Canada's legalization of cannabis ushered in a new zeitgeist of undiluted euphoria towards a new industry that for far too long had been suppressed to oppress certain substrates of the country. The expectations for Canada were extremely high. Indeed, Deloitte estimated in its now infamous 2018 cannabis report, "A society in transition, an industry ready to bloom, estimated that recreational cannabis sales for the first full year post-legalization will be between CD$1.81 billion to CD$4.34 billion.
Chart from Deloitte's 2018 cannabis report
For Cannabis Bulls The Reality Is Disappointing
The reality has been different. Not only did some bulls deride the Deloitte estimates as far too low, putting forward estimates that conveyed a future where the sky was the ground floor and heaven itself was too small a prize. Understandably, the valuations of the Canadian LPs had to rise to match these expectations.
That is why I ended up in a situation where I found myself placing limit orders to buy put options on a wet and windy morning in June. A situation where I just shorted almost every optionable Canadian cannabis company. When life gives you lemons, you make lemonade. In a sense, this was life giving me an opportunity to potentially gain alpha from delusions of grandeur stemming from the irrationality of crowds. How will this end up? No idea. The markets can stay irrational longer than one can stay solvent.
As position sizing was integral to manage the risk of potential fallout, the trades were placed in my alt-portfolio (alternative to my principal portfolio). My alt-portfolio is capped at 10% of my principal long-only portfolio and then itself split equally into four different intra-portfolio strategies. So if this goes wrong, the maximum downside is limited to 2.5% of my wealth. Enough to move the needle but I'm not at risk of losing everything. This fact is reinforced by the use of put options rather than shorting actual shares.
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The aggregate actual sales of cannabis since October legalization is US$247 million, with estimated sales for the first full year following legalization at US$561 million. This is roughly 30% of the lower end estimate provided by Deloitte.
Would cannabis edibles boost the total market? Of course. But these are not expected to be available until mid-December 2019. There is also some political risk to this date if there is a change in Government following the 2019 federal elections.
The extent to which edibles would move the market is also limited. Data from other North American cannabis markets show that while a healthy part of the overall cannabis landscape, it is still dwarfed by product categories already legalized in Canada.
Further, most US states have designed regulations with a relatively laissez-faire approach to branding. In Canada, the regulations have been explicitly designed to remove any potential appeal to children.
This contrasts heavily with the US, where cannabis brands have been able to use packaging that would better appeal to both experienced and first-time cannabis consumers. Against this backdrop, the capacity of the only other catalyst for the growth of Canada's cannabis TAM would be limited.
Promotional image for Kiva, a US cannabis chocolate brand
A Valuation Based On Faith
Aurora's current market cap is US$7.4 billion, that is 13.1x the estimated sales of cannabis for the first full year following legalization.
The aggregate market cap of these companies, not counting all the public non-optionable Canadain LPs is more than 61x estimated 2019 cannabis sales. The sole numerical figure fundamentally captures the extent of the euphoria surrounding cannabis companies. Years from now, people will look back and ask questions as to why seemingly intelligent investors were willing to pay 61x the size of the TAM for companies growing an agricultural commodity.
You might argue that the TAM is actually global, and as such these specific set of Canadian companies have the skills it takes to dominate not only the US (when or if it opens up within the next 5 years) but other developed countries. Only time will tell.
Fundamentally, to be a Canadian cannabis bull is to cast away any sense of rationality. It is to label bears as heretics, to reinforce your bubble with quasi-sanctimonious statements on how huge the industry will become. These valuations are based on faith, they fundamentally ignore hard quantitative facts. This will not end well and I intend to profit from it.
Disclosure: I am/we are short CRON, ACB, CGC, HEXO, TLRY, APHA. 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.