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With the legalization of recreational marijuana in Canada coming into force on Oct. 17, investor interest in cannabis producers as an investment has soared. Cannabis companies like Canopy Growth Corp., Aurora Cannabis Inc., and Tilray Inc. have been sucking pretty much all the oxygen out of the cannabis space recently, to say nothing of commanding breathless headlines in the business news. Their spectacular upward price trajectory has many analysts worried about the kind of stretched valuations characteristic of market manias and fads. No doubt, it’s become a risky proposition to invest in individual cannabis companies at this stage. But apart from investing in individual companies, there aren’t many other ways for investors to get exposure in this growing business, which also no doubt is here to stay. However, various cannabis funds are beginning to debut in the market.
One such fund is the Horizons Marijuana Life Sciences Index ETF (TSX: HMMJ), launched last April. It was the first to invest in cannabis-related companies and remains one of the few ways to access a diversified portfolio of “pot stocks.” It carries an MER of 0.75% (plus applicable sales tax) and boasts assets of $1 billion as of Aug. 31.
The fund tracks the performance of the North American Medical Marijuana Index, a cap-weighted index. To be considered for inclusion, a company must be involved in the production of cannabis, the research and development of cannabinoids, equipment providers, and companies involved in leasing property to growers. The maximum weight of any one name is capped at 10%, and the index is rebalanced quarterly.
There is little doubt that the potential for growth is very high in the space, as the industry is in its infancy and governments in Canada and some U.S. states continue to legalize the drug. Some estimates expect that annual, regulated pot sales in North American will top more than $20 billion by 2021. But strong growth potential doesn’t necessarily make a good investment.
Today, there are many small players in the industry, with more joining in every day. Some are well-managed, with well-thought-out business plans, but most are undercapitalized and have inexperienced management with poor business plans.
Furthermore, valuation levels are off the charts, based on any normalized fundamental metric. For example, the largest holdings in the Horizons fund, Aurora Cannabis (17.6% of assets at Aug. 31), with market capitalization of $11.4 billion, just reported its fiscal fourth quarter profit of $79.9 million, up from a loss of $19.2 million in the year-ago quarter. The stock is trading at a forward price/earnings ratio of 322, and a price/sales ratio of 124. That level of valuation increases the risks substantially in an evolving industry.
There is no doubt that money is to be made in the sector, but one is cautioned to proceed with caution.
In such an evolving industry, I don’t believe an ETF that selects and weights stocks based on market capitalization is necessarily the best way to access the sector. One of the flaws of a market-cap index is that it tends to overweight the most overvalued names, which in this sector significantly increases the risks.
Instead, investors who want diversified exposure to the sector may be wise to hold off until other, more actively-managed funds become available and establish a trading history of at least a year or more.
Dave Paterson, CFA, is a money manager and an expert on investment fund research and due diligence on a variety of investment products.
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Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of performance is made or implied. This article is for information purposes only and is not intended as personalized investment advice.
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