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Wild volatility, stocks doubling in a few hours and valuations that rival the bluest of blue chips. David Berman and Tim Kiladze explain why cannabis euphoria has reached new levels in the equity market - and what happens next

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Saturday, September 22, 2018 – Page B1

Welcome to the second wave of marijuana madness.

Gone are the days when it was notable for Canadian cannabis stocks to swing 10 per cent in a single trading session. Volatility has given way to chaos and inexplicable, manic activity in pot shares.

Exhibit A is Tilray Inc.'s performance this week. With little more than US$20-million in revenue in 2017 and no indications that it will be profitable any time soon, the Nanaimo, B.C.based cannabis producer went public on the Nasdaq at US$17 a share in July.

By Tuesday, the stock was at nearly US$155.

By midday Wednesday, its shares had rocketed to US$300 - marking a 17fold increase from the IPO price. And then it crashed, closing the week at US$123.

At its Wednesday peak, a company that few investors had even heard about two months ago was suddenly worth $36-billion, more than Sun Life Financial Inc., Loblaw Cos. Ltd and all but 17 publicly listed Canadian companies.

"It's a complete mania, total insanity," said Stephen Takacsy, chief executive of Montreal-based Lester Asset Management.

It also marks a dramatic pivot. After a correction earlier this year, marijuana shares drifted sideways for a while - until Aug. 15, when alcohol giant Constellation Brands Inc. announced a multibillion-dollar investment in Canopy Growth Corp. The news sparked a huge rally, as investors became convinced that even more bluechip consumer companies would move into the sector, via takeovers or joint ventures. Renewed speculation that Coca-Cola Co.

was interested in pot-related beverages helped boost shares of Aurora Cannabis Inc. by 29 per cent by week's end.

At the same time, the bloated valuations are being justified by a belief that some Canadian producers will dominate the world. It used to be that investors here would pile into a company's shares based on domestic announcements, such as the news of a contract to supply a large Canadian retailer with medical cannabis. Today, so much excitement is tied to export potential.

It is this sentiment that sent Tilray shares through the roof. On Tuesday, the company announced it had received a rare approval from the U.S. Drug Enforcement Agency to export a capsule form of one of its products for a clinical trial to treat a neurological disorder. Even though it was an incremental development, investors got excited about the possibilities and convinced themselves the company had cracked a complicated nut and found a way to break into the U.S. market - a feat that has evaded most Canadian companies because cannabis is still illegal there under federal law (although has been legalized in a number of states).

Amid the hype, nearly 32 million Tilray shares traded on Wednesday, meaning each share traded hands on average three times over the course of the day (the company has a little more than 10 million free-trading shares, or float). At its peak, Tilray's stock traded at 62 times estimated 2019 sales. Almighty Inc., by comparison, trades at 3.3 times the same year's sales, while Facebook Inc. trades at 5.7 times.

Tilray is the most extreme example. It isn't alone. Euphoria has spread across the sector, and since the day of the Constellation investment, the Horizons Marijuana Life Sciences Index, which tracks the Canadian cannabis sector, is up 71 per cent. These valuations, coupled with frenetic buying and selling, have spurred comparisons with the dot-com frenzy that captivated market watchers in the late 1990s - before it all came crashing down.

"Back in the dot-com days, it was very much the same. If you were making money, it was actually a negative - because you weren't growing as fast," said Peter Hodson, who runs 5i Research, an independent research shop.

"That can last for a while - it just doesn't last forever."

Yet, no matter how much investors are warned about the inevitable correction, many remain transfixed by the opportunities.

The cannabis industry is backed by some institutional money, notably Canadian hedge funds such as K2 & Associates, MMCap Asset Management and Anson Group.

But enthusiasm among Canadian retail investors helped catapult the industry this far.

Richard, a retired postal worker in Elora, Ont., said he has made about $2,500 since December on an initial $5,500 investment in his tax-free savings account. "It was never intended to be a long play," said Richard, who spoke on condition his last name not be used.

"I'm not an expert of course, but I feel that I've done quite well. If I'm playing with money that is more or less profit, if I can put it that way, I'm not so hurt by taking a kick in the nuts."

In January, enthusiasm from do-it-yourself investors was so intense that online trading platforms run by some of the country's largest financial institutions broke down. The interest in cannabis stocks overwhelmed servers, leading to brief outages at discount brokerages run by the likes of Royal Bank of Canada and Toronto-Dominion Bank.

