Weed Stocks: A Further Analysis

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The euphoria that took the Canadian stock market by storm at the end of 2016 has subsided as marijuana stocks have traded essentially flat year-to-date. Investors paid heavy premiums (based on traditional valuation methods) to access the budding industry with the hopes of being part of the next big thing. Muted trading has given the market a breather and provides us a moment to analyze the shares. Are stock prices trading at a premium or a discount? Will investors make money or should they bail at break-even? Will this industry become as large as the rest? Here are some facts which we will use to provide you with both a bullish and bearish case.

In 2016, the state of Colorado reported total revenue of marijuana sales at $1.3 billion US. This equates to a total base of about $225 US per resident. The government projects sales will rise another 25% in 2017 which will generate $250 million in tax revenue for the state. This revenue projection would equate to about $280 US per resident.

National surveys done in the US showed a reduction in teen usage in the state of Colorado compared to the national average and a slight reduction in teen usage year-over-year within the state. Most international surveys also cannot prove or come to the conclusion that the legalization of marijuana increases total usage and some surveys draw the conclusion that total net consumption is reduced.

Canada projects total users (above the age of 15) to exceed 5 million if/when marijuana becomes legal in the country. However, total market consumption is undetermined.

When industries are newly forming and do not earn a profit, one metric used to measure a public company is by the price-to-sales ratio (PSR). This divides the stock price by its revenue per share or alternatively, divides the market capitalization of the company by its total revenue. The industry with the highest PSR is Internet software (6.66) and the lowest is auto parts (0.67). Click here for the full list.

Metrics

If we draw parallels from Colorado and apply it to Canada, and we expect that consumer trends remain similar, the expected size of Canada's weed industry should be $10 billion CDN assuming the average resident consumes $280 of weed per year (note we removed foreign exchange from the calculation as marijuana would most likely be unaffected by foreign exchange or futures markets).

The three most prominent stocks in Canada by market cap are Canopy Growth (WEED), Aphria (APH), and Aurora Cannabis (ACB) with a combined market capitalization of $3.15 billion CDN. Their 2016 revenues were $30.27 million, $15.07 million, and $4.51 million; a combined $49.85 million. This results in a PSR of 63.19.

Bullish Case

The legal weed industry is still in its infancy and the market has discounted its potential value. A $10 billion market could push stock prices higher. With a comparable PSR to tobacco of 5.66 (or 6 for simplified math), this would value the total industry at almost $60 billion in market capitalization, which is about 20 times more than the current value of the three companies mentioned above. Triple-digit growth proves that there is significant growth and it may not peak or plateau for years down the road.

Legalization could also increase tourism and it is estimated that an additional 900,000 Canadians would consider trying it after legalization according to a recent survey. The total market capitalization predictions also exclude the potential for expansion into the US which has a market ten times larger. There is a strong movement for legalizing in the remaining states to boost government tax revenue.

Bearish Case

Bears do not doubt that these businesses will grow, however, their shares may not. Current PSR show that the market is pricing the stocks almost ten times more than the highest industry. Its current PSR of 63 requires growth over 1,000% (or 11-fold) before its PSR matches the tobacco industry. A projected 20-times increase in revenue would only double the stock (at most) and this assumes Canopy, Aphria, and Aurora control more than 99% of the market share. The second assumption is that market capitalization does not grow due to increased float, which means the company issues shares and reduces the amount of ownership per unit.

The most recent quarter showed Canopy posting revenue up 180%, but the shares declined 8% on the news. Premiums are now catching up with fundamentals and the $10 billion projection could be an overstatement due to concentrated data from Colorado. In economics, the law of big numbers indicates that a company growing rapidly cannot maintain that level of growth forever because there are fewer new customers available. If this law applies to weed companies as well, it can be inferred that the following quarter will show less than 180% growth which results in an "asymptote-like" chart; a plateau or peak is an inevitable part of any business.

The $1.3 billion generated in Colorado includes tourism revenue. This is an important fact to dissect because it would provide evidence where revenue can plateau. If legalization hits all 50 states, would revenue specific to marijuana be reduced for Colorado on a resident-based average? The current projections assume $280 spent per individual, but in Canada, only 5 million (or about 15%) of Canada's population would be a regular consumer. This means that in a room of 7 people, the one individual would generate revenue of $2,000 directly to the producer.

