"Gateway Drug" to Profitability?

This report discuses some investment prospects in regards to marijuana. A friend asked me to do a quick analysis on a Canadian company that specializes in medicinal cannabis. I thought it would be even more beneficial to post this analysis for those who are interested in taking the plunge in this up and coming industry or who are unfamiliar with the topic.

I hope you find this interesting and

informative and if anyone has stocks that they want me to look at, feel free to email me at mawukogolokuma@gmail.com. I would love to give you a hand. So without further ado let's “weed” out the competition!

Marijuana Analysis

To begin, I will talk about the catalysts that have the potential to drive or inhibit an investment in marijuana.I will than guide you through my fundamental analysis where I will give my top marijuana pick!

-According to an article by CBC from 2015, 20% of Canadians smoke marijuana, and this number is expected to grow after it is legalized

 

-It will be good for the economy, due to the fact that weed, like any other legal product, will be taxed, which will further stimulate the economy creating another revenue stream for Canada from a macroeconomic perspective

 

-Marijuana is already legal in some states in the USA like Colorado, California (population greater than Canada) and a few others. Already, we are seeing revenues of over six billion dollars, and these projections are expected to grow

 

-Marijuana has amazing health benefits, aiding in cancer treatment, migraines, MS, turrets and many other health issues.

 

-Recreational use will most likely increase after legalization as well, especially in places like Ontario and BC, who have the highest percentages of marijuana consumers nationally.

 

-I am sure there are many more benefits but these are the ones that truly stick out to me, especially the extraordinary medical applications that have seemed to be silenced by the media

Positive Catalysts
Negative Catalysts

-If weed is for some reason not legalized in Canada by 2018, your investment will go to ZERO

-From a finance and risk management standpoint, it is HIGH RISK, but I will get into that a bit later

-Regulation of the substance consists of many factors, from advertisement, impaired driving and underage use.

 

-If Canadian governments at all levels can legislate it and insure no negative consequences can come from selling it legally, you have the opportunity to invest in an untapped market that is growing, and growing fast!

Fundamental Drivers

In my opinion, stock price is driven by 3 main factors: Risk, Growth and Profitability.

 

Out of all the companies I looked at, I narrowed it down to 3 Canadian companies: Aurora Cannabis, Aphira and Canopy Growth, for one simple reason: THEY ARE ALL TRADED ON A PUBLIC STOCK EXCHANGE.

All the other companies I have looked at are traded OTC, which means over the counter. Typically, these companies do not have a lot of longevity and tend to take a lot more due diligence and require timing the market (securities on this exchange usually consist of penny stocks). That is because analysts haven’t really looked into them as much as companies that are publicly traded. You can still make money off of them but they are extremely RISKY! The companies that I have chosen, even though still risky, have less of a chance of going to zero than those that are OTC.

Fundamental Analysis

1.Aurora Cannabis(ACB.V)

Out of the top 3, this stock is undervalued, which means that the market has priced it below its intrinsic value at a current P/E ratio of 34.71, the lowest amongst the three. Stocks with a low PE ratio are stocks that tend to have high growth in terms of earnings, so this is very exciting, especially if legalization happens. It is also a small cap company, and generally, these are the kinds of stocks that have large returns in the short term. I have not forecasted the forward P/E for the next 12 months, but after legalization, this number should increase, so it is definitely a good idea to get into it early.

 

Furthermore, I have calculated annualized returns for each of these stocks to give a holistic picture of the types of returns you should expect if you had held this stock for a year, given historical prices. Aurora Cannabis had an annualized return of 41.73% compounded daily, and this would have been before legalization. The day that I wrote this report, the stock was up 6.58%. Essentially, if I bought 1000 shares (That day it closed at $2.59 and I’m excluding commission costs for simplicity) my market value would be $2590.00 and you would have finished the trading day with $2760.42. You made $170.00 in one day by just holding a penny stock in your portfolio (In my opinion, you should never hold a penny stock unless you are absolutely sure about the investment)!

 

But unfortunately, this was not my pick for one simple reason: Profitability. This company and many other marijuana companies are losing money and therefore, cash flows, which is a key part in not only my valuations going forward, but also the ability for the stock price to increase. So even though this stock is undervalued, it is not profitable long term, especially if marijuana is not legalized. And with negative profitability, there is negative return on equity, which is important in determining long-term earnings growth. This company, as well as most small caps, also does not pay a dividend, so you are only relying on capital gains from the asset itself, which can be risky if the stock market does not do well, as well as the stock itself.

 

Lastly, I want to talk about the stocks relative risk to the market. In finance, we use a metric called beta, which measures how sensitive a stock’s return is to the  overall market. A beta less than 1 signifies that your asset is less risky than the market, a beta greater than 1 indicates an asset that is riskier than the overall market. Aurora Cannabis currently has a beta of 4.34, which is the highest beta I have ever seen from any stock I have looked at, regardless of industry. I use this metric to project expected returns for the stocks I’m invested in so a high beta can be good if the market is booming, but if the market is down, your loss well be amplified greatly. When I see a beta around 2, I start to get worried. Also, the volatility of the stock, which is it’s own individual risk, is over 50% annualized, which is also quite high.

 

Aurora Cannabis has partnered with a German company called Pedanios which should provide potential for expansion into the European markets, as well as improving their profitability overall  in the long term (Pedanios has a strong retail of presence with 750 pharmacies). So it is not a bad pick, but something that I personally would not recommend until I see positive cash flows and lower idiosyncratic and systemic risk.

2.Canopy Growth Corporation(WEED.TO)

. This company is slightly larger than Aurora Cannabis at a 1.36B Market Cap, but again profitability is a major issue here. In terms of market risk, it is less than Aurora Cannabis with a beta of 2.79, but that is still way to high by my standards. Volatility is still an issue at 42.39% annually and again we have a company with negative ROE that shows the company struggles to grow earnings from their own equity investments.

 

This stock also doesn’t pay a dividend so you also lose that extra yield if the market does not perform. This company is also overvalued at a P/E of 59.07, but because of negative earnings, P/E is also negative, which really doesn’t present a good picture for a long position. It does have a very appealing ticker symbol though, which could help promote the brand of this company and the company does have a partnership with Snoop Dogg as well.

3.Aphria(APH.TO)

My pick for you is Aphria, and I will tell you why. It’s about the same size as Aurora Cannabis at a Market Cap of $855.341M. But the best part about this company is that it is making money! Profit margins are 20.54%, which is fantastic. These are the kinds of margins we see in companies like Apple and Facebook (This is just to give perspective, these companies are in different sectors). ROE is also positive, which implies that if this company continues to use their equity well, we can already predict an earnings growth rate of 2.72% annually (assuming 100% retention of earnings since they also do not pay dividends), and that is all before legalization.

 

Also, the fact that this company specializes in medical marijuana also excites me and should be able to drive sales, as well as the other diversified recreational products in it’s portfolio.

 

This company also has the highest annualized return out of the 3 stocks I picked, with a return of 62.81%. In regards to risk, this stock is still highly volatile with a risk level of 58.32% annually, but relative to the market, its beta is very attractive. Various sources give this stock a beta ranging from 0.77 to 1.22, which is the safest stock relative to the market out of the 3 picks. So based on those metrics, Aphria is my top pick. Despite its overvaluation, I believe it is justified by its performance alone in such a risky industry this early in the weed game.