Warrior Trading Blog

The Best Marijuana Stocks For 2021

marijuana stocks

 

Who remembers when Tilray (TLRY) was trading at several hundred times TTM sales? That was during the marijuana stocks mania of 2018 when finding them at reasonable valuations was nearly impossible.

Figure 1.1: Tilray’s historical price-to-sales ratio from YCharts

 

Following the pop of the bubble, everyone mostly forgot about cannabis stocks for a few years. To illustrate the cannabis bear market’s severity, take a look at the ETF that tracks cannabis stocks: the ETF Managers Alternative Harvest ETF (MJ) in Figure 1.2. 

In hindsight, one of the most interesting things about the 2018 cannabis bull market was the allure of full legalization in Canada. It was viewed as the factor that would allow the bull market to extend a few more legs.

Except, in true “buy the rumor, sell the news” fashion, the date of legalization marked the top of the cycle, almost to the day. 

Further, the bull market was very short-lived. While the ETF nearly doubled, with a number of cannabis stocks like TLRY multiplying several times, there was no sustained trend on the weekly chart for the ETF.

Instead, we see a huge momentum thrust upward, followed by an equal thrust to the downside–much like most manias.

Sure, a lower time-frame would present us beautiful trends, but the bull market, if you could call it that, lasted about two months.

Figure 1.1: $MJ weekly chart 

 

Some may be tempted to extrapolate this behavior to price action in the future and remark that today’s rally in cannabis looks awfully like the front side of the 2018 move; therefore, this trend should also crash.

But every cycle is radically different. In this case, the industry is different, the players are better developed, and the people trading the stocks are different.

I’m not saying that we won’t see a similar outcome to that of 2018, but that this type of “chart overlay” analysis doesn’t add a ton of tradeable value. 

Are Cannabis Stocks Entering a New Bull Market?

Cannabis stocks are back in vogue. It’s a hot play on Reddit right now, and the top stocks are seeing massive inflows.

Here’s the 2021 performance of hottest stocks in the sector: Tilray (TLRY), Aphria (APHA), Sundial (SNDL), and Terra Tech (OTC:TRTC) against the $MJ cannabis ETF: 

 

However, the price action of this new bull run is worrying because of its resemblance to the last short-lived bull run.

It looks awfully like a blow-off top or a trend climax, which some may call it. Massive spikes like those in the above charts without any hugely significant news typically indicates that the trade is crowded with short-term traders who are aggressively lifting offers.

Once they’ve taken their piece out of the market, or if they’re late to the party and buy the top, they start aggressively hitting the bid on their way out.

I think this is exemplified by many news services like Briefing and SeekingAlpha referring to this rally as the “Reddit Rally.” 

A short-term blow-off top doesn’t spell doom for the long-term prospects of the sector, however. It’s just something to keep in mind when initiating positions right after this rally.

What might look like a pullback in a new trend, could be the start of a short-to-intermediate-term downtrend in the sector driven by all of the traders rushing for the exit at once. 

News flow drives cannabis stocks for the most part. Their shareholder bases aren’t value investors who read the financial statement tea-leaves.

Most shareholders are exposure investors, making bets on many horses, betting that one of them will reign supreme in the global cannabis market in several years.

The news flow this time around is mostly driven by the US elections.

The Democrats in the US have control of all political chambers and have historically been quite favorable to cannabis legislation. Many of the top Democrats have recently put out statements to this point too. 

So the market is pricing in a higher possibility of US federal legalization of cannabis, which would likely be most bullish for the US-based MSOs (multi-state operators). 

The Hottest Cannabis Stocks

During the last bull market in 2018, the big names were Tilray (TLRY), Cronos Group (CRON), Canopy Growth (CGC), Aphria (APHA), and Aurora (ACB). This time around, the hotlist is a bit different. 

Tilray and Aphria are still among the hot names this time around, but the other three from the previous cycle have lagged.

Tilray (TLRY), Aphria (APHA), Terra Tech (OTC:TRTC), and SunDial (SNDL) were by far the biggest movers of the 2021 rally as you can see in the chart below.