When Should You Dump Your Mutual Funds?

The 2016 RRSP deadline is fast approaching; that means large lump sum contributions for many. The majority of that money is allocated into debt (bonds) or a mutual fund. Most employee savings plans and pension plans directly buy mutual funds, but mutual funds are not necessarily the best choice for the average consumer due to their fees. As one's wealth rises, it may be ideal to move away from them, but when should you dump your mutual funds?

Firstly, what is a mutual fund? Essentially, they are professionally managed portfolios. They provide access to the bond and equity markets with minimal capital. In most cases, mutual funds do not charge for transactions. Instead, their earnings are made through a management expense ratio (MER) which is used to pay employee salaries, accountants, lawyers, and other operating expenses. These fees tend to be between 2-3% of the fund's net asset value. Although this amount seems small, these fees add up over time, and we are here to expose how much money is actually lost by retirement.

Let's assume you are contributing equal payments of $10,000 annually for 40 years into a mutual fund with an MER of 2.5%. We will also assume there is zero net growth in the fund to simplify the calculations. This means the fund's value rises equal to the MER and thus shows no growth.

In the first year, the MER paid would be $250 and in the 40th year, the MER paid would be $10,000. If you've forgotten the formula for this kind of arithmetic, it is (first year's MER plus final year's MER)/2 multiplied by number of years. We can see that the total MER paid by you is $205,000. While your retirement account is worth $400,000. The total MER paid is over 33.8% of your total wealth.

Of course, that's not all. Depending on the source, it is measured that in any given year, just one-quarter of all mutual funds will beat their benchmark. Over the long-term, less than 0.1% of funds outpace the index. In 2014, a report by Jeff Sommers, writer for the New York Times, concluded that just 2 funds out of over 2,800 beat the S&P 500 for five consecutive years (2009 to 2013). Both were small-cap funds, and thus, had a higher probability of beating the index. Unfortunately, both funds, in 2014, failed to maintain their run.

There is strong evidence to support that active funds cannot outperform an index, and this information is vital for investors looking to manage their own capital more efficiently. The alternative to mutual funds would be index funds, such as the iShares TSX 60, SPDR S&P 500, or SPDR Diamonds Index. MER's for these ETF trio are roughly 0.10%. Assuming zero net growth, the total MER paid over the same period is $8,200. If the index also grew by 2.5%, you would have an additional $196,800 at retirement, almost 50% more, by reducing your overall fees. These gains exclude potential capital appreciation and dividends, which historically yields 8% on average.

So getting back to the original question, when should you dump your mutual fund? Most self-directed registered accounts at a brokerage will charge up to $125 a year if the total equity is below a certain threshold. And trades on ETFs will run about $10. This translates into an annual cost of $135. Based on all that has been discussed, if your total portfolio exceeds $5,400, then it may be profitable to move your mutual fund into an index fund.

Many investors stick to mutual funds because they lack investment knowledge. Their lack of confidence or education persuades them towards products that are managed professionally, but as we see, spending just an hour a year educating yourself will pay significant dividends down the road. Even by simply making this transition, you will be 50% richer.

Minh Luu is a former Canadian investment representative with a major in finance. All advice and information in this article is opinion-based and is not a recommendation on buying or selling. Always speak to your investment advisor.

Put Options Versus Stock Ownership

Traditional buy and hold strategies have long been proven effective over the long term, especially when investors select quality companies. However, buy and hold is actually the least efficient investing method when it comes to generating returns. Although we have a bias for options, it is important that investors educate themselves on alternatives to just buy and hold because beating the market while driving on the same highway as everyone else is nearly impossible.

Hedge fund managers and professional traders often employ the use options over owning stock. Stock ownership requires significant capital and produces lower returns versus selling options. The advantage of using options is the ability to profit even when the stock falls; stock ownership has no room for error.

