This is a follow up to our Cannabis Podcast on December 8th 2018 which you can listen to on our Podcast page.
What really separates speculation from investing is the amount of risk associated with an instrument, company or other equity. The market considers US Treasury Bonds the most stable investment and that becomes a basis of investment return when considering risk/reward. It is considered the “risk free rate”.
Investment vs Speculative According to SC:
Companies like JNJ, MMM, P&G and KO all have a 60 year history of dividend increases. They are relatively less risky than other stocks, and pay a return in the form of a dividend to investors. These are about as close to US treasury bonds in the stock market as you are going to get (with the exception of corporate bonds). They have a long history of annual dividend increases, and are well branded into the market. They have consistent Free Cash Flow so we consider these types of stocks “investments” for the long term investor. Often these are referred to “value stocks”. Investments have a history of profits, free cash flow, and pay a dividend.
Speculative stocks, assets, or junk bonds, carry a high risk of default. In other words they are closer to gambling than investing. There is also the potential for high rewards if they are successful. Great reward comes with great risk. You must be able and willing to ride it to zero, with the exception of junk bonds. The moves are erratic and you can not be scared out of a position. We mention junk bonds as an example as there are benefits to owning junk bonds, but this is for another article and these are mainly for larger investors.
There is also the in-between. Equities that tend to lean one way, but are not entirely speculative or investment, they are a bit of both. Companies like Amazon, AMD & Netflix are examples of stocks that are more speculative and XOM, NVDA, and DE are more investment grade yet they are prone to market cycles and hence fluctuate.
For Investments we look for return in the form of a dividend or price appreciation over the longer term. Speculative equities we are looking for growth and the potential to move closer to investment grade in the future.
Then there is gold and silver, which I consider an investment due entirely on a 5000 year history of being a store of wealth. There are some that argue metals are not, but the history is there and history repeats.
TO BE PAINFULLY CLEAR – CANNABIS STOCKS ARE COMPLETELY SPECULATIVE AND SHOULD BE TREATED AS SUCH! YOU CAN LOSE YOUR ENTIRE INVESTMENT HERE, THERE IS NO SAFETY NET!
As we mentioned numerous times, and again on our podcast, we completely separate our investments from our speculative portfolio. I personally allocate an amount of capital towards a speculative asset class and that is it. At my age, about 20% of my assets are in speculative asset classes. This does not mean 20% in cryptos, 20% in cannabis, and 20% in speculative stocks; this is a total 20% in all speculative portfolios combined. The younger you are the more aggressive you can be as you have more time to recover from a complete loss. The older the less risk you want to assume with your sweat equity.
The strategy I have with any speculative asset, is to get my capital out when I can, not when I have to. Whether it is cryptos, stocks, or cannabis, I want to remove the risk as soon as possible, not ride it up to give it all back. We did this last year with our crypto portfolio when we started trimming out positions from December to February. We removed some risk, which provides opportunity now that the market is beaten up and sentiment is low.
Difference in Fundamentals:
Ok now that we have defined our objective and how we allocate capital to asset classes dependent on the risk profile we can go into what we look for in potential cannabis stocks.
When looking at Cannabis stocks from a fundamental standpoint, they are completely different than how we would look at a stock like NVDA. There we look for FPE, Cash flow, Cash to Debt, EBITDA, PS, PB, TBV, Dividend and share buy backs. The typical Graham or Lynch models.
With Speculative stocks we look for growth and the potential to become an investment. So the fundamentals are entirely different, but there are still fundamentals.
It’s all about Growth:
- Revenue growth – We are looking for revenue growth that exceeds it’s industry peers.
- Price to earnings Growth ratio or PEG. – We want to see the PEG ratio under it’s industry peers.
- PE – It does not matter, but if you start to see it coming down, this can be an early sign the momentum is waning
Keep in mind most Cannabis companies do not use GAAP and include biological inventory in their revenue stream. This can be misleading and result in margins that exceed 100%. In addition be aware of stock options and warrants that can dilute common shares. There are also reverse mergers, and other means of raising capital outside more traditional methods. If you are unaware or do not understand these items it is a good idea to do some homework before investing.
Reverse mergers are not entirely a bad thing, and are common in growth areas where time is of the essence or there is a tax advantage. However they should throw up a red flag, as they can bring about un-foreseen liabilities decreasing the value of a company. Private companies are not subject to stringent record keeping. They can also be misused, so whenever you see one, you should investigate further. Aphria recently merged with Nuveena which resulted in accusations the board used investor’s money to acquire a shell company owned by the board members. Some of the board members were part of Riot Blockchain as well. In fairness these are allegations but the stock has been hit hard.
