Cannabis stocks are due for a big pullback: Raymond James

Expect a cannabis sector sell-off over the next few weeks, says Raymond James analyst Rahul Sarugaser, who delivered an industry report on Monday. Sarugaser said Canadian names may be hit especially hard but that improving fundamentals in the Canadian market mean a buying opportunity should emerge.

Cannabis has been the hot ticket for a while now, where stocks in Canada and the US started to bolt ahead as far back as April 2020 without much letup. Importantly, the US Presidential Election in November and then the Senate run-off in January added fuel to the fire, as investors started to put greater faith in legislative reform at the federal level. That, the thinking goes, would pave the way for not just US cannabis companies to expand and solidify their operations but for Canadian LPs, as well, who are patiently waiting at the border with their plans to conquer US markets.

The cannabis sector had its reckoning in 2019, with stocks across the board suffering big pullbacks as confidence in the market expansion both north and south of the border seemed to wane. But 2020 was a different story, with US companies like Curaleaf (Curaleaf Stock Quote, Chart, News, Analysts, Financials CSE:CURA) and Green Thumb Industries (Stock Quote, Chart, News, Analysts, Financials CSE:GTII) making great strides not only in share price but in their respective build-outs across the country and Canadian names like Canopy Growth (Stock Quote, Chart, News, Analysts, Financials TSX:WEED) and Aphria (Stock Quote, Chart, News, Analysts, Financials TSX:APHA) rebounding nicely, as well.

Indeed, cannabis was Canada’s best-performing sector just last week, Sarugaser pointed out, where it returned 38 per cent, which was twice as much as the next best sector, biotechnology at 19 per cent. Cannabis also captured over five per cent of total weekly trading volumes on the TSX last week for the first time in recent history.

But the fun may be over for a while, according to Sarugaser.

“Now that the fullness of the U.S. election is behind us, we believe the primary catalysts driving near-term strength have played out, and we anticipate some weakness over the next few weeks,” Sarugaser said.

The analyst pointed to three main factors: profit-taking after the massive run-up; the fact that although institutional investors are now taking notice of the sector, they are likely to remain on the sidelines in the near-term, waiting for a pullback; and the fact that it’s likely to dawn on investors that cannabis reform in the US will actually be a lengthy, time-consuming process rather than an overnight affair.

“Until a fresh stream of cannabis-positive news events presents itself — e.g., strong earnings, major sector consolidation, wildcard cannabis legislation — we believe the next few weeks will see some wind coming out of cannabis stocks’ sails,” Sarugaser said.

“In particular, we believe Canadian cannabis stocks could see a rather significant pullback; excepting Canadian LPs with direct operational through-lines to the U.S., investors may (should) begin to realize that the prospect of U.S. cannabis reform benefits Canadian companies very little, at least in the near-term. The direct beneficiaries here are the U.S. MSOs,” he wrote.

Sarugaser advised that near-term weakness would represent an opportunity for investors to “slowly accumulate positions in top Canadian operators, motivated by the improving fundamentals in the Canadian market,” pointing to the fact that Ontario added over 100 cannabis stores over the past two months, with 1,485 stores now open across the country compared to about 400 last summer.

The analyst also noted the SAFE Banking Act in the US as an X-factor in the drama. The Act, which passed the US House last September with bipartisan support, would give US operators access to banking services, potentially ushering in “a wave of institutional capital” into the sector, according to Sarugaser.

“SAFE Banking being considered by the newly Democrat-controlled Senate—and so soon —would, we expect, provide a significant shot in the arm for the cannabis sector, demonstrating that cannabis reform is, indeed, on [President-elect] Biden’s agenda,” Sarugaser wrote.

“We anticipate the news would, at the very least, temper a cannabis sector sell-off during the next few weeks—if not drive material strength—in the time intervening the stimulus bill’s disclosure and its consideration on the House floor. This said, we expect a long wait between any reform’s announcement, acceptance, and enactment, which may cause cannabis stocks to drift downward,” he said.

As for Sarugaser’s best picks in the Canadian market, the analyst delivered a report on January 11 where he gave the nod to both Village Farms (Stock Quote, Chart, News, Analysts, Financials TSX:VFF) and Cronos Group (Stock Quote, Chart, News, Analysts, Financials TSX:CRON). On Village Farms, Sarugaser said it’s the fastest-growing cannabis company in Canada and now has the fourth-largest share of the national market, with operations in the US as well. On Cronos, Sarugaser said it looks to be on the beginning of a material upswing over the next 12-24 months as the company and its large cash reserves and CPG equity partner Altria look to break into the US market.