We always break down our analysis by the Canadian and U.S. stocks due to the distinct features of the two markets. For details of how we conduct our research, you can check out our Investment Strategy Statement. The Canadian market is already fully legalized and companies are trying to ramp up production, fight for market share, and achieve profitability. On the other hand, the U.S. market remains very much like the Wild West with highly fragmented regional markets and continued regulatory changes that could alter competitive landscapes overnight. Thus, we think cannabis investors need to dissect their thinking into Canada vs. the U.S. in order to orient their cannabis portfolio construction.
- Top Canada Picks: Canopy, CannTrust, HEXO
- Top U.S. Picks: Basket approach including a number of multi-state operators ("MSO") and Charlotte's Web and KushCo
Top Canada Picks
In Canada, we think the industry landscape is very much settled between most of the industry participants. The largest players have established their market position through provincial supply agreements and production capacities through aggressive expansions early on. For newcomers, the barrier to entry is higher now because the Canadian market is expected to become oversupplied and there is no guarantee that one will be able to secure market access for new productions. Ultimately, we think the Canadian market will enter a stage of consolidation and elimination beginning in 2019 whereby smaller companies will increasingly look to combine to get bigger and aggregate resources.
For example, Aleafia (otcqx:ALEAF) is trying to buy Emblem (otcqx:EMHTF) because it does not have access to end markets, whereby Emblem management and Board has lost confidence in its standalone strategy and just wanted to get out by capitulating to Aleafia's low ball offer. For many of the smaller players, the only way to survive is to combine with other companies and consolidate resources so that they could compete with the larger companies such as Canopy (CGC), Aurora (ACB), and Aphria (APHA).
Thus, we think investors should focus on investing in Canadian companies that have a strong market position and are unlikely to be significantly affected by the potential oversupply and the temporarily dysfunctional system run by the government. We think the following companies are the best choices:
- Canopy Growth: no question the best way to go if you are looking for one stock in the Canadian market and do not want to speculate on the smaller high beta names. Canopy has become the de facto bellwether of Canadian cannabis stocks and investors can't go wrong with it in their portfolio.
- CannTrust (otcpk:CNTTF): We like CannTrust for many reasons, including its cheap valuation, solid market position, and ample production capacities. The new CEO has been underwhelming so far but we think the company is on a solid footing in the Canadian market. The company reported strong Q3 earnings which bode well for the upcoming quarters.
- HEXO (otcpk:HYYDF): Another promising player in Canada is HEXO which benefits from its unique positioning in Quebec and a joint venture with Molson Coors (TAP). HEXO is relatively new to the cannabis market and has a very small presence in the medical market. Most of HEXO's expected revenue will come from its Quebec contract with expected volumes of 20,000 kg in Year 1 going up to 45,000 kg in Year 3. Assuming an average wholesale price of $5.00, HEXO is looking at potential revenue between $100 million in year one and $225 million in year three from the Quebec contract alone.
- OrganiGram (otcqx:OGRMF): Very strong domestic player with a dominant market position in Eastern Canada. Management recently guided next quarter revenue to be at least $12.4 million with only partial inclusion of legalization sales. We think OrganiGram remains a core holding for the Canadian portfolio of cannabis investors.
- Others: We think Aurora and Aphria represent inferior options than Canopy in the large-cap space. Aurora has many problems that we've discussed in the past. Aphria is damaged goods at this point and can be only played with caution. We upgraded Cronos to Neutral after the Altria deal and maintain our negative view on Tilray (TLRY) due to extreme valuations. Green Organic Dutchman (otcqx:TGODF) is another highly overvalued company with weak fundamentals which led to our cautious view.
- Small Caps: We do not recommend average investors to invest in the small-cap space unless you are confident with your diligence. There are too many stocks with weak fundamentals and very challenging business outlooks. One thing to be clear is that there will be opportunities among the small-cap stocks but it would require an incredible amount of diligence, risk tolerance, and patience to successfully navigate this part of the market. We will continue to provide comprehensive coverage on these stocks, however, we would not recommend this group of stocks to average investors that just want general exposure to the cannabis industry.
Top U.S. Picks
We have said this before and we will say it again, we think the best way to play the U.S. cannabis sector is to employ a basket approach that includes some of the highest quality names in the sector, including:
- Green Thumb (OTCQX:GTBIF): MSO with footprints in most of the major markets; valuation appears very attractive now after the recent drop.
- iAnthus (OTCQX:ITHUF): Modest valuation combined with a strong presence in key growth areas. The MPX (otcqb:MPXEF) acquisition was complementary to its existing footprint and strategic direction.
- Charlotte's Web (OTCQX:CWBHF): One of the best ways to play the hemp-CBD industry. With the legalization of industrial hemp, we expect the stock to be seeking an uplisting to a major exchange. There are potentials for exponential growth once FDA approves interstate commerce.
- KushCo (OTCQB:KSHB): One of the best pick-and-shovel cannabis plays with strong and diversified product offerings. Expect continued growth as KushCo expands into everything cannabis-related.
We like the following MSOs and believe they will become some of the most dominant players in the U.S. However, we think investors should wait for better entry points due to current valuations. Similar to the buying opportunity that emerged after Green Thumb slumped in late 2018 before recovering much of the losses, we think better entry points could surface from time to time.
- Cresco Labs (OTCPK:CRLBF): One of the recent new listings and the stock has shown incredible strength post-RTO. Its shares are currently up 2.4% from the RTO round but valuation remains elevated. Initiating coverage report coming in the next few weeks.
- Harvest Health (OTC:HTHHF): Very expensive stock with a decent growth profile. We would recommend waiting for better entry points. Initiating coverage report coming in the next few weeks
- Acreage Holdings (OTC:ACRZF): Acreage's all-star Board members and an experienced management team are a plus but valuation remains elevated after the stock recovered most of the losses since RTO.
- Curaleaf (OTCPK:LDVTF): We thought the IPO was priced too expensive and the stock was punished post-IPO. It has traded down 30% from its RTO round and its valuation is more reasonable now.
We do not recommend the following stocks for now:
- MedMen (OTCQB:MMNFF): Management showed greed and incompetency since the May RTO as the stock fell below listing price. CFO quit after top 3 execs got paid $10.5M in cash in addition to one of the highest salaries in the entire industry. The company's financials are a mess after posting consecutive quarters of staggering losses. We do not see near-term catalysts and consistent execution is the only way out for them.
- Trulieve (OTCPK:TCNNF): Single state focus is too risky and limits growth potential; Florida is becoming very crowded and Trulieve's market position will be challenged in the near-term. The recent entry into MA and CA is too little and too late in the grand scheme of things.
- Others: We wouldn't recommend most of the small single state operators due to the significant business risk they carry. When you have a handful of stores it would be devastating to lose your license (Ascent Industries in Canada became the first LP to lose its license) or fail to win more licenses (Planet 13 (otcqb:PLNHF) announced that it didn't win any of the six retail licenses it applied in Nevada, leaving its Medizin store closed indefinitely). These stocks are more for investors that could handle higher risks and have the time and resources to conduct frequent diligence in order to stay current on their latest developments.
We are pleased to present our top picks for the cannabis sector in 2019. We hope we were able to provide a useful discussion on how to position your cannabis portfolio in 2019. We look forward to hearing your feedback and to continue providing unbiased analysis on the sector in the new year.
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.