This story was originally published in the Daily Maverick on 20 June 2023.

As a Canadian who lives in South Africa, I still enjoy visiting the cannabis section of Nova Scotia Liquor Corporation (NSLC) stores when I am back home. The sheer novelty of the experience has not worn thin yet for this correspondent. The staff are friendly and helpful, and the wide product selection ranges from prerolled joints to loose grass, vape products and edibles with various levels of THC – the stuff that gets you stoned.

It’s just fun to browse and chat with the staff.

“What do you want it for?” the young lady behind the counter asked me while I was checking out the edibles. Such questioning can help to inform your purchase. Do you want to relax, or something to help you sleep?

“I’d like to get stoned,” was my reply, and I can reliably report that the raspberry-flavoured sativa gummies I purchased did the trick.

As social policy, legal pot simply makes sense. The “war on drugs” has been an utter failure, and enforcement in both the US and Canada has been long tainted by racism. Millions of adult Canadians consume cannabis, with 27% of those over the age of 16 reporting they had used it within the past 12 months, according to the Canadian Cannabis Survey 2022. And adults should not be treated as criminals for doing so. Like alcohol and tobacco, which are far more addictive and damaging, regulating and taxing cannabis is just a no-brainer.

Against this backdrop, one might reasonably assume that there is a compelling investment case to be made for cannabis stocks. Pot is now completely legal for adult recreational and medical use in Canada, and 20 US states have decriminalised marijuana on one or both of these fronts. There is significant demand for the product and it is probably “recession-proof”. Surely there is money to be made throughout the value chain, and as a legal industry it is still fairly new and exciting.

Well, that bubble has well and truly burst. If anyone with a portfolio of cannabis stocks tells you that it is performing well, that is probably a reflection of the performance of their own stock of cannabis.

Cannabis shares pretty much across the board have simply collapsed.

Take the Global Cannabis Stock Index, which is tracked by New Cannabis Ventures, an industry newsletter. Launched in 2013, in early 2014 it scaled a record peak of about 930 points. It is now in single-digit territory below 8 points. As the regular writer for this column might say, I am not making this up. In the space of just over nine years, it has shed about 99% of its value.

The cannabis index for the Toronto Stock Exchange (TSX) has also cratered in spectacular fashion, losing about 90% of its value over the past two years.

In hindsight, it seems that much of the initial hype around cannabis stocks was rather like an epiphany that strikes after a good joint. At the time, the concept seemed blindingly brilliant. But the next day, if you can recall it, the idea will not hold up to sober scrutiny.

One thing that is gin-clear is that initial valuations for cannabis companies were completely unrealistic. This is partly no doubt a consequence of an industry that is brand new. There is simply nothing to really compare it to, such as a peer that has been trading for years. Listed alcohol or tobacco companies might offer some guidance, but the products are ultimately different.

The best explanation for the cannabis crash that I can find dates back to February 2018, a few months before legal pot began retailing in Canada. It is a report by Scott Willis, head of research at Grizzle, a cannabis-focused investment analysis firm, called “Up in Smoke: The Overvalued Haze of Marijuana Stocks.”

“Euphoric retail and institutional investors have stratospherically bid up the sector, diving head first into rich equity offerings that will in aggregate allow licensed producers to grow 2x the peak amount of marijuana this country will ever need,” the report says.

The report highlighted “three inconvenient truths”:

1. Legalisation of marijuana always equals price deflation.

2. Black Market Inc. The biggest competitor no one wants to talk about.

3. Extreme valuations are reminiscent of the 2010 rare earth bubble.

“The marijuana oversupply is going to push retail and wholesale prices down by as much as 50% within 12 months of legalisation. In every legal market, retail and wholesale prices peak near the date of legalisation due to a lack of supply and then quickly begin to fall, driven down by new entrants into the market and a rapidly expanding production base. The ability to grow plants at home along with significant grey and black market supplies puts a ceiling on prices even if Canada severely restricts production licences,” the report said.

And that is pretty much what happened – the market has been oversupplied and prices for producers have tanked.

“The marijuana market is mature with black market supply already exceeding demand [Canada exported 20% of marijuana production in 2017]. Legal supply will have to successfully compete on price to take away market share. Stock prices are implying the impossible: that both stable pricing and exploding volumes can occur at the same time. You can’t have both in a mature commodity market,” the report cautioned.

That warning also proved prescient. The illegal market has not evaporated and plenty of Canadians are still relying on their old dealers, who don’t have to fill out reams of paperwork for Health Canada to get in on the action.

“Marijuana stocks are trading on 2019-2020 EV/EBITDA multiples of 48x and 18x, respectively, in the 98th percentile of multiples across all stocks in North America – implying extreme levels of overvaluation,” was the report’s third major point, noting that this state of affairs mirrored the rare earth minerals bubble of 2010.

So, is there value in cannabis stocks? Well, there is perhaps a buying opportunity in a market that has lost between 90% and 99% of its value. But the valuations that were obtained a few years ago are unlikely to be reached for a long time.

That doesn’t mean that legal marijuana is a bad idea. It just means that its investment case is wanting. As the Dude in The Big Lebowski would say, “This is a bummer man.”

Perhaps the broader point is that social policy should not be informed by its economic potential, and that one should be cautious about investment decisions that are based on changing social policy. If cannabis legislation in South Africa ever paves the way for a wave of listings on the JSE, beware.

Good investing,

Ed

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