Pot Stocks For Dividend Growth Investors

by: Nicholas Ward

No one wants to miss out on a massive growth industry.

Marijuana names are being priced with highly speculative valuations, though.

So, I'm targeting high quality names with strong fundamentals that may get involved in the pot craze.

If you follow the market at all, you’ve probably gotten wrapped up in the pot stocks craze lately. It’s hard to ignore trends like this when you see stocks essentially doubling their value in single trading sessions. Market caps in the marijuana space have grown to be larger than many of the S&P 500 names. Honestly, this trend seems crazy. We’re talking about companies trading for 100’s of times their sales…that’s right, sales, not even earnings (these companies aren’t known for their profitability quite yet). When I see fundamentals like that I quickly recognize a bubble. But then again, I also recognize the growth potential of the cannabis industry and I don’t like the idea of being left behind in these early stages. So, what’s a conservative, value based, income oriented investor to do?

The pot craze that we’ve seen in recent weeks reeks of exuberance to me. But then again, it’s the old guard names that many of us DGI investors know and love, like Coca-Cola (KO) rumored to be interested in getting involved in the cannabis market that have given validity to the industry and spurred further interest in buyers. To me, while it’s still highly speculative that any of these more established, cash flow positive, income-oriented names will get into the pot rush, I still like the idea of adding to them as a means of potentially gaining exposure to the marijuana industry than buying the highly speculative pot stocks themselves.

So, with that in mind, let’s break down a handful of names that could find themselves in the cannabis space moving forward.

First and foremost, let’s start off with my favorite cannabis related play: Constellation Brands. STZ made big news recently with a $4b+ purchase of shares of Canopy Growth Corporation (CGC). CGC is considered to be a leader in the marijuana industry, though I suppose in recently days that title may have shifted towards Tilray (TLRY), in terms of market cap, at least. Regardless, Constellation has built up a significant stake in CGC and that investment is already paying off. STZ owns ~38% of CGC right now and currently has options to bump up that share to over 50%. STZ shares recently sold off on the news that it was making such a large investment into CGC. At the time, it appeared that STZ was paying a massive premium for CGC shares, though the pot rally since then seems to have proven STZ management right (in the short-term, at least). STZ is already a leader in domestic beer, posting some of the best volume growth in the industry. Constellation is best known for its Corona Brand, which it has the rights to sell domestically in the U.S. However, STZ isn’t a one trick pony, offering a variety of beer and spirits. The company is highly profitable, with over $1b in free cash flow and a rapidly increase EPS. What’s more, STZ management has proven itself to be very generous with these rising cash flows, rewarding investors with very strong, double digit dividend growth since establishing its dividend payments in 2015. With STZ shares income oriented investors get the best of both worlds: a reliable yield (albeit, a small one, at just 1.4%) and a significant stake in one of the world’s leading marijuana producers. I’m personally long STZ, having recently bought shares at $208.24. With that being said, STZ isn’t exactly cheap at these levels. Having bounced a bit off its post-Canopy acquisition news lows, STZ is currently trading for 24x earnings. This is well above its long-term average and it’s expensive relative to its peers as well. With that being said, STZ appears to be best in class in the beer space, so I suppose a premium is warranted.

Up next, we have another beer company that has also made big news with a pot partnership: Molson Coors Brewing Company (TAP). Molson Coors Canada entered into an agreement with Hydropothecary (OTCPK:HYYDF) to form a joint venture interested in producing cannabis infused beverages once weed is officially legalized in Canada. Coors owns the majority stake in this J-V and while the investment pales in comparison to STZ’s, TAP still remains an early mover in the pot rush and investors looking for U.S. companies with exposure to the Canadian pot craze may want to take a look at Coors shares. Like STZ, TAP pays a dividend, though as a dividend growth investor I’m less impressed with TAP’s income metrics since the company’s dividend has remained frozen for several years now. However, dividend growth aside, TAP does offer strong free cash flow and a dividend yield that is higher than the S&P 500’s, at 2.6%. Unlike STZ, TAP does not trade with a premium valuation. TAP shares currently trade for ~13x 2019 EPS expectations. This is a far cry from the essentially infinite P/E ratios that many of the pot stocks trade for. Is TAP likely to double or triple its market cap in the coming years? No. But, is TAP likely to implode, causing a massive destruction of invested capital? I’d also say no. To me, TAP shares represent a relatively low risk play in the marijuana space with a respectable dividend yield to boot.