 

Does that mean that these stocks will continue as the leaders? That remains to be seen, but there are some big question marks around some of the hotter names, especially at these price levels. 

Tilray (TLRY)

Tilray is the poster-child for cannabis momentum. The stock is hated by most contrarian analysts and loved by momentum traders. Go on Twitter or SeekingAlpha and look at any discussion around Tilray, and it becomes quite clear that it’s as polarizing as Tesla (TSLA) for cannabis investors. 

The stock led the 2021 cannabis rally, returning around 160% YTD at the time of writing and at one point was up about 650% YTD. 

Despite the massive volatility levels over the last few years, Tilray is right back where it started near its IPO price.

 

What The Bulls Say

Here are the main points I’ve collected from Tilray bulls about the company’s prospects:

  • The company is merging with Aphria (APHA), which will make them by far the global leader in the cannabis business, giving them a huge edge.
  • The synergies created by the merger will allow the firm to take advantage of the capital markets far better than the rest of the industry, which are largely cut off because of the federal illegality of cannabis in the US.
  • Tilray has significant international exposure, allowing them to spread their bets across several different markets.

What The Bears Say

  • The valuation is too rich. At the time of writing, Tilray is trading at 16x TTM sales while still losing money.
  • Canada isn’t a good place to grow cannabis, and the US-based companies will ultimately win.
  • There are better cannabis stocks with less volatility and lower valuations.

Sundial Growers (SNDL)

Sundial is a newer name, unrecognizable to those who traded the 2018 bull market. It went public in late 2019 and was a flop from the get-go.

The IPO offering price was $13, with the stock closing the day at $8.48. Since then, the chart looks like what you imagine Blockbuster’s chart would look like if it was still publicly traded. 

The stock went public amid a cannabis bear market, and IPO investors paid the price. However, lately, the stock has caught a real bid, appreciating about 130% since the start of 2021. At one point, it was up over 600% YTD.

Left: weekly chart of SNDL. Right: daily chart of SNDL since the start of 2021.

What The Bulls Say

  • The rally allowed the company to raise oodles of capital and make investments because of its elevated share price.
  • The company has a large cash balance of $610 million, according to a recent press release. This is compared to just $21 million in cash, back in September 2020.

What The Bears Say

  • The company had lost 99% of its IPO share price value before the rally.
  • The company was nearing bankruptcy and Nasdaq delisting prior to the rally.
  • Little or no US operations
  • Much of the top executives just stepped down in late January.

Mergers and Acquisitions Activity in the Cannabis Sector

Tilray and Aphria Merger

In December 2020, Tilray and Aphria agreed to a merger, which would create the largest global cannabis company.

  • APHA shareholders will receive 0.8381 shares of TLRY for every share of APHA they own.
  • The new company will partner with Anheuser Busch and SweetWater Brewing to sell cannabis beverages in the US market.

What’s interesting about this deal is how wide the spread was for how long. Amidst the rally, APHA was trading at a huge discount to its value in the merger. See the spread chart below, which subtracts APHA’s share price from Tilray’s and multiplies the difference by 0.8381, which is the merger multiple.

The resulting number is the merger spread.

 

One way merger arbitrage traders would put this trade on is to buy Aphria and short Tilray hedged to the share count or dollar value based on the merger multiple.

In most of these types of deals, the spreads are much lower because there’s a barrage of hedge funds and prop traders putting the spread on.

What happened here is unique. First, everyone was very cautious about short selling and tending to their wounds from the massive short squeeze rally just weeks earlier, driven by GameStop (GME), but widespread across all high short interest stocks.

Then, TLRY was going absolutely parabolic while APHA’s rally was comparatively tame.

If a merger arbitrage trader is confident that the deal goes through, they know that they’re hedged regardless of what the market does in the short-term. However, reality doesn’t work that way.

What if Tilray just kept going up while Aphria lagged behind? What if the trader got a margin call? What if their manager or investors pleaded with them to get out of the trade because of the mark-to-market losses?

While the spreads were obviously very fat for a trader willing to take the risk, it was clear that most were not willing to do so. It’s also possible that the experts in merger analysis don’t have confidence that this deal will go through. 

