“The stock market is filled with individuals who know the price of everything, but the value of nothing.” – Philip Fisher
Fisher suggests popular opinion can sometimes misguide speculators to justify unreasonable prices. A prime example of this was the fervent yet precarious proliferation of cannabis investing over the past few years. The more recent bout of volatility in the cannabis industry has seen several of Canada’s former darlings, such as Canopy Growth Corp. (TSE:WEED), drop dramatically from their peaks earlier this year. Some early speculators brave enough to jump on and fasten their seatbelts may have done reasonably well through select stocks or ETFs, but that is not the case for the majority of investors, as evidenced by the 78% decline in the TSX Cannabis Index since September 2018.
Source: Bloomberg
We have written several times over the past few years about QV’s stance on the cannabis industry. During the industry’s peaks, we had to explain why we underperformed due to our decision not to participate with direct investments in cannabis stocks. Our investment process requires the discipline to forego near-term excitement in favour of better long-term prospects rooted in sound fundamentals. In addition to uncertainties surrounding the regulatory environment at the time of legalization, the main reason for not participating was our inability to justify exorbitant valuations for companies with limited and largely unproven financial track records. Despite periods of strong revenue growth, cannabis stocks were burning large amounts of cash and it was unclear which businesses might eventually emerge with enduring competitive advantages. In one of his letters from 2018, Portfolio Manager Ian Cooke wrote: “From what we can tell, the current buying frenzy in marijuana stocks has little to do with fundamentals… [To justify its valuation] Canopy will likely need to command a presence similar to that of Molson Coors in the beer industry. The marijuana market will also need to grow to a size comparable to the Canadian beer market. It’s not impossible, but we foresee the odds as very low. When capital is thrown at an industry in an increasingly indiscriminate fashion, the long-term returns on investment rapidly diminish.”
This coming Sunday marks the three-year anniversary of legalization of cannabis in Canada. Unfortunately, most major market players in Canada have yet to make a profit when excluding non-cash gains. The chart below shows that the three largest Canadian cannabis companies lost $1.10 in cash operating profit for every $1 of revenue they’ve brought in over the last four reported quarters. At its height, this divergence reached as high as nearly $10 in negative cash operating profit for every $1 in revenue. A tight regulatory environment surrounding the production, distribution and marketing of cannabis products has created challenges for producers and retailers that have made it hard for legal operations to compete with the black market. Further challenges may lie ahead; Mexico’s recreational legalization this past summer may introduce formidable, lower-cost competition to the Canadian cannabis industry.
*Operating losses defined as cash flow from operations less cash flow from investing
Source: Capital IQ, QV Investors
We are certainly not discounting the possible opportunities this industry could bring, and neither is one of QV’s core holdings, Alimentation Couche-Tard (ATD.B). The company, whose primary business is the operation of Circle K convenience stores in North America and the UK, has recently decided to expand its strategic partnership with Fire & Flower Holdings Corp. – a multi-banner cannabis retailer with an attractive proprietary analytics platform. It is expected that the strategic partnership will open several new co-located retail stores over the next few months in Alberta, Saskatchewan and Manitoba. Continued success of this partnership could help both businesses benefit from economies of scale thanks to Fire & Flower’s technology platform and possible future expansion into the budding legal market in the US. Although this endeavour may not be overly impactful to the company’s bottom line at this time (ATD.B’s 20% stake in Fire & Flower represents less than 1% of ATD.B’s revenue) it demonstrates a willingness to innovate in an area that extends well from its existing capabilities. Keeping an open mind allows us to see the potential value in these types of opportunities, while not sacrificing our commitment to our investment process.