Sticking with the beer sector, I’d be remiss not to mention Anheuser Busch InBev (BUD) as a potential future pot stock with a strong dividend yield. Like TAP, BUD shares have experienced weakness recently. BUD is actually trading near 52-week lows. This weakness is due to fear of continued volume declines, rising input costs associated with tariffs/trade wars, lost market share to competition like marijuana, and BUD’s high debt load. However, fears aside, BUD remains the world’s largest brewer with a global distribution system that is the envy of the industry. It’s this distribution that makes any investment that BUD makes into the pot industry interesting to me. For a company as large as BUD (currently market cap: $149b) it would be very difficult for any cannabis investment to really move the needle. However, I imagine it could help to change the sentiment surrounding the stock and lead to capital gains. Either way, BUD has fundamentals that should put a floor under its recent sell-off at some point in the near future. BUD shares are currently trading for ~21x ttm earnings, which is essentially in-line with its historic average. However, analysts expect to see double digit bottom-line growth in both 2019 and 2020 and if this comes to fruition, I expect this EPS growth to bolster the share price (even if we don’t see multiple expansion). Furthermore, BUD offers investors a hefty ~3.6% dividend yield. It’s worth noting that BUD makes bi-annual dividend payments and the income it produces is subject to foreign withholding taxes. However, from a risk/reward scenario, as a conservative investor, I still find BUD much more attractive than any of the speculative pot stocks. Although it hasn’t made any official inroads yet, there are rumors that BUD is interested in getting involved in the marijuana industry and I could easily imagine a future where this global behemoth in a leader in the marijuana space.

Another alcohol giant that I really like is Diageo. This British company has amassed an impressive portfolio of spirits, including popular brand names like Johnny Walker, Crown Royal, Ciroc, Captain Morgan, Bailey’s, Smirnoff, Bulleit, Kettle One, Don Julio, and Guiness. This brand portfolio has resulted in strong cash flows, EPS growth, and dividend growth over the years. DEO isn’t particularly cheap right now, trading near 52-week highs and 22.4x ttm earnings. This is well above the ~18x that DEO shares have historically traded for. However, Diageo offers investors a solid 2.5% dividend yield and a strong defensive position (historically, the alcohol industry has generated some of the best long-term annual returns). Bloomberg recently reported that DEO management had met with several Canadian pot companies gauging interest in partnerships in the CBD infused beverage space. Once again, right now these reports appear to be only rumors. And, even though DEO appears to be expensive on a historical basis (probably, in part, because of the thought that they might get into the high growth pot space), I’d still rather pay 22x for DEO than the sky high premiums that investors are forking over for marijuana specific stocks.

Another beverage giant known for its world-class distribution network has also reportedly shown recent interest in including cannabis infused products into its portfolio. I’m talking about the classic American company, Coca-Cola (KO). About a week ago, Bloomberg reported that KO was in talks with Aurora Cannabis regarding CBD infused beverages. Looking back at the crazy week we had in the pot stock space, it appears to be this news that investors really jumped on. A company like Coca-Cola moving into the industry would certainly give it validity. KO always seems to trade at a premium to the market and I wouldn’t say that it’s cheap right now, with a 22.9x multiple. However, KO’s long-term average P/E ratio is 23.9x, so it is a bit cheaper than its usual price (it’s also significantly cheaper than any marijuana name, even you if you’re accounting for potential growth metrics in the short-term). Also, analysts are expecting high single digit earnings growth for 2019 and 2020, so looking ahead a few years, KO is even more attractively priced. And with an investment in KO, not only do you get exposure to whatever speculative cannabis related plans they may have, but you also get exposure to their 20+ billion dollar brands, $33b+ in sales, nearly $5b in free cash flow, and probably most importantly, a 3.35% dividend yield, which is almost twice the S&P 500’s yield of 1.72%.

