Cutting Through the Haze of Pot Stocks

Sky-high stock valuations can be sexy, which is currently the case with pot stocks.

And they can become even sexier when it appears as if they will continue to soar.It seems impossible to watch the business news these days without encountering a segment on the booming cannabis industry, especially with the legalization of marijuana looming in Canada. These news items often feature a company executive with over-the-top enthusiasm for what is to come for a specific cannabis company and the industry in general.However, we need to make an important distinction here: choosing to smoke pot for recreational or legitimate medical purposes supervised by a doctor, is a separate question from the advisability of investing hard-earned dollarsin cannabis stocks, especially given those high valuations.As I have mentioned in previous editions: the first goal of investing is not making money.That’s the second goal. The first goal of investing is not losing money or stated more formally: capital preservation.Certainly, the cannabis industry is here to stay. On October 17th, Canada will legalize recreational use of weed. Two things are clear: the Canadian government sees huge potential revenues, and some cannabis companies will evolve into massive operations.However, what is equally clear is that current valuations of pot stocks do not make sense from an investment perspective, explains Jay Nash, Senior Vice-President, Portfolio Manager and Investment Advisor, at the London branch of National Bank of Canada. Nash likens the current market for cannabis stocks to the 1999 tech bubble, meaning that only a few stocks will really survive over time, with the possibility that there are more ways to lose than to win here. The current enthusiasm also recalls the fervor in the 1840’s and 1850’s that drove valuations of British rail stocks to levels that, in hindsight, were completely unsustainable by future earnings.Similarly, with pot stocks, those who argue that these stocks offer a huge opportunity, base their forecasts on future expectations for the sector rather than hard sales numbers. Sooner or later, genuine valuations will likely matter again and the downside risk is significant, he says.Meanwhile, a Reuters report in June suggested that cannabis investors, researchers, policy analysts and government data point to a possible flaw in overly exuberant sales projections. The report suggests that many users of black market cannabis will have little incentive to switch to legal weed since it is expected to be more expensive than black market pot and less available due to strict regulations on sales. Believing that a majority of those currently buying illegal pot will dutifully begin buying it from government-sanctioned outlets seems a bit of a stretch, as does believing that there will be a reduction in home-grown operations.Nash points out that some believe that sector funds help reduce the risk of investing in marijuana stocks. However, if the current enthusiasm for these stocks really does amount to a bubble, a sector fund with a number of them actually guarantees some participation on the downside.Related: Côte d’Ivoire: Positioned Perfectly for InvestorsNo one suggests that these stocks must be avoided completely, and an investor does have some options. Mutual fund equity managers have every right to own the sector if they believe it is the best option, Nash says. The Fidelity Canadian Growth Fund started investing in these stocks in 2017. Large-cap companies have become interested. Constellation Brands (NYSE: STZ)) in the United States, owns a large stake in Canopy (WEED-T) and Coca-Cola (KOUS), has suggested that it is looking into launching cannabis products.Those who wish to proceed with cannabis investing might consider the ‘bingo money’ concept. This refers to how our parents or grandparents played bingo in the church basement, and if they lost $0.25 cents or $0.50 cents or $1.00 playing the game it was no big deal. Similarly, investing a small amount of money where a loss would not become a financial threat may suit some investors. The key, Nash says, is to be completely clear on the downside risk. Even though the industry appears likely to grow and become a significant player in the Canadian scene, buying pot stocks at today’s prices amounts more to speculation than to investing in the real sense of the word, he says.The potential for the sector may be huge, but this doesn’t mean an immediate payoff. As legalization takes effect, there will be a lot of attention on the sector, but a major market correction remains a strong possibility and those investing in these stocks need to prepare for it.As well as the bubbles discussed above, Nash points out that history is littered with examples where valuations were ignored by investors in favour of the latest mania. There are stories of those who got rich getting in and out, and stories of those who lost it all. Those searching for the former must be ready to accept the latter. If this is a bubble, the correction will be swift, he predicts.Related: Cannabinoids Might Unlock the Cannabis Pharmaceutical IndustryAt least one group of investors are already betting heavily on a correction. A recent Bloomberg News report says that short interest in cannabis stocks shot up by 52 per cent in the third quarter of this year, and that wild price swings indicate that there may be more activity than reflected by the data.Quoting data from S3 Partners, a data analytics firm, the report says that total short interest in the marijuana space hit US$3.1 billion on Sept. 27, up from just over US$2 billion at the end of June. .According to the report, much of the increased shorting activity centered on two hot stocks: Canopy Growth Corp. and the very volatile Tilray Inc. (NASDAQ: TLRY).This kind of interest by short sellers intimates their belief that share prices will drop dramatically.It’s very possible that some investors will see part of their hard-earned money going up in smoke. Disclosure: I do not hold any units in any of the investments mentioned in this article and have no plans to purchase any.