Be careful with stocks in this market despite projections for rapid growth
Thursday 11 Apr 2019 Author: Ian Conway

At midnight on Wednesday 17 October 2018, Canada became only the second country in the world after Uruguay and the first country in the leading G7 group of nations to legalise the recreational use of cannabis for adults over 18.

Canada’s ‘experiment’ is being closely watched by other governments and lawmakers to see how it manages the drug’s use and whether legalisation succeeds where prohibition has so far failed.

This historic event has unsurprisingly created an opportunity for businesses and investors. People have seen cannabis-related stocks shoot up in value and so interest is now spreading around the world including a few stocks in the UK.

WHAT’S GOING ON?

Cannabis production and its use for medical purposes has been allowed in Canada since 2001 so there is already a legal framework in place for both its production and consumption.

In the US, 39 states already allow medical use but only nine allow recreational use by adults over 21, including California which is the world’s largest market for recreational cannabis.

The global cannabis market was estimated to be worth $177bn in 2017 but over 90% of the market is illegally trafficked so the legal market is tiny.

However analysts are forecasting that with more countries moving towards allowing recreational use the legalised market could grow more than tenfold over the next decade to over $150bn.

Prohibiting its use for recreation has led to the market being dominated by stronger strains which as well as creating mental health issues can draw users into trying other illegal drugs and is contributing to increases in crime.

On the other hand regulating its use for recreation, especially among younger people, helps bring the trade ‘out of the shadows’ and generates financial benefits in the form of tax income.

MEDICAL DEMAND STRONG IN EUROPE

Currently 10 European countries allow the medical use of cannabis but only two countries tolerate its cultivation and sale, the Netherlands and Spain.

The UK was due to legalise the medical use of cannabis late last year but like a lot of legislation the bill has been shoved to the back of the queue while efforts to secure some form of Brexit continue.

Analysts at investment bank Canaccord estimate that the continental European medical market was worth around €160m in sales last year, driven by Germany.

Based on reimbursements for prescriptions of cannabis products by German insurance companies, the country’s medicinal market was worth €110m last year followed by the Netherlands and Denmark.

The Dutch market is already mature with around 10,000 to 12,000 prescriptions each quarter. The German market has grown sharply in the last year and a half from just over 5,000 prescriptions in the second quarter of 2017 to well over 50,000 in the final quarter of  last year.

This growth is likely to continue albeit at a slower pace while newer markets like Denmark and Poland are expected to see prescriptions increase as more people take up treatment.

WELLNESS IS IN FASHION

Cannabis production and its recreational use are still banned in Europe although in Spain it has been more or less tolerated for some time and a relatively large number of people use it for self-medication or ‘wellness’.

‘Wellness’ centres on the use of products such as creams and oils which contain cannabidiol (CBD) but no psycho-active or controlled substances and are technically regulated as food supplements.

The UK CBD market has exploded in the last year with Boots, Holland & Barrett and every vape shop on the high street selling CBD oil.

The continental European market has also seen explosive growth and Canaccord analysts have raised their estimate of the size of the value of the market from €200m a year to as much as €1bn a year.


Tilray’s shares are a perfect example of how investors chase over-hyped stocks for fear of missing out, with many burnt for buying too high.

Having floated at $17 in July 2018, the stock soared more than 12-fold in value to $214.06 two months later. It has since crashed back down to $63.68.


EQUITY STOCK VALUATIONS ARE SKY-HIGH

Numerous cannabis producers have been quoted in Canada for several years thanks to its early adoption for medical usage and there has been something of a bubble in ‘pot stocks’ as investors have piled into the sector.

The largest stock by market capitalisation is Canopy Growth which is valued at C$20bn although it has around C$5bn of cash. While revenues are still growing it is valued at a lofty 20 times sales and is loss-making.

That hasn’t stopped Constellation Brands, the US company behind Corona lager and Mondavi wines, taking a 9.9% stake in Canopy.

Other well-known and highly-rated cannabis stocks include Tilray which is valued at 18 times sales and Aurora which trades on 14 times sales. Like Canopy Growth, neither firm currently makes a profit.

In Europe there are just a handful of cannabis-related stocks and none are generating meaningful revenues or profits. These include Sativa Investments which is listed on the NEX Exchange and FastForward Innovations (FFWD:AIM), both of whom are small and illiquid.

Such is the hype that oil and gas company Highlands Natural Resources (HNR) has just raised money to ‘establish an organic, vertically-integrated CBD operation’ in Denver, Colorado.

It plans to grow the ‘green gold’ and sell it as CBD-infused chewing tobacco and pre-rolled ‘smokeables’ and, despite the odds, it expects to be profitable by the end of this year.

We expect more companies to target the sector, particularly at the smaller end of the AIM market. Our advice is to be very cautious about any of these investments unless they can demonstrate a proven, profitable business model.

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