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Altrius Capital Blog

You'd Have to Be Smoking the Stuff to Buy Pot Stocks

Posted by James Russo on November 12, 2018

Cannabis FarmThough I've never used illicit drugs, I do regularly drink caffeine through my coffee habit, consume alcohol via two or three glasses of wine a year, and have ingested nicotine having smoked a handful of cigars over the past couple of decades. As a libertarian on social issues, I won't comment on whether or not marijuana or other drugs should be legalized. As a fiduciary charged with providing a sound rate of return for my clients, I don't make any moral judgements on companies in which I invest as there is too much grey involved in making a judgment as to the goodness or evil of a company's people or its goods.

Thus, my observations on the cannabis industry, and stocks such as Tilray (TLRY), is merely a comment on the mania and astronomical valuations of companies involved in cannabis cultivation and distribution. Investors are always chasing the hot stock looking to find quick riches. Yet, in my over twenty one years in business, none of our clients became a millionaire overnight. They did so by diligently building their businesses and saving for their retirement rather than pursuing the newest fad. Importantly, we have remained wealthy by avoiding fads, manias and the madness of crowds by not participating in them. My warning about Bitcoin in my blog in January (when priced at approximately 20,000 before plummeting to its current valuation of ~ 6,400) is just one recent example.

My book is currently in the editing stages and should be published soon. I've been sharing snippets from it over the past few months and thought I'd share another extract from Chapter Nine which covers my value principles and investment discipline. My illustration of the mania surrounding GoPro, and its subsequent demise, is similar in my opinion to stocks in the cannabis sector which have astronomical valuations and contain serious risks. I hope you enjoy the preview from my book and the warning so that your investments don't go up in smoke!

The popular show Shark Tank offers a good metaphor of how to define value. Willing only to pay for real past earnings, the sharks refuse to apply an exorbitant multiple (price to earnings ratio) to companies being pitched to them. The sharks invest their money in a disciplined manner, understanding that it will take time to recoup their initial investment before beginning to participate in potential future earnings.

Investing in a stock should be conducted with similar discipline. Just as the sharks aren't willing to invest based purely on potential, neither should you invest in a company promising great potential but lacking real earnings or selling at an unreasonably high valuation.

Over longer periods of time, stock prices will eventually follow a company's earnings. In the short term, investors can drive a price to dizzying heights based upon the excitement of its growth potential, or conversely, to lower lows due to abject fear about its prospects. A value investor can take advantage of such negative sentiment as the price has been driven to a low valuation because selling begat more selling as investors believed the company's prospects greatly diminished. A value investor must be contrarian by nature, and though it often doesn't feel right to invest when others are selling, significant bargains can be found if you are willing to bravely step up when others have given up.

I believe that value investing should stick to a purer valuation metric as study after academic study has shown that traditional valuation methods work when valuing a company. Burton Malkiel's classic book on finance, A Random Walk Down Wall Street, had a profound impact on me over two decades ago. Malkiel, a professor of economics at Princeton University, debunks most of the investing schemes which have been attempted over the years with the one notable exception of recognizing that lower P/E companies outperform higher multiple stocks (i.e. growth stocks). Though considering many valuation metrics (such as cash flow, book value, etc.) when analyzing the puzzle pieces of a particular investment opportunity, I find myself often utilizing the P/E ratio as my primary consideration, one that usually presents the clearest - albeit most traditional - definition of value.

As I write this chapter, former tech darling GoPro has reported it is laying off another 20% of its workforce and the stock has fallen almost 20% today. This is yet another example of the dangers of investing in a company with unrealistic growth expectations and what happens when they don't materialize. The company IPO'd at $24 in 2014 and hit a high of about $80, flying higher on hope of continued growth. Prior to the beginning of its collapse in 2015, roughly 70% of Wall Street analysts maintained a buy rating, none with a sell or strong sell.

The fear of missing out (FOMO) is very strong on such companies when they go public or reach new highs. Maintaining the discipline to not pay too much for a company and not purchasing companies that don't provide income to our clients kept me from purchasing GoPro, among the many other growth companies which have failed. Though value investing also entails suffering through such declines at times, and entails the risks of "catching a falling knife," time has proven that patient value investors like me are able to purchase such companies at more reasonable valuations and achieve sound risk-adjusted returns over time. Though you may not be able to brag to your golf buddies about the hot, highflying stock you purchased, maintaining this patient discipline may help you stay in the fairway and win the more important score in the clubhouse.

For every one company that defies the odds of high valuations by achieving long term success, there are more GoPro's which fail miserably at worst and provide horrific returns at best. Your golfing friends won't mention these stocks which likely created greater losses than the one stock that provided some gains - just as they won't count that mulligan!

As a value investor, I resist overpaying for ridiculously valued companies that lure investors in with their momentum. So many have made the mistake of jumping into investments that were the fad of the day for fear of missing out.

As we used to say with our NATOPS (Naval Air Training and Operating Procedures Standardization) manual, there are some procedures which are written in blood and if you chase momentum, you will eventually blow yourself up. Like the inviolate rules when I flew C130s, there are certain things I believe you should never do when investing. The euphoria of the masses may make it seem as though you can go ahead and do it at the time, but like unwary pilots, investors can get killed.

 

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Topics: stocks, market forecasts, cannabis industry

Written by James Russo

Founder & Chief Investment Strategist