If Coca-Cola were to make a play in the pot space, I have to imagine that PepsiCo (PEP) would follow suit. These two names are always in an arms war of sorts in the beverage space. We’ve seen this recently with PEP’s Sodastream acquisition, quickly followed by KO’s answers with Costa in the coffee space, Organic Raw and Trading Co. in the kombucha space, and Chi in the juice space in Africa. These two companies continue to gobble up smaller, growth oriented plays and that’s why I love owning the large-cap, cash cows in an industry. Some call these investments boring, but over time, I feel quite comfortable knowing that names like Pepsi and Coke can use their strength to bolster growth where need be. I’m not certain that this will come in the cannabis area, but it seems clear that if demand for CBD infused food/beverage spikes and these products are widely legalized, the beverage giants will quickly gain major footholds in the industry. Oh, and I forgot to mention…an investment in PEP comes with a 3.25% yield and a fairly conservative 20x multiple of 2018 EPS expectations. I’ll take that over 100x sales multiples any day.

In a similar light, I wouldn’t be surprised to see names like Keurig Dr. Pepper (KDP), Starbucks (SBUX), or even some of the packaged food names struggling for from like General Mills (GIS), Kraft Heinz (KHC), or Kellogg Company (K) get involved. Granted, I think the alcohol/beverage giants make more sense, but packaged goods players are starved for growth and I could easily imagine a management team trying to change the sentiment surrounding their stock with a marijuana investment. Remember, even though these names are boring and lacking top-line growth, they still have significant cash flows at hand.

Another industry that seems like a perfect fit getting involved in the marijuana space is tobacco. The major players in the tobacco space are known for their cash flows, giving them the flexibility to make acquisitions. Furthermore, tobacco faces secular headwinds because of health concerns, which is baggage that weed doesn't bring with it. Recently, Phillip Morris International (PM) management made comments saying that the company wasn't interested in getting involved in the cannabis space at the moment, instead, focusing on transitioning its customers to e-cigarettes. I think this is short-sighted. It seems obvious that marijuana has a better growth trajectory than e-cigarettes (though it's worth noting that these devices could be used to consume CBD oils, etc). If marijuana is legalized in the states, I'd like to see Altria (MO) get involved. Time will tell, but thus far, it seems like the food/beverage names are more interested in weed than the tobacco players.

And lastly, we’ll leave the food/beverage space and go to the lawn and garden care market. Scotts Miracle-Gro Company is known to be a major player in the hydroponics space which fuels the pot industry. I actually like hydroponics as a long-term growth story. The crop yields produced in these highly controlled environments are oftentimes well above natural averages and with renewable energy becoming more prevalent and cost effective, indoor agriculture begins to make a lot more sense, especially in high population density/urban areas. Now, SMG doesn’t represent the same sort of quality as the previously mentioned companies. This name is surely less speculative than the pot stocks, but SGM has had sales and EPS growth issues in the recent past. SMG shares were lumped into the pot trade during 2016 and 2017 where we saw the stock’s multiple shoot up from its ~17x long-term average to nearly 30x in late 2017. Throughout 2018 SMG seems to have lost its luster and shares have fallen precipitously. Today, SMG is down more than 25% from its 52-week highs and trades for ~21x ttm earnings. Analysts are calling for strong EPS growth in 2019 and 2020, so on a forward basis, SMG is only trading for 18x. This seems about right to me. What’s more, SMG yields 2.8% at today’s prices and while the stock isn’t known as a great dividend growth stock because of a freeze during the Great Recession, SMG’s dividend has increased significantly since being initiated in 2005 and I suspect it will continue to trend upwards.

Now, it’s important to remember that going this route (the one where we buy high quality companies that are rumored to have interest in getting into the cannabis space) is admittedly speculative as well. First of all, only a couple of these names are actually involved in the cannabis industry currently. Many investors/analysts expect for alcohol, packaged foods, and tobacco names to get involve in this pot craze, but there are no guarantees. Furthermore, a lot of the growth potential regarding marijuana is focused on the medical/wellness space and these food and beverage focused names might not experience the same sort of growth with their cannabis exposure as companies in other industries. However, at the end of the day, I feel much more comfortable making this speculative bet on the cannabis industry because even if a company like Anheuser Busch or Coca-Cola doesn’t get into the pot market, you’re still left with high quality, income producing names. The same can’t be said for the pot stocks at the moment.

Disclosure: I am/we are long BUD, STZ, DEO, KO, PEP, SBUX, GIS, MO. 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.