Cannabis Stocks Have Underperformed in 2020: What's Next?

This year, financial markets around the world have been highly volatile amid the coronavirus outbreak. In March, the S&P 500 fell by more than 54 percent from its peak. Though it has managed to regain most of those losses, the cannabis sector has continued to underperform broader equity markets. The ETFMG Alternative Harvest ETF has fallen more than 24 percent this year. Robust black market sales, rising operating losses, lower-than-expected demand, and weakening cash positions are dragging down cannabis stocks. 

Although Canada legalized recreational cannabis in October 2018, the black market still forms a significant part of total cannabis sales. In the U.S., only 33 states have legalized medical marijuana, while 11 states have legalized cannabis for recreational use. Delays in legalization, higher tax on legal cannabis products, and a lack of easy availability have helped black markets thrive. The U.S. government still has cannabis classified as a Schedule 1 drug. Therefore, banks can’t conduct any business with companies involved in cannabis, starving companies of much-needed cash to fund their growth prospects.

Demand for cannabis products has been lower than expected, but supply has been on the higher side. This demand-supply imbalance had led to a fall in cannabis prices, pressuring companies’ margins. Some companies are selling their assets and slashing jobs to cut their losses. Let's see how these companies’ stocks are trading. 

Many cannabis companies trade on the NYSE, the world's largest stock exchange. Of these cannabis companies, Canopy Growth is the largest, with a market capitalization of $6.1 billion. Canopy is followed by Aurora Cannabis, with a market capitalization of $1.18 billion. Other prominent cannabis stocks that trade on the NYSE include HEXO and Innovative Industrial Properties.

Some cannabis companies also trade on the Nasdaq, the world’s second-largest exchange. GW Pharmaceuticals and Cronos Group, the largest cannabis companies trading on the Nasdaq, have a market capitalization of $4.08 billion and $2.26 billion, respectively. Other prominent cannabis stocks trading on the exchange include Tilray and Sundial Growers. For more information on gaining exposure to cannabis stocks, read How to Invest in Cannabis. Last month, Aphria moved from the NYSE to trade on the Nasdaq. 

The cannabis sector is still in an early growth stage. During this stage, companies incur higher expenses, and as a result, pay lower dividends. Innovative Industrial Properties is a REIT that acquires and leases back assets from cannabis companies. As cannabis is a Schedule 1 drug, cannabis companies can't raise debt from banks. Therefore, IIPR provides capital to these companies by acquiring their assets and leasing them back through long-term agreements. IIPR collects lease payments from these companies. 

On June 16, IIPR announced its second-quarter dividend of $1.06 per share, which represents sequential growth of 6 percent and an annualized payout rate of $4.24 per share. As of July 24, the company's dividend yield was 4.6 percent. Some companies, such as Altria Group, ScottsMiracle-Gro, and Constellation Brands, are involved in other businesses but have exposure to cannabis stocks through investments in cannabis companies. These companies pay dividends. So, if you want to participate in a cannabis growth story and also earn dividends, these companies provide excellent opportunities. Altria, ScottsMiracle-Gro, and Constellation have dividend yields of 8.03, 1.59, and 1.67 percent, respectively.  

Despite weakness in cannabis stocks, Green Thumb Industries, GW Pharmaceuticals, and Curaleaf Holdings have managed to deliver excellent returns this year.  Green Thumb has returned 25 percent in 2020. In May, the company reported an impressive first-quarter performance, beating analysts’ revenue and EBITDA expectations. While many cannabis stocks are struggling to attain profitability, the company has managed to report positive EBITDA in its last three quarters. GW has returned 20.7 percent this year. It sells Epidiolex, the only CBD product approved by the FDA. The product treats seizures associated with epilepsy. Driven by strong Epidiolex sales worldwide, the company did well in the first quarter. That strong performance and the company's product expansion across Europe may have boosted its stock. 

Curaleaf Holdings, the sector’s third-best performer, has returned 18.2 percent this year. In May, Curaleaf reported strong a first-quarter performance, with its EBITDA beating expectations. It also completed its acquisition of Grassroots, making it the world’s largest cannabis company. Earlier this year, the company acquired Arrow Alternative Care, BlueKudu, and Select, boosting its stock price. 

Although the cannabis industry faces multiple issues, interest in cannabis stocks has renewed due to cannabis sales surging amid the pandemic. In Canada, cannabis sales hit a new record in May, of 185.9 million Canadian dollars. As I’ve mentioned, very few U.S. states have legalized recreational cannabis. However, efforts are being made to change that. As cannabis companies are bringing in cannabis-derived products such as edibles, beverages, and vapes, the sector has strong growth potential. There are four companies I believe will perform particularly well in the second half of this year. 

Curaleaf is my first pick. As more states warm up to cannabis, the U.S. cannabis market will be set to grow. Curaleaf, with its recent acquisitions, is well positioned to gain from the industry expansion.

My second pick is GW Pharmaceuticals. Its revenue tripled in the first quarter, primarily due to Epidiolex, and I believe that growth is far from over. After introducing the product in England and Germany, the company is looking to expand in Italy and Sweden. GW is also working on acquiring approval for Epidiolex to treat seizures associated with TSC (tuberous sclerosis complex) in the U.S. and Europe.

My third pick is Canopy Growth. With cannabis companies still struggling to raise capital, having a strong balance sheet is a significant advantage. Backed by the investments from Constellation Brands, Canopy Growth had 2.0 billion Canadian dollars in gross cash at the end of its last quarter. Along with its strong balance sheet, the company's focus on expanding its product portfolio has made me bullish on its stock.

My final pick would be Aphria. It has managed to report positive EBITDA in its last four quarters, and had 515.1 million Canadian dollars at the end of its last quarter. The company has yet to introduce cannabis-derived products, which could further drive its fundamentals.

 Rajiv Nanjapla has no holdings in any of the companies mentioned in the above article.