As legalization looms, Canada’s volatile marijuana stocks are a risky bet

As the timeline for legalization becomes clear, stocks in cannabis producers have jumped. But the sector remains a high-risk proposition for investors

Tweed marijuana plant

Tweed employee Ryan Harris works inside the Flowering Room with medicinal marijuana at Tweed Inc. in Smiths Falls, Ontario, on December 5, 2016. (Lars Hagberg/AFP/Getty)

It doesn’t take much to move the dial—up or down—on cannabis stocks. The last five months alone have been a roller coaster for Canadian medical marijuana producers on various stock exchanges, whose investors tend to flinch at the faintest whiff of news that’s just off-neutral in tone.

The latest trigger for investors was a recent CBC report that the Liberal government would stick to its plan to table legislation for recreational marijuana production, distribution and use this spring, and have laws in effect by July 1, 2018.

This information wasn’t actually new; it reinforces the general timeline the government had already talked about. Still, it sent stocks soaring. Canopy Growth Corp., Aurora Cannabis Inc., and Aphria Inc. for example, all shot up about 10%.

Canadian cannabis stocks have been extremely volatile since Canada began its long journey to legalization, but their general trajectory has been upward—a trend that Scott Clayton, a senior researcher at TSI Wealth Network, says is driven by speculation. He thinks it’s a risky sector to buy into.

“The prices have really become detached from the fundamentals like sales and cash flow,” says Clayton, who suggests that the market is caught in a cycle of news driving stock prices and stocks fueling news. Take Canopy, for example, the highest-valued Canadian cannabis company and one whose shares move in lockstep with the headlines. The company has a market cap of $1.77 billion, but its year-over-year gross profits reported in its recent annual financial statement amounted to $20 million in losses.

“The speculative appeal—and why stocks have soared so high—is that investors are looking for a ground-floor opportunity,” says Clayton. “But the pioneers in industries aren’t always the ones that survive. And there’s a pretty good chance that many of these won’t.”

Clayton sees the possibility of large tobacco companies moving into the space, pushing out the small startups that currently comprise the industry. It’s possible that some tobacco behemoths would buy up existing cannabis companies, but Clayton notes that “the chance of a takeover is never really a good reason to buy a stock.”

Another threat to the nascent market is the potential of a post-legalization glut of companies, which could drive down share prices. “Once they’re being judged on their actual fundamentals, they can plunge as fast as they moved up,” says Clayton.

Daniel Pearlstein, principal at Eight Capital, is among the less skeptical analysts, wagering that there are gains to be had for all companies in the business. “Rising tides lift all boats,” he says. He adds that investors’ knee-jerk reactions to negative news—such as a recent pesticide contamination scare—are signs of “growing pains” in the new industry. That said, Pearlstein acknowledges that scaling quickly is one challenge cannabis companies face. “Some of them need to grow 10 times the size of where they’re currently operating” in order to meet the demand that’s expected to come with legalization, says Pearlstein. “It’s not easy to grow that quickly in a highly regulated environment.”

Clayton is skeptical that all, if any, of the companies can grow as fast and as big as they’d need to to thrive. “Certainly,” he says, “the chances of them making sales big enough to justify their [market cap] is not realistic. We think you should really stay away from these high-flying speculative stocks.”