The simple explanation here is: who the heck wants to short Tilray? How do you hedge the risk of a Reddit rally? Most of the time, you can’t. 

Jazz Pharmaceuticals Acquires GW Pharmaceuticals

In early February, Jazz Pharmaceuticals (JAZZ), a mid-cap drug company, made a bid to acquire GW Pharmaceuticals (GWPH).

This drug company makes a pharmaceutical formulation of CBD for $220 per ADR, $200 in cash, and $20 in JAZZ common stock. The deal represented a roughly 50% premium to where GWPH was then trading.

Here’s the GWPH chart:

 

See how different that looks to the APHA chart? It’s clear that the merger arbitrage traders are in this deal and are reasonably confident that it will close successfully.

Let’s look at a chart displaying the merger spread. Below is simply subtracting the current price of GWPH from $220 (the deal price).

 

The spread is currently about $7.50, representing just a 3.4% discount to the deal price, pricing in the time value of money, FX risk (GWPH is a British company), and the risk of the deal not closing or the terms changing.

Cannabis SPACs

A SPAC is a blank-check company. You can think of it like a publicly-traded investment with a venture capital firm that only ever makes one investment. You can read our piece explaining SPACs here.

There are a number of new SPACs coming to market that aim to make acquisitions in the cannabis space. SPAC-focused hedge fund manager Chris DeMuth Jr. did a podcast episode with SeekingAlpha on this subject here, which might provide some color. He mentioned that some names to watch are:

  • Silver Spike II (SPKB.U), of which the sponsors are in the process of de-SPACing the popular cannabis website Weedmaps.
  • Greenrose (GNRS)
  • Tuatara Capital Acquisition Corp (TCAC.U)

SPACs can be confusing, so make sure you read the filings and disclosures to know exactly what you’re buying and who controls the funds.

Risks With Investing in Marijuana Stocks

Although marijuana stocks are scorching hot right now, there are certain risks you need to know about including increased competition and political risk from the federal government.

Right now, the marijuana industry is growing faster than the pot plants they are selling. However, large biotech companies have taken much of the market share when it comes to providing medical marijuana solutions.

This has enabled them to get a head start over startup companies that have fewer resources.

Problem is others want a piece of this cake. As a result, start-ups are popping up everywhere and will undercut prices to get some of the market share which will ultimately benefit the end-user with more competitive prices but could also limit the potential the bigger company’s have.

However, the marijuana industry is still brand new with a ton of different ways for these companies to capitalize.

Federal Marijuana Laws

Another major risk involved with investing in the marijuana industry is that it is still technically illegal on the Federal level and pot stocks aren’t technically allowed to be listed on any major exchange.

“As long as cannabis is classified as a Schedule I substance, Wall Street’s regulator-in-chief isn’t going to approve an S-1 filing from a cannabis company wishing to go public.”

This means that most US marijuana stocks will only be able to trade Over the Counter and that means that they don’t have to adhere to the strict rules and regulations that are set in place to protect investors like financial transparency business initiatives.

That doesn’t mean all companies are deceiving investors it just means that they don’t have as strict of guidelines to follow.

Despite these risks, the marijuana industry is still a force to be reckon with. Popularity is gaining and more states are approving medical marijuana usage with recreational weed right behind it.

Bottom Line

Common sense says that over the long-term, the cannabis sector will grow. The growth doesn’t depend on actually converting more people into cannabis users, but regulation.

There are already millions of cannabis users, but companies can’t access most of them because of the regulatory environment.

Compare this to other sectors, where the long-term growth ultimately depends on the industry’s ability to keep and create new customers.

There were plenty of cannabis users well before any commercial alternatives were available, so companies’ primary challenge is getting access to those customers rather than creating them. 

This isn’t to say that any of the current hot cannabis stocks will be long-term winners.

They could easily be acquired or just put out of business by more experienced operators like tobacco companies or another big fish that decides to take a dip in the pond.

This is why investing in cannabis is such a high-risk play, and picking any individual long-term winner will be very difficult and will involve a large degree of luck.