Fuelling investor interest was an intense level of promotional activity among companies. To stand out in investors' minds, companies routinely send out news releases touting even minor corporate developments - a ploy even corporate peers are now railing against. This, too, has echoes of the dot-com era.

"I'm disgusted sometimes when I read some of these press releases," Aphria Inc. CEO Vic Neufeld said in an interview in late January, adding that some companies put heavy spin on their production or marketing prospects, simply to garner attention.

Nonetheless, promotional buzz has undoubtedly helped to boost valuations. So, too, has the perception the industry is going to evolve away from its domestic focus and begin selling in other countries, particularly in Europe, as cannabis legalization sweeps across other regions.

Aphria was one of the first to talk this way. In Jan. 29, it struck a deal to buy Nuuvera Inc. for $826million. Even though the target had only been a public company for four weeks and had never turned a profit, it had a small but growing presence in Europe - and, most importantly, was in the running to win a lucrative licence to grow cannabis in Germany.

"Make no mistake, there is a global secular trend" toward more cannabis consumption, Nuuvera CEO Lorne Abony said on a conference call. "It is no longer a question of if. It's a question of when."

Soon, the whole sector was on board and the messaging only grew more intense. When Aurora Cannabis acquired MedReleaf for $3.2-billion in May, a deal that would combine two of Canada's most prominent cannabis companies, Aurora CEO Terry Booth justified the expensive transaction to investors by stressing the need for scale amid surging global demand. "It's not even a hockey stick," he said on a conference call, referencing a type of demand that moves sideways on a chart until it suddenly picks up at a sharp angle. "It's straight through the roof."

To meet this expected demand, companies started touting some massive production facilities.

Aurora is building a new flagship facility, dubbed Aurora Sky, near the Edmonton airport that is expected to yield 100,000 kilograms of cannabis a year when it is finished in 2019.

Still, it wasn't until Constellation made its big investment in Canopy that investors truly believed. In that instant, everything changed. Here was one of the world's biggest alcohol companies betting on Canopy's global growth potential - and Bruce Linton, Canopy's CEO, told the market to expect more deals.

Within 18 months, he said on a conference call, the major marijuana players "won't be any of the cannabis names that are started up in Canada. It will be Big Pharma. It will be other packaged beverage [companies] ... a day doesn't go by that somebody doesn't send me an article that the Wrigley family are looking at this, everybody is looking at this."

The sector has gone haywire since - and now, it seems, U.S investors are intrigued. On Tuesday evening, Tilray CEO Brendan Kennedy appeared on the popular CNBC show Mad Money with Jim Cramer to share the same message as Mr. Linton. But because only a handful of cannabis stocks are listed in the United States, largely thanks to the federal ban, American investors have few ways to play the sector.

The result: Tilray shares swung so wildly the day after Mr. Cramer's show that market regulators had to halt the stock five times to let cooler heads prevail.

So marijuana shares are on a rapid upward trajectory again, just as they were before the January correction. And this time around, it is arguably even harder to convince investors that valuations are frothy. Because so much money has already been made, both before and after the correction, any naysayers are more likely to be thought of as haters - no matter how logical their arguments are.

Yet, the reality is that even industry insiders who want the sector to succeed are skeptical of what's happening now.

Kris Krane is the president of 4Front Ventures, a U.S. consultancy, and serves on the board of directors of the U.S. National Cannabis Industry Association. A hater he is not. Yet, he is concerned about this growing consensus that Canadian companies will be the only ones capable of supplying the world with weed.

"I don't want to discount the advantage that Canadians have.

They have an incredible head start," he said, acknowledging that recreational legalization here has created a groundswell of energy. But he cautions that it's far too simplistic to assume the next step is global domination.

"The notion that Canadian companies are the only companies that can and will be able to do this is nonsense," he said. "There's no reason to believe American companies won't be incredibly competitive on global markets."

Of course, U.S. pot producers cannot export at the moment, because of the federal ban, but no one seems to know if that will last.

And if the ban is lifted, it is a whole new ball game. California legalized recreational cannabis at the start of the year and its economy and population are roughly the size of Canada's. The state is also situated on coastal water, which makes export easy.