This is why before we invest in any Cannabis stock we look at the management team and their bio’s. Do they have experience with mergers and acquisitions, are they reputable and come from a parallel industry. We want them to be a former executive of a pharmaceutical, retail, tobacco or beverage company. Not a former executive of Dexter shoes or Lulu Lemon.
- FMV or First Mover Advantage, or Market Penetration. Do they have grow and production facilities along with retail outlets already in place.
- Name Branding – Eco-systems are all about branding such as Apple Google Amazon or Samsung for examples. They demand a premium and higher premiums lead to higher net margins. We look for branding, or name brand recognition early on. Neflix or AMZN is a perfect example.
- Financially Sound – Do they need to raise money or do they have enough cash where they do not need to dilute shares with bonds and stock issuance. Look at Tesla or NVDA that had to raise cash to continue growth vs Amazon that has a bankroll.
- Leadership – Does the CEO and management team have a track record, experience in parallel industries, and the necessary connections?
- CFO – Nothing more important than a CFO. We look for integrity in the form of previous positions prior. Just look at Aphria where there are accusations that the directors including the CFO were shareholders of Nuuvera and did not disclose this before acquiring the company for 826 million.
- International exposure – Canada has a population of 36 million or about 1/10 that of the US 1/20 that of Europe and 1/3 of Mexico. In contrast the UK has over twice the population of Canada. Since Canada has been a launching ground for Cannabis companies, we are looking for those companies with the current means to access international markets.
- Growth – This is critical for speculative stocks. Just look at Amazon and Netflix which have been trading at ridiculous PE multiples. Look at Spotify, they do not make money, but they are growing, and this fuels sentiment which fuels prices. Look at the cloud kings, growth growth growth. It is not a high PE you should be worried about, it is a low one in growth stocks. We are looking for those that are using capital to feed growth, new facilities, new products and expanding markets.
- Current and future production levels – This breaks down into several categories, but we are looking at annual production levels both currently and in the future.
- Diversification of products – We do not want to invest in pure grow facilities. Do they extract CBD oils, or synthesis for medical products. What happened in Oregon, when complete deregulation took place, is pricing and margin pressure took a hit. Supply and Demand. Do not think farmers with 5000 acres of land can not grow cannabis. The average grow time is 3-4 months outdoors. In Canada you must have an indoor grow facility, in most of the US you can grow outdoors.
- Too much diversification – We do not want companies that are in everything. Having several products lines is good, having too many leads to not focusing on market demand and losing market share in what you do best. Is the board focused and clear about their goals.
- Key Metrics. Often forgotten but very important. We want to compare to others in the industry the key metrics for the space. Airlines it is % seats full per flight as the Key Metric. A few we look for in Cannabis are.
- Average Kg yield per sqft This is key with indoor grow facilities and average yield per acre with outdoor growers.
- Cost of energy per yield. What is their Kw cost per Kg?
- Overhead – Cost of rent, loans for buildings or equipment, security etc. These are flat costs.
- Variable costs – Maintenance, fertilizer, water and labor.
- Do they release accounting reports per GAAP or other method? We want to see GAAP quarterlies and we want transparency, or a history of it.
- Do they have a business strategy?
- Are they a potential takeover target or have the capacity to partner with mainstream businesses like Altria, Constellation brands, Proctor and Gamble, Coca Cola.
- Sustainability – Are the products they offer something you would buy and are they sustainable by the market? Remember Blackberry? Yet Netflix and Amazon sustained competition.
If and When deregulation happens, the market will be flooded, will the companies you pick survive. Look at Blackberry, Nokia, and Yahoo. They were hot back in the day and not so much today. Just because uncle Clyde has a “stock tip” does not mean it is a good one and just because we like a stock does not mean it will be profitable.
If you want to be a good at investor or a good speculator, understand what you are investing in, understand the market, the players, and the Key Metrics. You should have a spreadsheet with your fundamentals and grade each company based on your research. In the end it is up to you to determine if it meets your criteria for allocating capital to. Look at those who have your same investment or speculation philosophy as you, not just pumping hype and throwing garbage out there.
Investing nor speculating is for the lazy or ignorant. To be a good stock picker you must do your homework, and ignore the opinionated news!