Future Returns: Investing In The Cannabis Industry

Several years ago Morgan Stanley did a poll of over 1,000 high-net-worth investors to see if they’d invest in legal cannabis. A full 65% said they were not likely to invest if cannabis were legalised in the next 12 months.

But Matt Bottomley, equity research analyst at Canaccord Genuity in Toronto, doesn’t hear this same level of objection to the industry today, and for good reason. “At the end of the day, I think the U.S. cannabis sector at maturity is probably US$80 billion to US$100 billion in sales,” he says.

The stigma once associated with cannabis has dropped off dramatically, and within the past month states including New York and Virginia, as well as Mexico, have either legalised it or announced plans to do so.

“You’re going to see it slowly, over the next years and decades transition from a more traditional consumer-packaged goods market,” Bottomley says. Presently, leading U.S. companies “are kind of doing everything in every market,” he says—from growing to producing, up to creating edibles and even operating retail in some markets. As legalisation expands across the world, big pharma may look to get in on it, changing valuations.

Big-name companies trading in the U.S. such as Canopy and Tilray see their stock prices appreciate when pro-legalisation stories hit the news. But because cannabis is still a Schedule I drug, meaning tightly regulated by the government, Bottomley says, “the fundamentals are not necessarily going to flow down to those types of companies.”

Meanwhile, leading American companies like Curaleaf or Trulieve trade on Canadian junior exchanges, less easily accessed by the overall U.S. retail investor market. He thinks there’s a tremendous amount of capital yet to come into this space. Many companies, he adds, are underserved by institutional investors as well.

“Over the long term if you pick the right horses in the sector, there’s still quite a lot of growth to be had.”

Here are three things Bottomley says to keep in mind when investing in the cannabis sector.

Take Stock of Your Risk Profile

Investors entering the cannabis market have to consider their risk thresholds. “All of our buys on cannabis stocks to date are all speculative buys, and we do have holds and sells as well,” Bottomley says.

The sector can be home to wild price swings where for weeks at a time stocks go in one direction, before pivoting and going the other way. If they consider a 2%-to-3% move in a day outside their risk threshold, it might not be for them. Especially because the “wild directions” stocks move in aren’t necessarily tied to company performance.

Bottomley says it also requires a lot of patience. “You really have to be comfortable about where you are on that growth curve and how far ahead of markets opening up—you want to invest your incremental dollar to get ahead of what could eventually be a very large push upward.”

Valuation is Relative

Cannabis is a sector where policy announcements about the future of legalisation can cause stocks to move in the same direction, but investors can’t let that alone sway them. Even if every cannabis stock is moving up or down, and the shift seems uniform, Bottomley advises exercising caution.

Not every cannabis company has exposure to the same markets or regions. When looking at companies in the cannabis space, he says it’s necessary to see how they’re situated in markets relative to their peer group.

He offers the example of a Canadian company trading at 30 or 40 times its forward profitability metrics, or Ebitda (short for earnings before interest, taxes, depreciation, and amortization), but that lacks access to the U.S. market or other growth drivers.

“I prefer buying a company that’s trading at a lower multiple than that, but actually has that exposure,” he says. “That’s the first thing that I look at when I’m putting a rating to any of these companies that I cover.”

Understand the Management Team

For Bottomley, management teams and their philosophies are particularly important in the cannabis industry. “We’ve seen a lot of good case studies for huge success stories and a lot of case studies where things haven’t gone so well,” he says.

Prior to Covid-19, Bottomley went on a lot of site visits, meeting management teams. What benefits investors long term, he says, are companies that aren’t too aggressive with mergers and acquisitions, don’t overpay for assets and focus on core markets where they have competencies and market share. But this also means having good infrastructure, like call centres to support patients for medical cannabis companies, or adequate supply for and quantity of retail locations to gain market share.

“Management teams can be fairly aggressive with respect to their messaging,” Bottomley says, “and that’s fine if you can back it up, but I think that’s something investors have to be particularly careful of when they’re choosing which operators they want to back.”

The past five years have been good to stock-market investors. The S&P 500 index has climbed an annualised 12% during that period, outstripping the 9% annualised gain over the past 40 years. This year alone the index is up 6.9% as of April 26, tacking on to the 24% gain in 2023.

But signs are emerging that the stock market could be due for a breather. As of April 25, the S&P 500 went 133 trading days without a decline of at least 10%, according to PNC Institutional Asset Management. To be sure, that’s still short of the 172-day average since 1928. But the S&P 500 has jumped 24% in the past six months (about 180 days), which buttresses arguments for a correction.

What’s more, the multiyear ascent has arguably sent stocks to overvalued levels. The S&P 500’s forward price-to-earnings ratio—a gauge of market valuation based on earnings estimates for the next 12 months—registered 20 as of April 26, exceeding the five-year average of 19.1 and the 10-year average of 17.8, according to FactSet.

