Stay clear of marijuana stocks and their crazy valuations, this investor says

Canada’s marijuana stocks may be trading sideways over the past few months, but there’s still a lot of investor interest out there —look no further than earlier this week when three pot stocks were tops on the TSX in terms of trading volume.

But the spell cast over investors keen to get in on the modern day green rush is to be avoided, says Ryan Modesto, CEO of 5i Research, who argues that investors a key fact often missed is that, ultimately, cannabis will be commodified, meaning that the high valuations currently attributed to Canada’s pot stocks just don’t make sense.

Well off their December and January highs, marijuana companies are still clamouring for space in the lead-up to rec cannabis’ legalization, set for late summer. The Marijuana Index, which charts the top 25 cannabis stocks in Canada, now boasts five companies with market caps over $1 billion and a sixth (The Hydropothecary Corp) almost joining the club.

And the lead companies like Aurora Cannabis and Canopy Growth Corp are likely only going to get bigger as M&A activity heats up in the space. Aurora has been one of the more visible players, this year acquiring both CanniMed Therapeutics and MedReleaf Corp., with a number of other middling companies said to be ripe for acquisition.

But with only weeks to go until legalization, much is still unknown about how Canada’s pot industry will shake out. One hanging issue that should be on investors’ minds, says Modesto, is the likelihood that marijuana will become a branded retail product like alcohol or more of a commodity like corn and soybeans. For his part, Modesto thinks it’s the latter, and thus, all those promises of huge profit margins go up in smoke.

“These companies are priced for probably better than perfection,” says Modesto, in conversation with BNN Bloomberg. “At 11x sales, with all the uncertainty, you’re really expecting probably everything to go right for these companies.”

“We think that the big point that maybe gets missed, more for the ones that are going to be serving the retail space, is that it’s looking like it’s going to be a commodity product,” he says. “They can’t do branding, they can’t differentiate themselves easily on the retail side of things, and when you have a commodity product that means you have low margins. Typically commodity companies don’t get 11x sales valuation.”

Some see cannabis licensed producers as likely to grow their product for under $2 per gram, thus allowing for enticing numbers when compared to the $7.50 – $8 per gram being floated as potential selling prices for legal weed. But commodities producers operate on profit margins much smaller, typically in the one to two per cent range (or even less).

“It’s going to be a big market, it’s going to be a big space, and there’s lots of return potential, but we just think there’s too much uncertainty to call it an investment at this point,” says Modesto.

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