By DAVID MILSTEAD
Wednesday, June 20, 2018
Investors have been pushing marijuana shares back near their highs, with a number of stocks recovering most of what they lost during a recent correction, as the federal government neared passage of legislation that will legalize recreational use of the drug.
Canopy Growth Corp., the most valuable cannabis company by market value, hit $42.53 Tuesday, approaching the $44 high it set Jan. 9. CannTrust Holdings Inc., the Hydropothecary Corp. and OrganiGram Holdings Inc. are within 10 per cent of 52-week highs. And the Horizons Marijuana Life Sciences Index ETF, which tries to replicate an index of U.S. and Canadian cannabis stocks, is up 35 per cent from mid-April lows.
The enthusiasm comes despite questions about how profitable these companies can become under legalization, a potential that has led to extremely high valuations in the sector. That's led to intense interest in the stocks from short-sellers, who profit when stocks decline, not rise. IHS Markit says US$2.5-billion in cannabis stocks are being shorted as of Monday, the highest level it has recorded.
Short-sellers have significant short positions in Canopy, Aurora Cannabis Inc., Aphria Inc., Auxly Cannabis Group Inc. (the former Cannabis Wheaton Income Corp.), MedMen Enterprises Inc. and Delta 9 Cannabis Inc.
All but Aurora just cracked the lists of stocks that have a high proportion of shares outstanding sold short, or a high cost of borrowing shares, the first step in a short sale.
The two facts are often complementary: As a well-shorted stock rises meaningfully, turning the trade into a loser, a short-seller often decides to unwind a short position by purchasing the shares on the open market. That drives the price even higher and creates what's called a "short squeeze."
Still, it's clear that sentiment for pot stocks is heating up again, with investors choosing to buy in at the beginning of what they see as a monster trend - conventional metrics of price-to-earnings, and even price-to-sales, be damned. After a bottoming-out in March and April, they're rocketing back.
"It honestly feels sort of like Tesla [Motors Inc.] where there's an industry that's guaranteed to grow by a fair amount, and over all, the stocks are largely being valued, especially the Canadian ones, on fully legal cannabis in 2020," says Sam Pierson, director of securities finance for IHS Markit. But "everything cannabis won't be legal in year one, and there will be a phased process ... so the tension here is that the valuations here are extreme given any sort of historical metric."
The question becomes, as it often does, whether investors are bidding up nearly every company in the industry as if it will become one of the top two or three players in a mature cannabis space.
Certainly, it's nearly impossible to assess the stocks by price-to-earnings ratios, as few have meaningful earnings, or even by their current business operations.
A review of nearly four dozen North American companies operating in the marijuana/cannabis space shows a median trailing price-to-earnings ratio of 42, and a median multiple of enterprise value - market capitalization plus net debt - to EBITDA, or earnings before interest, taxes, depreciation and amortization, of almost 22. (These numbers, courtesy of S&P Global Market Intelligence, are roughly double the broader markets.)
The median price-to-sales figure for the group is 56, versus a price-to-sales for the S&P/TSX Composite of about 3, according to S&P Global Market Intelligence.
MedMen, one of the moreshorted stocks, has a market value of $1.4-billion but currently has just 12 stores in New York State, Nevada and California. While investors clearly envision a significant expansion, the current market capitalization is more than $100-million per current location.
"It becomes a challenge to see how it's going to work out, but to say 'well, when are you going to know it isn't working?' that sort of downside catalyst for the industry seems like it won't happen for year, as far as seeing the actual scale of the Canadian market and how quickly legalization happens elsewhere," Mr. Pierson says.
Jerome Hass of Lightwater Partners Ltd., which runs a longshort fund, may sell cannabis shares short but hasn't done so yet. "There is still a lot of enthusiasm and momentum in the names, so it's best to stay on the sidelines."
An employee handles cannabis at a Canopy Growth facility in Smiths Falls, Ont., in February. Short-sellers have significant short positions in the company.
SEAN KILPATRICK/THE CANADIAN PRESS