In February, the Liberal government perfectly illustrated the regulatory risks for Canada’s highly anticipated cannabis bonanza. Justin Trudeau reneged on his campaign commitment for electoral reform, a reminder that no promise is money in the bank.

The government has introduced bills to legalize marijuana for recreational consumption, but policy uncertainty continues to cast a shadow over those betting on big growth for the sector. While the Trudeau government has committed to legalization in 2018, the process is expected to be bumpy, lengthy and involve much provincial tinkering. All the same, investors are salivating.

“Regardless of how you’re looking at it, the medical opportunity is priced in. For most, if not all of these stocks, there’s some component of a recreational market that’s also expected,” says Neil Maruoka, analyst with Canaccord Genuity. “It provides a bit more clarity, but there’s a lot of blanks left unfilled in the legislation, particularly as it relates to distribution and taxation.”

The market projection

The assumption behind the call is that Canada is an early mover in a global movement toward pot legalization. Canaccord, in an equity research note in November, says there are significant barriers to becoming a licensed Canadian medical producer. These existing market players will face supply lag when the drug is legalized, creating a price floor of about $8 per gram until legal supply catches up around 2020.

The medical market is also growing. Registered patients numbered a few thousand just over two years ago, but there are now well over 100,000; and they’re expected to hit about 500,000 by 2020, Canaccord forecasts. The firm’s analysts say cannabis patients will consume more than 150,000 kilograms of marijuana per year by 2021, representing roughly $1.8 billion in retail sales.

That’s for the dried bud market. A higher-priced, higher-quality oils market could also emerge, led by the same producers.

Bruce Campbell, founder and portfolio manager of StoneCastle Investment Management in Kelowna, B.C., says recreational use has gained mainstream acceptance in Canada and other jurisdictions, facilitating the prime minister’s case. But, he acknowledges, there remain risks. “How many more licensed producers can there be under a legalized regime? The production standards are very strict,” he says. “And, we don’t know how they will be able to brand themselves and advertise.”

For mostly unprofitable cannabis companies, high expectations are making their stocks look overvalued. Canopy Growth Corp. (TSX: WEED), for instance, Canada’s first marijuana unicorn, was about $10 per share in mid-April, up more than three times its price from a year earlier, when it was less than $3. Forget earnings per share; the stock’s been trading at multiples above 35 times sales.

“If you look at [the stocks with] traditional valuation techniques—current revenues, cash flow or earnings—then your eyeballs pop out of your head,” Campbell says.

Strategists are valuing Canadian names by projecting the medical market, plus a recreational market based on the current black market, out to about 2020. Looking at growth in now-legal markets like Colorado helps them estimate cash flows and earnings. Campbell points to a Deloitte study last year projecting that Canada’s marijuana market, when including related services like security, testing and real estate, could be worth $22.6 billion.

Other unknowns

Time is an important input for estimating value and risk, as well as market share. It’s impossible to know Canopy’s share in 2020, because the future number and size of licensed producers is unknown. Large international tobacco or alcohol could enter the market, or buy up startups, if they see cannabis cutting into booze and cigarette sales. Companies could also face operational troubles. Canadian marijuana stocks dipped in March after Mettrum Ltd. and OrganiGram Inc. were found to have used myclobutanil, a prohibited pesticide, and lawyers proposed class-action lawsuits.

If recreational cannabis is fully legalized, Canaccord expects producers to earn smaller margins as big pharmacy chains or provincial beer and liquor stores assume some distribution and sales. Lowest-cost producers would probably outperform.


Campbell says he expects further industry consolidation. “They’ve bought two other companies already,” he says of Canopy, which in December announced the acquisition of Mettrum. “It wouldn’t surprise me if they bought several more.”

Speculative buy?

Norman Levine, partner with Portfolio Management Corp. in Toronto, says buying the pot startups is gambling, not investing. If a recreational market is established, he predicts many people will exceed unenforceable grow-at-home limits, pushing up supply and pulling down prices. “To me, there’s a lot of hype and hope, but it’s very speculative,” Levine says. “Not everybody’s going to make it. What happens when big tobacco gets involved?”

If clients want in despite the risks, suggest diversification, not just in Canada but globally. Stonecastle, for instance, is launching an open-ended fund covering the global marijuana sector. And Horizons has launched a medical marijuana ETF. With an annual fee of 0.75%, it trades on the TSX as HMMJ, tracking Solactive’s North American Medical Marijuana Index.

Tell clients to think about cannabis as a long-term investment. “This is probably going to be one of the biggest growth businesses over the next 10 years. We’re basically at the stage where the U.S. was when they went through prohibition. It’s the same thing, but on a global basis,” Campbell says. He’s comfortable with comparisons to the dot-com boom, which crashed but eventually yielded huge growth companies like “It traded at these ridiculously high multiples of sales. They didn’t even have any earnings or cash flow,” he says of a company that started as an online book seller and is now planning parcel deliveries by aerial drone. “If you held it for that entire period, you were laughing all the way to the bank.”

by Simon Doyle, an Ottawa-based financial writer.