As of today, the large capitalization S&P 500 Index is now 19% off its Feb. 19, high; the smaller cap Russell 2000 Index is officially in a bear market at 26% off its Jan. 17 high, and the 10-year treasury yield is only 0.86% versus the 2.63% yield one year ago.
The average cannabis stock that we track is down 76% from its 52-week high.
What does this all mean for cannabis investors and executives?
Stocks down, but underlying business and long-term thesis intact
There is a big difference between the performance of the cannabis stocks and the underlying cannabis businesses.
While strong operating performance usually leads to higher multiples and stock prices, this is not always the case – especially when an external shock to the markets (such as COVID-19) leads to rapidly declining multiples to account for higher risk.
While the underlying business may be fine, the valuation multiples ascribed to the business will decline as broader market multiples decline.
The EV/EBITDA multiple of the S&P 500 Index has declined from 13.8X on Feb. 21 to 11.8X on March 9 – a 17% decline in what the market will pay for EBITDA, regardless of any changes to actual EBITDA.
The trend is similar on earnings per share.
Similarly, as shown in our Cannabis Comp Tables, the EV/EBITDA multiple for U.S.-focused vertically integrated operators has declined by 24% to 9.9X on March 9 from 13.0X on Feb. 18.
Generally riskier companies (such as cannabis) will move up and down more than the broader market and less-risky stocks (this can be quantified as a stock’s beta), but when the market shifts to “risk off,” or taking lower risk by reducing multiples, it will hit riskier investments harder.
Companies that also have more debt (and remember, sale-leasebacks really are a form of debt) also will see their equity prices move around more, given that the value of the debt (or the 15-year lease expense) is fixed; the equity takes the change in multiples.
It is no surprise that the least risky assets, such as U.S. Treasury bonds (i.e. lending money to the U.S. government, which can always print more money to repay), have increased in value.
While cannabis stocks have seen expectations reduced from far too optimistic projections, and the markets are ascribing lower multiples to all cash-flow streams because of rising risk, underlying cannabis sales continue to grow rapidly and nothing has changed the fundamental investment thesis:
Increasing legalization and social acceptance of a heretofore outlawed consumer and medical goods will result in years of profitable growth as the legal commercial market:
- Replaces the proven illicit market.
- Grows via increased use by nonusers, gaining share from existing pharmaceutical, alcohol and wellness markets.
If you generate cash, you can ignore short-term capital market volatility
Private market valuations are informed by the public market – but if a company generates cash, it doesn’t need to care what the public markets are doing.
The public markets could close, and a cash-generating company would still be fine generating its cash internally and operating its business. This business would be sustainable and give its owners the freedom to reinvest the cash or wait for public markets to ascribe a higher valuation.
The true business model of many cannabis companies was to sell their cannabis companies, rather than cannabis itself. The land-grab model relied on the assumption that someone else would buy the footprint one day, while investors would always fund losses in the interim rather than ever generating cash from operations.
This model won’t work in the current environment.
Advice for investors and companies
• Reassess your risk tolerance and investment horizon to see if there is an opportunity to better match those two factors with your current portfolio.
We are not suggesting that anyone sell or buy any particular security. What we are suggesting is to understand what amount of downside you are willing to bear over what time period and still be able to reach your long-term goals.
People rarely complain when they gain from taking too much risk, but it is still a poor decision regardless of the outcome. One must separate the outcome (making or losing money) from the decision (the amount of risk to take).
If you don’t have that level of confidence, reassess your risk exposure and develop a plan to build a portfolio that allows you to remain patient and disciplined when short-term panic or exogenous events drive the market down.
If the quality of companies you own gives you confidence that short-term market movements and exogenous shocks like COVID-19 will have minimal long-term impact on the performance those companies, then stick with your long-term investment process and discipline.
• Look for opportunities amidst the declines. The same businesses are now 24% cheaper, while the long-term opportunity has not changed.
• Ask: What is the true source of the investment’s return? Will the business generate $1 million of cash profit per year selling cannabis, or are you hoping that someone buys it for $20 million? The former lets you control your destiny, the latter relies entirely on hope – and hope is not a strategy.
Cash generation is its own return and gives the company control over its own survival.
• Look for companies that do not have a lot of debt. This will support the survival of the equity and provide capacity to raise debt in the future. Regardless of the size of an opportunity, only equity that can survive a capital drought will survive to realize it.
• Look for companies with profitable divisions – even if the overall is unprofitable – to focus on shifting the loss-makers to profitability or shut them down. As we outlined at our conference in December, seeing at least some profit lets investors value the current profit and the potential opportunity separately.
• Analyze your investments the supply chain. Your investment could be well-run, but it could still suffer if suppliers or customers run into problems.
Craig Behnke can be reached at firstname.lastname@example.org.
Mike Regan can be reached at email@example.com.