis stocks have had very little impact on the TSX Venture Index. In fact, the TSX and TSXV are still in conflict with Canadian cannabis companies investing in businesses in contravention of United States federal laws.

However, if we look at the Let's Toke Business Licensed Producer Index, we see a much different picture for the cannabis stock sub-cycle.

  1. In the first six months of the index, the rate of gain was approximately tenfold. But this is a bit misleading. The sharp advance in the index in August 2014 was the result of Tweed (now Canopy Growth) being joined by Bedrocan (now part of Canopy Growth) and Organigram as public companies. If we consider the index after there were three component companies, the increase is around fourfold which is similar to the Dot-Com experience up to Greenspan's speech.
  2. The Licensed Producers have moved in a "step-stumble" pattern. The first two steps should almost be ignored as they were produced by just three stocks going public using the Reverse Takeover (RTO) approach. These companies were Tweed Marijuana, now Canopy Growth, the first Licensed Producer to go public in Canada, Bedrocan that is now part of Canopy Growth and Organigram. In RTOs, there is usually a spike up in prices because shell companies with virtually nothing in them find valuable assets vended in.
  3. The next step up occurred following the election of Justin Trudeau and the Liberal Government. The Liberals ran on a platform of legalizing cannabis. After the election, investors felt the environment for cannabis companies would improve but it wasn't yet clear that the government would follow through on this election promise. So it was a relatively modest step up.
  4. The next major rally reflects growing confidence that the Liberals would fulfill the legalization promise. It started with the announcement by Canada's Health Minister Jane Philpott at United Nations General Assembly Special Session on Drugs on a symbolic 4/20 of 2016. She announced Canada intended to proceed with legalization and this step ended with the report from the long-awaited Task Force Report with recommendations on how to proceed with legalization that proved to favor the Licensed Producers.
  5. The final up-leg (that we are still in) was triggered by Constellation Brands' (NYSE: STZ) investment in Canopy Growth. It was always known that part of the evolution of the cannabis investment cycle would involve investment in the industry by the pharmaceutical, tobacco, alcoholic beverage and other giant companies. The STZ action triggered a reaction on the part of Licensed Producers who suddenly woke up to the importance of being large. This resulted in a takeover spree that continues today.

Here are some guidelines for dealing with the cannabis stocks in the weeks and months ahead based on this background:

  1. The cannabis stocks are surprisingly high. My experience is "surprisingly" high is just the beginning. There are wonderful things happening with the cannabis companies. My experience is you haven't seen anything yet. I think there will be many profitable opportunities ahead that you don't want to miss.
  2. Cannabis investors today are more willing to assume risk. That is why cannabis stocks are rising in price. Stories that investors would have ignored a year ago are readily and eagerly accepted today. This means investors are more willing to buy a "story" and owners are less willing to sell. This is a formula for rising prices.
  3. However, we have entered a higher risk phase of the cannabis stock market. For investors, risk is measured by volatility so be cautious of larger, short-term price fluctuations. This means at this time, it is more important than ever to not chase stocks up in price or dump stocks falling in price.
  4. On that same theme, in this kind of market, investors should be ready to sell when stocks pop up strongly for no apparent reason and buy them back assuming they subsequently decline. Don't do it with 100% of your holding. Try it with something less than half. But you'll have to do it on your own because these trades arise so quickly sometimes, there isn't an opportunity to seek advice.
  5. Risk and reward are directly related in the financial markets. The irony is as we now are in a riskier cannabis investment stage, the potential profits are higher too. But this is a time to remember risk and do what you can to minimize it. Above all, don't get in over your head.
  6. Using portfolio management techniques to reduce investment risk is not an all or nothing strategy. See (B) above. In other words, you can adjust gradually. But you must maintain the discipline of what you're doing. Do not throw in the towel because things aren't going perfectly. Nothing goes perfectly.
  7. My current expectation is the current "step" will end and the next "stumble" will begin before mid-2018. At that time I would want a portfolio to be 25% to 50% cash, that is, have funds on hand to reinvest when the "stumble" ends. The 50% cash is a defensive position. It helps buffer an overall decline and gives you some ability to take advantage of lower prices should that happen.
  8. Finally, it is a time to only own well-researched stocks. Concentrate on companies that don't depend on raising money from investors to keep the lights on and doors open. Look for companies that represent quality in management and the assets they own and develop. If you own stocks you bought on a fling, now might be a good time to fling them and refocus your portfolio.

Here is an update of my list:

Aphria (OTCQB:APHQF): I continue to like APHQF as it pursues its aggressive growth policies. The cloud on the horizon is the status of their TSE listing. I would hold off until the situation is clarified. An announcement is expected shortly.

Aurora Cannabis (OTCQX:ACBFF): Now that the CanniMed (USOTC: CMMDF) acquisition is being concluded successfully, I think ACBFF is bruised but not beaten. I was surprised they paid up but the acquisition vaults them to the top of the list of Licensed Producers. I would maintain positions and buy on weakness.

Canopy Growth (OTCPK:TWMJF): the company continues to reward shareholders. There is more competition at the top but TWMJF can be expected to hold its own. Their focus is now in international markets. I still believe if you only own one stock in the Canadian cannabis industry, this is it.

Emerald Health (OTCQX:EMHTF): sometimes the market runs ahead of prospects and I think this is happening to EMHTF. I would not be a buyer at recent levels and I think this is a serious candidate to use when raising cash in portfolios.

Lexaria (OTCQB:LXRP): a breakthrough in any of their major markets will vault LXRP to another level. We think such a major event can be expected in 2018. The stock ran up sharply but has had a substantial correction in recent weeks. I would buy LXRP at these levels.

Namaste Technologies (OTCQB:NXTTF): the recent Cannmart announcement means Health Canada licensing approval is at hand once the facility is constructed. The stock has been a big winner and may be running a little ahead of prospects. I would maintain existing positions.

Organigram (OTCQB:OGRMF): the company recently raised $100 million to fund expansion internationally. This is a plus as it was one thing missing in its corporate resumé. OGRMF has been a solid investment but is still very attractive. I think OGRMF should be a core stock in cannabis portfolios.

Radient Technologies (OTC:RDDTF): has a unique technology called Microwave Assisted Processing, or M.A.P., for extracting THC and CBD from the cannabis plant. It is part of the ACBFF portfolio and I think it is a smaller company that will continue to reward big in 2018.

Sunniva: (CSE: SNN) also trades SNNVF on the Pink and grey until an OTC listing is finalized shortly. SNN is my most recent recommendation and has moved higher but not as much as my other recommendations. I started targeting purchases under $10 CAN and then up to $12.50 CAN. The stock is on a strong uptick this week and I hope to see it come back a bit. But if you don't have any, take a starter position and add if it should weaken. If it doesn't, at least you'll have some exposure.

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.