3 Clear Signs Marijuana Stocks Are in a Bubble

After a first-half lull, marijuana stocks are on fire once again — and it’s not hard to understand why.

To begin with, Canada is set to become the first industrialized country in the world to legalize recreational marijuana. Exactly six weeks from today, adult-use cannabis will go on sale in our neighbor to the north. When the industry is fully ramped up, we should be looking at billions of dollars in annual added revenue.

Secondly, deals have been littering the cannabis space in 2018. Aside from Aurora Cannabis(NASDAQOTH:ACBFF) pulling off the largest marijuana acquisition in history (a $2.5 billion buyout of Ontario-based MedReleaf), it’s Constellation Brands‘ $3.8 billion equity stake in Canopy Growth Corp. (NYSE:CGC) that’s turned heads of late.

And lastly, there’s the continued expansion of cannabis around the globe, and the possibility that the U.S. could eventually change its tune. Recently, Oklahoma became the 30th U.S. state to have passed broad-based medical cannabis laws. More importantly, though, a widening rift between President Trump and Attorney General Jeff Sessions, an ardent opponent of marijuana, has investors excited. Should Sessions be dismissed from his position, it would be a major win for the legal cannabis movement.

Add all of this up, and it’s no surprise that the North American Marijuana Index — a measure of the largest growers, ancillary players, and cannabinoid-based drugmakers in North America — has nearly tripled in value over the trailing-12-month period and is up well over 650% since February 2016.

There’s little denying that marijuana stocks are in a bubble

But what if I told you that marijuana stocks were clearly in a bubble that will, eventually, burst? Don’t believe me? Here are three signs that suggest my bubble thesis will be proven correct.

1. Investors always overestimate the impact of the “next big thing”

The biggest knock marijuana stock investors have working against them is that each and every next-big-thing investment has overheated and retraced a lot of its gains over the past two decades. Whether we’re talking about the advent of the internet, internet business-to-business commerce, decoding the human genome, 3D printing, or blockchain technology, the result has been the same in every instance: a burst bubble.

Now, this isn’t to say that long-term investors weren’t handsomely rewarded if they held on to key names in these industries over the long term. If you held your shares of Amazon or Netflixwell after their bubbles burst, you’ve likely come out well ahead of your initial investment. But the key point here is that it takes time for an industry to mature — even one that’s been around illicitly for a long time. It’s not going to happen overnight, and there will be unforeseen hiccups in the cannabis arena that catch investors off guard.

2. Profitability and dilution are being completely ignored

If history isn’t enough of an indicator that pot stocks are in a bubble, then perhaps Wall Street’s and investors’ rampant disregard for profitability and dilution are proof enough.

Although most marijuana stocks are expected to be profitable in their upcoming fiscal year, none of them are particularly attractive on a fundamental basis. Aurora Cannabis, which is expected to lead all growers in annual production at 570,000 kilograms per year, once at full capacity, is only expected to produce 0.06 Canadian dollars per share in profit next year, which works out to a forward P/E of about 147. Canopy Growth, which boasts a $10 billion market cap, is even worse with a forward P/E of 213. Even with strong revenue growth prospects, it’s difficult to support these lofty valuations. And they certainly leave no room for error on the company’s part.

Building on this point, investors appear to be completely ignoring the impact of ongoing dilution on pot stocks.

Prior to the passage of the Cannabis Act in June, the only way that marijuana companies could consistently raise cash was through bought-deal offerings. This is where common stock, convertible debentures, stock options, and/or warrants were sold to raise capital. Though pot stocks had little issue raising cash, these bought-deal offerings wound up ballooning the outstanding share count of publicly traded pot stocks. These extra shares can weigh on a stock’s share price, as well as its earnings per share.

For instance, Aurora Cannabis’ numerous bought-deal offerings and acquisitions have inflated its outstanding share count from 16 million at the end of 2014 to around 950 million shares today. Dilution is an issue that marijuana stocks will be contending with for a long time to come as convertible notes, stock options, and warrants are exercised.

3. Wall Street and investors are chasing deals

The third giveaway that marijuana stocks are in a bubble is the hype that’s followed Constellation Brands’ investment in Canopy Growth. Since this equity investment was announced, Tilray has gained nearly 170%, Cronos Group temporarily doubled, and Aphria is up by close to 94%.

All three of these marijuana stocks have gained as much as they have in just over two weeks on the expectation that they’ll be next to land a major partnership with big alcohol. But I have another phrase for this recent rally: the “fear of missing out,” or FOMO.

FOMO is what’s caused cryptocurrency investors to lose most of their money in 2018, and it’s probably a very good reason the dot-com bubble burst back in the early 2000s (along with a lack of profits). I understand the desire of investors to not want to miss out on the large expected uptick in sales once Canada legalizes, but investors also have to realize that there’s little logic in wanting to dive into an industry that hasn’t yet proven it can capitalize on any of its numerous promises. These are stocks that priced to perfection — and the business world is never perfect.

Long story short, whether it takes another few weeks, a few months, or even longer than a year, I do expect the marijuana bubble to burst eventually. While there will be long-term winners, now doesn’t look like the right time to invest in marijuana stocks.

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