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Pot Stocks: Could They Save Your 401K?!

It could be a $146 billion sector in less than a decade, but for investors whose interest has been piqued by cannabis stocks, there is still no reason to rush into the publicly traded companies.

For the first time since Canada legalized recreational cannabis, pot stocks are reporting earnings. While cannabis company revenue is up, share prices continue to come down. Long-term investors should not be convinced that it is time to buy on the dip. And the dips have been big.

Over the last three days, some of North America's largest cannabis companies saw revenue soar — Tilray, Aurora Cannabis and Canopy Growth grew top line by 85 percent, 260 percent and 33 percent, respectively. But these cannabis companies continue to lose money.

Tilray: a net loss of $18.7 million for the third quarter. Canopy Growth: a net loss of $330.6 million. Aurora: a $112 million operating loss. While recreational cannabis use wasn't included in these figures, the numbers show that Canadian cannabis companies are spending far more than they're bringing in.

All three stocks were down by at least 10 percent on Wednesday, with Canopy suffering the heaviest losses. The marijuana ETF, the ETFMG Alternative Harvest ETF (MJ), was down 7 percent. MJ is down 21 percent in the past month and was down about 5 percent for the year through Tuesday, according to Morningstar data.

"Costs are still going up faster than revenue," said Scott Willis, head of research at Grizzle, a New York-based investment research company that studies cannabis companies. "They haven't turned the corner."

Even with the steep losses, the MJ ETF is still taking in money — $100 million in the past month and more than $700 million this year. That makes it the most popular consumer sector ETF in 2018, according to data, beating out consumer sector giants like the Vanguard Consumer Staples ETF (VDC) and Consumer Staples Select Sector SPDR (XLP).

While some companies are starting to see the size of their losses slow, not one is profitable, and it could still take some time before they start making money.

These companies are better at growing their bank accounts than cannabis

Widespread shortages, bungled rollouts — in Ontario, Canada's most populous province, people must buy cannabis online, and some have had to wait two weeks to get product — and still-in-production greenhouses have made the legalization dream more of a nightmare.

"Canadian producers have been better at growing their bank accounts than growing cannabis," said Alan Brochstein, a portfolio manager and author of the 420 Investor newsletter.

It doesn't help that cost-per-gram is falling as Canada's provincial government is buying product in bulk and at their set prices. (Canada's cannabis companies can't sell directly to retailers.) Tilray's average per-gram price fell to $6.21 from $7.53.

Many of these businesses experienced a massive run-up in their share price — the Marijuana Index is up about 538 percent over the last three years. But positive political headlines aren't business reality.

"It's ironic because it's been such a great year for the industry with legalization," Brochstein said. "But it's also been disappointing."

Investors in early have made tons — the rest can wait

Investors who bought in early still have made a boatload of cash, but those wondering if they should buy now better hold off, Willis said. He said prices could fall by 60 percent from where they were trading before legalization day. Noted short seller Andrew Left of Citron Research is short Tilray, Canopy and Cronos.

It will still be months before Canada's pot companies produce enough to meet what appears to be strong demand. Until then, they'll be spending big money on developing larger greenhouses. For instance, in August, Aurora announced it was starting production on a 1.2 million-square-foot facility, which will take months to build.

These companies also are still trying to figure out how to market their products, while edibles, which is expected to be a $4 billion industry worldwide, according to Arcview Market Research, isn't legal until July 2019. The black market also offers more choice, cheaper prices and faster delivery.

"The black market still has a good foothold, because of some of the government's missteps," Willis said. "There are delivery services that will come to your door in 10 minutes and have lower prices, so it's going to take some time for this to work itself out."

Stocks may drop further after the government provides cannabis sales figures at the end of this year or early next. Those numbers won't be as strong as people had hoped, he said.

Investors need to remember that this is a new industry and Canada is the first G7 nation to legalize the drug, so hiccups are to be expected. Both Willis and Brochstein think the long-term opportunity is huge, with Grand View Research saying the global pot market will be worth $146 billion by 2025.

For things to really take off, though, other countries need to legalize weed. Canada, with 35 million people, is a decent size, but it's small compared to everyone else. If the U.K. legalizes marijuana — and the country did just start allowing doctors to prescribe it — and Germany comes around, and if the United States legalizes it on a federal level, then it becomes an industry on par with tobacco or booze.

It will still be years before this happens, but Canada's foray into legal weed should push other countries to get there faster, Willis said. "The U.K. did an about-face; it flipped in three months from not allowing medical prescriptions to allowing them," he said. "That shows the power of what Canada has done."

Even if you believe in the long-term opportunity, Willis suggests waiting until the second half of 2019 to buy in. Valuations are still too high, with some of the big companies trading between 20 to 55 times earnings, but they will come down over the next few months. Eventually, they should be more in line with tobacco and alcohol businesses, which trade at around 10 to 14 times earnings.

Any investor feeling the cannabis itch should consider some opportunities in the United States, which is less regulated than Canada. American companies have fewer restrictions on how they can market their wares, and they have more strains to sell. They're much smaller, so they carry even more risk, but companies like MedMen or iAnthus, which have operations in multiple states, trade at lower valuations than their Canadian counterparts. Both are down 7 percent on Wednesday, but still up on the year.

"They're expensive, but it's not as crazy," Willis said. "It's kind of like Canada in 2013."

Willis said the best advice is to look for the lowest-cost producers — it is currently Aphria in Canada – and for businesses that seem to be closer to generating a profit. Tilray had the smallest net loss among the big three reports this week, though its loss did widen from the year-ago quarter. Willis said none of them are close to making a real profit. Aphria is the closest to breaking even and should be generating net income by the second quarter of 2019 (June-ending quarter). Canopy is the farthest away from breaking even.

The best advice for investors determined to bet on the cannabis sector: Be patient.

"This is a long-term story," Brochstein said. "It's a huge market, and things will get better."

Top 10 holdings in MJ ETF

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