Mr. Krane is particularly suspect of the prospects for growth in Europe. For all the hype around medical marijuana on the continent, the market there is still in its infancy. While a number of Canadian companies tout the massive potential, "I'm much more realis-

tic about what's going on," he said, having attended the International Cannabis Business Conference in Berlin this spring. At the moment, "these are really, really tiny programs."

While there is potential for growth, it probably will not be, well, straight through the roof.

With a population of 83 million, Germany is seen as the most lucrative market on the continent, yet early this year the government put a chill on the sector by cancelling its process to grant licences for domestic cannabis cultivation.

The news put Aphria, for one, in a tough spot. The company had just spent a hefty sum to buy Nuuvera, but the gem of the deal was the potential for German licensing and that went up in smoke.

Still, retail investors remain dazzled by projections of growth of cannabis consumption in Canada, as new consumers are drawn in and existing users switch from the black market to legal operations.

According to Statistics Canada, 5.4 million Canadians will likely be purchasing cannabis products once recreational use is legalized in October, assuming that about a quarter of users will continue to buy from the illegal market. The legal market translates into an annualized spend of between $3.8billion and $4.8-billion.

Will producers be able to meet this demand? This is where investors get giddy. CIBC World Markets estimates that producers are currently producing about 350,000 kilograms a year but will have to meet demand of 850,000 kilograms by 2020, implying big growth ahead that will power industry revenues.

But not everyone believes these estimates will prove reliable.

"It's been very difficult for us to get our heads around this sector, where there is a lot of speculation built into how big the sector will be. We have estimates of demand, but they are only estimates," said Michael Willemse, senior research analyst at Toronto-based Taylor Asset Management.

He pointed to the situation in California, where legalization is already disappointing earlier projections. According to New Frontier Data, which analyzes trends in the global cannabis industry, expected revenue from legal marijuana sales in the state will be US$1.9-billion this year, half its earlier estimate.

Similarly, its estimate for 2025 consumption declined to about US$4.7-billion, down from US$6.7-billion. The new estimates factor in weaker medical marijuana demand and now assume that fewer consumers will switch from the black market to legal sources.

The prospect of more investments from global beverage companies isn't a sure bet, either. At these prices, it would take some serious gall to copy Constellation's playbook and invest heavily in a Canadian cannabis producer.

Instead, global giants may opt for joint ventures akin to Molson Coors Brewing Co.'s partnership with Quebec's Hydropothecary Corp., since renamed Hexo Corp., to develop non-alcoholic cannabis-infused products. By going this route, the behemoths can put much less capital on the line.

And then there are the changing dynamics of the domestic market, which can easily be overlooked amid all the global hype.

"In Canada, a lot is still in flux," said Daniel Goldberg, CEO of Good & Green, an Ontario-based producer.

The ground rules and competitive forces in the Canadian industry are hardly set in stone with legalization just four weeks away.

Regulations keep changing, and the impact of major developments such as allowing outdoor growing have barely been seen yet.

"Success will depend of how companies master these domestic challenges while simultaneously casting their eyes elsewhere," Mr. Goldberg said. "Melbourne and Berlin may have to take a back seat to Mississauga and Brantford[, Ont.] for a change."

Will any of these risks cool off the sector? Given investors' propensity for riding bubbles - the dotcom hype, the commodity supercycle, and so on - the answer is, probably not yet. The fear of missing out is real.

But take it from Peter Hodson, who spent years as a portfolio manager at Sprott Asset Management before moving into research and who has lived through multiple market bubbles: Timing the top is next to impossible. And if you're invested when the market turns, it can get ugly - fast. "I'd rather miss some or all of the party and skip the hangover," he said.

Things got so crazy this week that even Mr. Cramer, the host of Mad Money, had to walk back his support for the sector two days after having Tilray's CEO on the show. On Thursday evening, he cautioned that people are way too excited about pot stocks. "This whole group has gotten too hot - no argument here," he said. "Is it a bubble? Absolutely."

Associated Graphic

In the wake Constellation Brands' multibillion-dollar investment in Canopy Growth Corp., Bruce Linton, Canopy's CEO, said the major cannabis players within 18 months will be in Big Pharma and not any of the names that started up in Canada.



The bloated valuations of cannabis companies are being justified by a belief that some Canadian producers will dominate the world.


Much of the investor excitement in the cannabis sector is tied to export potential, a sentiment that sent shares of Tilray, whose trimming room is pictured in Nanaimo, B.C., in August, 2014, through the roof this week.



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