Take for example Google shares, now known as Alphabet. Priced at $827, these shares are most likely out of reach for the average investor looking to fulfill a board lot. This would require almost $83,000 just to avoid interest. However, selling a put option just out of the money (820 strike) would require only $17,200 cash. The difference in capital requirements is staggering and can actually limit the demand for companies. The ability for younger or financially strapped investors to buy and hold is often burdening and not possible.

If we take the 2018 LEAPs, you can sell the $820 puts and earn $67 a share. This is immediately paid to you. Regardless of what the shares are valued in a year from now, you keep the $67. This represents a return of almost 39% for the year. To match the same return in percent for a stock owner, the shares would need to climb to $1,150. To match the return in dollar value, shares would need to climb to $894. Now, selling a put does have its own risks as well. If the shares fall, you would be obligated to buy the stock at $820 or close the option. However, if the shares are worth more than $753, you would still be left with a profit. This advantage only lies with an option trader.

If the stock owner had purchased the shares in 2017 and held them for one year only to see the shares fall to $770, the stock owner would see a paper loss of $57 a share or $5700 per board lot. We however, have seen a profit of $17 a share or $1700. The cost to close the option on expiration date would be $50 but we received $67. This is an example of more efficient investing. Since Alphabet shares do not currently pay a dividend, there is no added benefit on owning the shares with the exception that the stock could be worth more than $1,150 in a year (let's see how it plays out), but this is worthwhile trade-off for option traders. It is very rare for a stock to return 40% a year every year and in the long term, the reality is that the option trader will be better off than an investor with a buy and hold strategy.

Weed Stocks Getting High, Maybe Too High

Share prices of marijuana companies have soared since their debuts. Prices are now at a critical point. New investors are being lured into the world's largest casino - the stock market - and that is a red flag for money managers.

On Wednesday November 16, 2016, six major marijuana stocks tripped circuit breakers on the Toronto Stock Exchange after spiking up at least 10% in five minutes. Circuit breakers were put in place to prevent unusual trading patterns from continuing in either direction. This triggers a halt, which can last as little as a five minutes or as long as the remainder of the day, and allows traders and investors an intermission to re-examine the price movements and prevent panic selling or irrational buying.

However, the major moves seen on Wednesday, with stocks opening as much as 44 per cent higher then losing all of their gains in an hour and continuing to fall further, indicates that support in prices has left the building. We are in a gambler's environment that risk intolerant traders should highly avoid. Although there will always be opportunities to make money, it appears it will be out of luck and not proper timing. A person that purchased shares on Wednesday morning would have lost half their investment before the trading day had ended. The inability of novice investors to understand irrational exuberance cannot be understated. Momentum is a greedy and risky game that always ends up in losses for the last man because the well of buyers eventually dries up.

History often shows that a mass entrance into an asset class coupled with significant volatility may well be the final period of upward momentum - the end of a bubble as they say. In this century, we have seen speculators hop onto the bandwagon of uranium, silver, potash, Bitcoin, and Internet stocks, just to name a few. The prices of most of these assets have broken down from their highs coinciding with similar mainstream euphoria we are currently observing. And major companies like Microsoft took 15 years to re-reach those prices.

Supported by the belief that regulatory bodies in Canada and the US will provide better access to marijuana and increase sales, as valid and factual as that may be, what many novice traders are ignorant of is proper valuation. On Wednesday, for a brief moment in time, Canopy Growth was worth $2 billion, doubling its value from Friday, which was also a record high.

The unicorn of the industry, earned $12 million Canadian in revenue over the last 12 months with a net loss of $3.5 million. Penny stocks are very hard to valuate because their projected growth in revenue are unlimited. In a decade, it is highly possible for this company to be generating over $100 million annually. Once it reaches maturity, to maintain its $1 bilion market cap, it would have to generate at least half a million in revenue per year or offer net income of around $100 to $200 million. Essentially, if you purchased the stock today, the company would need to grow sales more than 40 times to more accurately justify its current price. That's not to say the price won't climb to fresh highs. Growth companies are given heavy premiums, but long-term investors won't be finding any deals in the near future.

