It’s always darkest before the dawn.
This melodramatic tautology originated in the 17th century. It has been popularized as a cliché for its psychological value.
It is just before the first rays of dawn when we have endured the darkness for the longest time. It’s a concept that has obvious relevance to markets – and investors.
It is generally at the very end of a bear market that we see “capitulation”: one last flushing of weak hands. The emerging cannabis sector has retreated to greater than two-year lows, completely defying rationality, even as the S&P 500 hits a new bubble-high.
With strong revenue growth and extremely bullish fundamentals, especially in Canada, a reversal is coming – as rising profitability in Canada’s cannabis industry collides with collapsing multiples.
Already, Canadian cannabis retail leader National Access Cannabis (CAN:META / US:NACNF) is trading at less than half current revenues. The Company reported CAD$61 million in revenues in its latest quarter. Its current market cap is an absurd CAD$29 million. National Access is also reporting strong gross margins (32%) and positive EBITDA.
Canada’s extraction leaders have transitioned to full profitability. MediPharm Labs (CAN: LABS / US:MEDIF) just reported its second consecutive quarter of positive net income.
Retail cannabis stores have (finally) reached a critical mass with over 700 cannabis stores across Canada. Store-openings are now accelerating. Cannabis 2.0 brings a vast array of new products and a 50% increase in the consumer base.
However, before all these strong, positive fundamentals drive cannabis valuations higher, there is one final “bitter pill” that investors (and cannabis companies) need to endure. Tax-loss selling.
In many ways, this is the bane of all long investors – even for those doing the selling. Locking in losses can be useful for offsetting capital gains. However, what is even more “useful” is for investors to avoid such losses.
Tax-loss selling is the choice to abandon hope of breaking even or turning a profit on a particular investment.
The sad irony is that it tends to be companies that have already fallen the longest/hardest that are then subjected to the most tax-loss selling. That’s true even if the underlying business remains strong. There is much less inducement for tax-loss selling for holdings that aren’t as far ‘underwater’.
With many individual cannabis companies having seen brutal selloffs, these companies are now prime candidates for end-of-year tax-loss selling.
This means that over the very near term, there will likely be even more weakness across most of the sector. But (as the opening cliché observed) it is an unavoidable reality. It will almost certainly get a little “darker” in the battered cannabis sector.
The flip-side of this is that many cannabis stocks that are already insanely cheap may still get cheaper.
This begs the question: should cannabis bulls hold off on taking advantage of extremely low valuations (now) in the hope they will go still lower?
There are still six weeks to go in 2019. During the last six weeks of 2017, the entire sector doubled.
The spike in 2018 started in the second half of summer. The last spike in cannabis stocks started (literally) the first trading day after Christmas.
Obviously, market dynamics are much, much weaker today. But industry fundamentals are much, much stronger (especially in Canada).
Because of this, many prudent investors may choose to adopt a hybrid strategy with respect to investing in cannabis stocks.
They will add to their favorite companies now, so that the train doesn’t leave the station without them. But they will “keep some powder dry” as we move into the beginning of 2020.
The brutal (and artificial) trough in cannabis stocks cannot continue. However, it’s still premature for investors to go all-in in their cannabis investing.
DISCLOSURE: The writer holds shares of MediPharm Labs.