Why Marijuana Stocks Are Risky

May 14, 2019

Ben PhillipsNot everybody is bullish on marijuana. Ben Phillips, Chief investment officer of EventShares, warns investors to remain cautious on the burgeoning sector, because should cannabis ever be legalized in the U.S., "every incremental piece of demand will be met with oversupply."

Phillips is the portfolio manager for the $19 million EventShares U.S. Policy Alpha ETF (PLCY), a unique fund that tracks companies exposed to changes in U.S. government policy and regulation. The ETF takes long and short positions in companies exposed to several public policy themes, including innovation in health care, defense appropriations, infrastructure development and more.

Though PLCY's investment committee tracks cannabis regulation as a potential investment theme for the fund, the committee has decided to hold off on investing in any marijuana stocks for now. ETF.com recently chatted with Phillips to learn why.

ETF.com: Most analysts these days are bullish on marijuana's investment prospects. Why do you remain cautious? 

Ben Phillips: It’s a function of the investable names out there in cannabis. We've narrowed it down to a universe of six [companies] that we think are legitimate, well structured and investable. But then we look at traditional valuation metrics. And even if we assume very large growth numbers, they're still trading at multiples of higher revenue than EBITDA [earnings before interest, taxes, depreciation and amortization] and other metrics.

So, yes, there’s an opportunity here. There’s a policy push, with the states leading the way. But long story short, we think the fundamentals just aren't supporting investments in these stocks. A lot of them are better shorts, in our view. You'll get better opportunities to buy them at lower levels, we think, especially in a downturn.

This is a money play. Enthusiasts are investing in it, and that could wane in a downturn when you have some of the retail money exit the sector, even just temporarily. That'll cause pressure on the sector.

ETF.com: How have you expressed this view within PLCY's portfolio?

Philips: We're a long-based fund, so we look for ways to play a policy inflection that's going to be supported on a fundamental long basis; for example, we rarely do single-name shorts.   

Marijuana stocks are really volatile, and they're not really being driven by the fundamentals. They're being driven purely by sentiment. They're not being driven by policy changes either. So we generally don’t want to step into a situation like that. Cannabis falls into the category of “just avoid for now and watch.”

ETF.com: So what question do you think investors should be asking themselves about the marijuana space that they're not?

Philips: "Are you evaluating the supply side of the equation?" Because everyone's, like, "demand, demand, demand!" and throwing out different big numbers on what that demand is. Sure, demand is great. But there's always supply out there to match it.

Marijuana takes four to six months to go from initial plan to harvest. That's a very short lead time. It’s a very productive crop that grows fairly easily, if you know what you're doing.

Think about just a few acres of cornfield converted into outdoor cannabis. Take Missouri, my home state. There's very fertile land that’s very good for growing a crop like this. And then there are all the zones that can easily convert for a higher-margin crop.

There's just going to be constant oversupply that will keep pushing prices down. We’ve seen it happen. When recreational [marijuana is federally legalized], the price drops 25-50% from the prior year:

 

Chart courtesy of Ben Phillips, EventShares. Reprinted with permission.

 

If marijuana becomes legal on a federal level, every incremental piece of demand will be met with oversupply, in our view. There's going to be a constant price pressure pushing down on the wholesale side: It'll be on the price of the crop, initially, but also it'll play out through the entire supply chain, impacting not just growers, but retailers who now have a lower price point and have a lower margin.

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