The industry itself is growing and the drug is more accepted. Money always trumps morals as some would argue, but governments acknowledge the reality that weed is a money-making machine, and there's a reason why so many gangs and illegal producers have lobbied to prevent and oppose its legalization. The truth is that these companies will make more money than they do today, but with low barriers of entry, the question you must answer is whether the value of a company's stock price will climb with the growth of these businesses and how will increased competition affect overall business?

Money managers, aka the professionals, are staying clear of the trade and will re-examine once euphoria wears off. Valuations are seen as "stupid" and that will prevent many of these stocks to price much higher without investment and price support from billions of dollars. Although we have seen some big bought deals worth at least $35 million, this could bode well, but cuts short-term prices.

To quickly explain, a bought deal is when an investment bank or firm secures shares from the company. However, the investing client is given a discount to the market price and they then attempt to sell shares to their clients or in the stock market. This could lead to a supply glut and undermine current strength.

Not all money managers are as concerned in the short-term. A Jacob Securities money manager believes and predicts "...there is a fundamental business to support here. People want recreational cannabis ... If you have a longer investing horizon then you’ll do fine — these stocks will be trading higher a year from now than where they are trading today."

Disclaimer: the author and its household do not own any nor are short stocks and industry related stocks mentioned in the above article and do not have any derivative positions.

Why Oil Will Never Push $100 Again

Bad news Alberta - stagnant oil prices are potentially here for a long time; multiple forces in play suggest this. Stability and low prices offer relief for consumers and businesses, but oil-dependent parties and organizations will need to adapt to the new reality.

An unofficial meeting between OPEC members on Wednesday September 28, 2016 showed some promise that a supply reduction was on the table, however the cut drops oil production to 32.5 to 33 million barrels per day, from the estimated 33.25 million currently being drilled. Although it is just a hair cut, it triggered a 6 per cent rise in the two sessions following. Prices are now back hovering near $50 a barrel again. That sounds great, right?

Well, these knee-jerk reactions allow non-OPEC members to re-enter the market even momentarily and elevate supply, a concern that plagues the industry. This has and will continue to counter any major bullish move in oil prices for years as long as OPEC maintains its strategy of capturing market share.

Take for example the promising run-up in oil prices in June and July of 2016 which created a pivotal situation. US oil rigs were moving conversely to crude prices. CNBC reported that when oil had reached $50 that spring, US oil rig counts were at their lowest. However, as they started going on line, persuaded and incentivized by higher prices, crude fell again back to $40 due to larger supply.

Unlike most consumer goods, oil and commodities are typically traded through futures and forward contracts. Producers secure prices months or years in advance. So, when oil surged for just one week, dozens of rigs were able to lock in $50-plus oil revenue.

According to the U.S. Energy Information Administration (EIA), in 2015, an estimated 93.88 million barrels of oil are consumed per day and supply amounts to 95.72 million. Even with the reduction by OPEC producers of at most 750,000 barrels per day, there is still more oil being supplied than consumed and nearly an additional 3 billion barrels of oil sitting in inventory as of year-end 2015; this represents 32 days of oil coverage (if all producers closed operations).

OPEC maintains its stance. It wants to capture global market share however it appears its strategy has changed with ministers in Saudi Arabia having been swapped. They are more inclined to support prices at current levels than to allow it to drop back below $30 - a price that still is profitable for OPEC members. We must acknowledge that prices around $70, what many consider the most efficient oil price in America, would be a level that introduces significant competition. The United States is number 2 in oil production and OPEC, to remain consistent with its strategy, must ensure prices do not reach that level for years to come.

Oil is also traded in US dollars and therefore, strength in the currency will reduce the price of oil in relation. Since the US Federal Reserve is looking to increase borrowing rates, which in turn increases the value of American currency, this does not bode well for oil prices. All things being equal, gains in the greenback as a result of interest rate hikes, increases in American investments, or economic growth reduces the price of oil in American dollars.

The current environment and conditions do not favour a sustained bullish move for oil and sweeping changes and renewed sentiment of oil ministers and OPEC will continue to keep prices at bay for many more years. Regardless of the tactics of the speculators that exist in the trading pit for energy derivatives, the reduced interest in oil trading only elevates the accurate pricing of supply and demand. And it appears that $45-50 US is where it will remain.