“A correction is certainly possible,” says Jack Ablin , chief investment officer at wealth-management firm Cresset Capital, pointing to the high valuations and the prospect that rate cuts will come later than expected thanks to inflation that has been higher than expected.

Given the danger of a stock-market correction, commonly defined as a 10% to 20% drop, how can investors guard the profits they have made in recent years?

Wait and see

Assuming you have a well-diversified portfolio and aren’t counting on the money from your stocks to finance an imminent expense, financial advisers say the best strategy is to hang tight.

Corrections generally don’t stick around long. Since 1985, declines between 10% and 20% for the S&P 500 have lasted only 97 days on average—three-plus months—according to a CFRA analysis of S&P data.

It then has taken the market an additional 101 days on average to recover the ground lost during the correction. So in about six months, investors tend to be back where they were before the correction.

“If there’s a shallow correction of 5% to 10%, we recommend riding it out,” says Karim Ahamed , an investment adviser at wealth-management firm Cerity Partners. “Eventually the market recovers. The idea of selling out and climbing back in is difficult to achieve. You’re more likely to stay on the sidelines with your losses crystallising.”

The S&P 500 did fall more than 5% in recent weeks, from March 28 to April 19.

Sell losers

Some people, though, simply find it impossible to do nothing if they fear a correction is looming. At the least, they want to protect the gains they have earned so far. What’s the most prudent way for them to reduce their market exposure?

Keep in mind that most actions you can take to guard your stock profits carry a cost. The easiest method, selling stocks, subjects you to capital-gains taxes unless you are selling from a tax-advantaged retirement account. That tax rate varies according to your income, but will likely be 15%.

One way to limit the burden is through tax-loss harvesting, says Amanda Agati , chief investment officer of PNC’s asset-management group. That is when you sell stocks at a loss, lowering your net capital gain. If you have any dogs in your portfolio—stocks with poor fundamentals—you can unload those.

If you do sell stocks, you could put the proceeds into a money-market fund for now, financial pros say. Many such funds yield 5% or more, far higher than rates over the past 15 years. Or if you want to increase the safety of your overall portfolio, you could put the money into safe government bonds. Three-year Treasury notes yield around 4.75%.

Play defence

If you are going to unload stocks, but don’t want to sell right away, you can put in a stop-limit sell order through your brokerage. That order can automatically sell your shares if they slide to a level you designate (they can go below it, too), protecting you from big drops.

Say you bought 100 shares of Tesla at $140, and they are now trading at $165. If you don’t want your profit to disappear in a downturn, you could enter a stop-limit sell order with your brokerage at $150 for some or all of your shares. Those shares can be sold if the price reaches $150, securing some of the gains.

You also might shift your holdings more toward defensive stocks, such as utilities and consumer-staple companies, which generally outperform during market downturns, says Michael Sheldon , executive director of wealth-management firm RDM Financial Group.

PNC’s Agati suggests an emphasis on quality stocks, those with high recurring revenues, strong and dependable profit margins, high cash flow and low debt. These stocks—such as AutoZone and Visa , she says—have lagged behind the leaders of the market’s surge over the past year.

Consider options

Advisers also suggest looking at “put” options to protect your stock gains. Puts give you the right but not the obligation to sell a security at a preset price by a preset deadline.

Note that we’re talking about a risk-reduction approach here, not the kind of risk-taking—to try to amplify returns— that has been rampant in the options market . The simplest strategy could be to purchase a put option on a market-index exchange-traded fund, such as one based on the S&P 500. You could buy puts on individual stocks rather than an index ETF, but that may get expensive and complicated as each option carries a purchase premium.

Here’s how the ETF strategy would work: First, buy an option that would let you sell the ETF at a price below the current one, protecting you from declines beneath that level. You wouldn’t have to sell the ETF, and you wouldn’t even have to own it. As the S&P 500 falls, the put option gains in value, and you can sell it.

Say on April 16 you wanted to protect 100 shares of SPDR S&P 500 ETF Trust (SPY) from a decline of more than 10%. With the ETF trading at $505 a share, you could buy an option that covers 100 shares for $1,050, or $10.50 a share. You’re paying a premium equal to 2% of your position.

The option’s expiration date is December, and its strike price is $455 a share, or 10% below the current value. The strike price is the price at which you could exercise the option. But generally you sell the option rather than exercising it, so you don’t have to dump any shares, especially if you don’t own them.

If the market doesn’t go down 10% by December, you let the option expire worthless, and you’re out the $1,050 you paid for it. If the market drops more than 10%, you can sell your option at a profit whenever you want until December.

While it might be more lucrative to sell it early, Ablin recommends holding until expiration if you’re using the option to protect your portfolio. “Think of it like homeowner insurance,” he says. “You pay a premium, like a deductible for insurance, and your coverage runs for a term.”

Keeping the option until expiration extends your coverage for the longest possible period.

By using options, you don’t have to sell any of your stocks, which are typically the best asset to generate strong long-term returns. “If you have the wherewithal to hold the S&P 500 for 10 years, your odds of making money are over 90%,” Ablin says.