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Cannabis Stocks Come Crashing Down to Earth

December 28. 2019. 6 mins read
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The world of finance is full of big egos that exhibit a herd mentality. As long as you’re on the cover of magazines and coming up with innovative ideas the industry can use to sell more stuff, everyone wants to be your friend. Make one mistake though, and you’ll find your name has been erased from every piece of collateral out there so that only your sins remain for the world to see. Just ask Mr. Barr Rosenberg how that works.

Barr Rosenberg in Institutional Investor
Credit: Robin Wigglesworth via Twitter

Google his name today and the first search result tells the world about how he didn’t let his clients know about a software defect which resulted in some unexpected losses. Consequently, the SEC barred him from the industry – for life. (Sounds like somewhat of a blessing if you ask us.) Prior to that, the man could do no wrong. Anyone remember MSCI Barra? The name “Barra” comes from the company which emerged around the man you see in the above picture. In 2004, Morgan Stanley purchased Barra for over $800 million and eventually transformed it into a $22 billion success story called MSCI (MSCI), a company that now considers Barr to be a four-letter word.

Barr Rosenberg’s innovations were around something called “multi factor risk models,” which are often presented in a series of cryptic formulas, when in fact, the underlying premise is extremely simple. It is simply this. Stocks with similar characteristics will behave similarly. (This is why we recently preached to you about the merits of diversification and pointed out how it’s not as simple as owning 30 stocks.) For example, even though we don’t have a single industry classification for “cannabis stocks,” they will all behave in a similar fashion when it comes to how they perform. If a large cannabis stock has bad earnings, then all cannabis stocks will likely take a hit alongside it. And lately, every cannabis stock has been taking a big hit. Here’s how one of the largest cannabis ETFs, Horizons Marijuana Life Sciences Index ETF (HMMJ), has performed over the past year.

The performance of the Horizons Marijuana Life Sciences Index ETF
Credit: Bloomberg

We’ll do the math for you. If you bought shares in that ETF one year ago, you’d be down -35% on your position. If you bought shares at the peak of cannabis stock mania – what appears to be in March of this year – you’d be down -64% on your position. So, what to do? Well, some of the world’s most successful investors would say you should be greedy and back up the truck. And of course, other successful investors would say exactly the opposite.

Catching a Falling Knife

There’s also another saying in the investment community which is “don’t try to catch a falling knife.” The problem with cannabis stocks is that they’re largely owned – in our estimations – by a bunch of newbie investors, many of which thought that because they smoke a lot of the stuff, it must make for a great investment. As the panic continues to set in, volatility will increase even more, and prices could be driven down even further.

Those same panicked investors probably tried to cherry-pick winning stocks instead of doing the prudent thing and investing in an ETF for all the diversification benefits – which wouldn’t be so obvious when looking at the above chart. One way to tell how much of a positive impact diversification had is by looking at how investors may have fared trying to cherry-pick the biggest publicly traded multi-state operators (MSOs):

1-Year 3-Month
Curaleaf CURA:CN +18% +6%
Cresco Labs CL.CN -13% +3%
Harvest HHL.TO +6% +11%
Acreage Holdings ACRG-U.CN -67% -16%
GTI GTII.CN +6% +8%
MedMen MMEN.CN -84% -68%
Trulieve TRUL.CN +30% +30%
Columbia Care CCHWF -61% -28%
Horizons Marijuana Life Sciences ETF HMMJ -35% -30%
NASDAQ Tracker ETF QQQ +38% +13%

As you can see, you would have been much better off – and more importantly, took far less risk – by just investing in the a broad Nasdaq tracker ETF instead of cannabis multi-state operators. Now, here’s something that we found surprising.  While the above stocks represent the ten largest multi-state operators in the United States, not a single one has made it into the top holding for HMMJ as it’s largely dominated by the large Canadian growers and a few companies that aren’t exactly pure plays. Here’s how the top ten stocks in HMMJ performed over the same time frames:

1-Year 3-Month Weight
Canopy Growth Corp WEED.TO -31% -17% 12%
Cronos Group CRON.TO -65% -24% 10%
GW Pharmaceuticals GWPH -3% -12% 10%
Aphria APHA.TO -19% -7% 9%
Scotts Miracle-Gro SMG +73% +5% 9%
Tilray TLRY -76% -24% 8%
Aurora Cannabis ACB.TO -63% -57% 7%
Charlotte’s Web CWEB.TO -34% -45% 6%
Hexo HEXO -70% -60% 3%
Innovative Industrial Properties IIPR +62% -18% 3%
Horizons Marijuana Life Sciences ETF HMMJ -35% -30%
NASDAQ Tracker ETF QQQ +38% +13%

Over 76% of the HMMJ portfolio is represented by the ten stocks seen above. The best performing of the lot was a $6 billion fertilizer company which happened to benefit from other trends like the explosive growth of indoor farming.

Even though we’re talking about a loosely connected set of various-sized stocks that trade across multiple exchanges, we’re still seeing a consistent theme here. Cannabis stocks are a volatile lot. If you’re trying to cherry pick the next Microsoft, your odds of hitting a landmine are quite high. Try to read through the filings to understand the typical complex corporate structure of a cannabis stock and you’ll quickly realize that these are not easy businesses to understand. Throw into the mix a whole bunch of regulatory complexities which are still evolving, and even the most risk-tolerant investors out there should not be asking if now is the time to buy, but questioning if this is a theme that merits an investment in the first place. We’re on the cusp of The Fourth Industrial Revolution, so there are many exciting technology themes – genomics, AI, gene editing, wind energy, robotics – that you’re not investing in when you throw your high-risk cash into cannabis stocks.

What to Do Now?

For those of you holding stocks that are underwater, you need to ask if your investment thesis has changed at all. Do you still believe that cannabis presents that investment opportunity of a lifetime once all this consolidation shakes out? If the answer is yes, then go put more money to work. There has already been quite the correction so just use dollar cost averaging and increase your position a little bit each month. If you’re now looking for a way to play this theme because you think there’s value to be had, diversification will be your friend. Exposure to the Horizons ETF is a good way to play some of the big Canadian growers if you’re comfortable with owning the ten stocks which make up over 75% of the portfolio. If not, there are now other ETFs to choose from.

Last June, we wrote about 5 Marijuana ETFs for Investing in Cannabis and listed out the top constituents for HMMJ. A quick search of the ETF.com database shows seven names with accompanying assets under management (AUM) numbers:

List of marijuana ETFs
Credit: Etf.com

The largest by far is the ETFMG Alternative Harvest ETF (MJ) issued by ETF Managers Group which now has nearly twice the assets of HMMJ with $686 million invested in their portfolio of stocks. They also represent a more balanced way to play the theme with a more equal distribution of stocks between Canada and the United States.

The ETFMG Alternative Harvest ETF
The ETFMG Alternative Harvest ETF – Credit: Etf.com

As for MJ’s performance, they sucked over the past year too, but managed to eke out a slightly better performance than HMMJ. As Mr. Rosenberg taught us, stocks that belong to the same industry group tend to behave similarly.

Conclusion

The recent decimation of cannabis stocks is precisely why we never put our own money to work in this space – aside from some shares in Charlotte’s Web because we really liked their story. (By the way, that story hasn’t changed and those shares are now on sale for 50% off.) Investors need to remember that cannabis is an especially risky theme because it attracts particularly irrational investors and is subject to a great deal of regulatory risk. We’re in one of the longest bull markets of all time and cannabis happens to be underperforming as the industry starts to question all those lofty valuations that it once ascribed to its constituents.

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