What to Look for When Evaluating a Cannabis Stock

Cannabis stocks have created new opportunities for investors to participate in a new and growing industry.

The legal cannabis market is growing at an incredible rate, ballooning toward the US$40 billion industry Arcview Research and BDS Analytics predicted for 2024. This evolution is also opening up new investment opportunities in the sector. Canada’s cannabis 2.0 legislation has ushered in a new era of marijuana-infused edibles and beverages. In the US, the promising possibility of the SAFE Banking Act passing the Senate has the potential to further accelerate market growth.

For investors looking to capitalize on this growth, there are several key criteria for evaluating which cannabis stocks have the potential for best return-on-investment. Chief among these are the management team, capital structure, business model and licensing.

The value of an experienced management team

As with any industry, a serious consideration of a specific cannabis company’s investment potential should include a thorough examination of the management team.

Cannabis cultivation companies need a roster of experienced growers with a passion for the industry. For companies focused on producing and distributing cannabis-infused edibles and beverages, C-level players with experience and relationships in the food and beverage industry are a big plus, and in the medical cannabis space, team members with experience in the pharmaceutical and nutraceutical industries are natural fits for companies developing medical-grade cannabis options. Executives with existing industry experience can also be a key differentiator when evaluating cannabis companies.

For example, the management team leading Chemistree Technology (CSE:CHM,OTCQB:CHMJF) is stacked with long-time cannabis industry gurus. Similarly, BevCanna Enterprises’ (CSE:BEV) executives are seasoned veterans when it comes to creating, branding, bottling and distributing wellness and recreational beverages on a global scale. In the medical cannabis space, companies such as Cardiol Therapeutics (TSX:CRDL,OTCQX:CRTPF) have assembled management teams well-versed in the research and commercial development of novel therapeutics.

Advantages of vertically integrated cannabis companies

After management, cannabis firm 4Front Ventures‘ (CSE:FFNT,OTCQX:FFNTF) chief investment officer Andrew Thut believes investors should consider a company’s operations as the main focus when evaluating a stock. “I think investors really should be looking for the asset base and the talent to be a long-term winner with proven battle-tested operations,” said Thut.

Cannabis companies with a diversified business model offer investors exposure to more than one segment of the industry, which helps to reduce the volatility that can plague companies with a singular focus. Vertically integrated companies with assets all along the cannabis value chain have the potential to unlock multiple revenue streams, which can enable stable and recurring cash flow. In addition, a diversified company can replenish one vertical of the business with cash generated from another in order to remain in line with consumer trends.

Capital structure

No matter the industry, there are specific metrics analysts and investors use to evaluate the investment potential of a given stock: cash flow, cash position, debt obligations, dilutive securities, share structure and revenue. Many of these key metrics can be found during a thorough review of the company’s financial sheets.

In addition to how many shares the founders and management hold, Mason Brown, a director with Stoic Advisory, told the Investing News Network that investors should look for any dilutive securities such as warrants and stock options as well as the prices and valuations of previous financings. For example, as of December 2019, TransCanna Holdings (CSE:TCAN,FSE:TH8) currently has approximately 35 million shares outstanding including over four million outstanding warrants. The company recently announced it had exceeded its revenue totals from the month of October by 90 percent, generating CA$473,000 in November, which grew by another 20 percent to C$564,000 in December 2019.

Investors can lessen their risk exposure by looking to those companies that are already generating revenue. “The level of revenue, as well as the growth rate, are important criteria to track,” Alan Brochstein, cannabis financial analyst and founder of 420 Investor, told the Investing News Network. “Additionally, it’s a good idea to adjust for revenue acquired through acquisition, as this can overstate the growth rate of the underlying business.” Brochstein advises tracking operational cashflow as well to help investors gain a better understanding of a company’s resources compared to their cash position. “If a company doesn’t have sufficient cash, it will need to raise cash, which can put pressure on the stock price,” he said. If the company has no tangible equity, raising capital can be all the more challenging.

At the 2019 MoneyShow in Toronto, Marijuana Millionaire Portfolio Editor Sean Brodrick offered up Organigram Holdings (TSXV:OGI,NASDAQ:OGI) and Nevada-based Planet 13 Holdings (CSE:PLTH,OTCQX:PLNHF) as top cannabis stocks. In May, Organigram became the third Canadian marijuana producer to list on the NASDAQ. Planet 13 is listed as one of the holdings in the new Horizons US Marijuana Index ETF (NEO:HMUS).

Licenses and supply agreements

Investors should also look at what types of licenses a company holds. If a company is still awaiting approval, the stage it is at in the licensing process can impact its valuation. “Depending on the stage of the licensing process, generating revenue could be anywhere from days to months to years away,” said Brown.

Early in 2019, California-based Next Green Wave (CSE:NGW,OTCQB:NXGWF) obtained all the necessary state and local licenses to carry out all its seed-to-sale operations for the adult-use and medical cannabis markets. Holding multiple licenses in California is rather rare given that local licensing regulations can vary from municipality to municipality. The licenses also allow Next Green Wave to begin full production at its Coalinga indoor facility, where it produced its third harvest in Q3 2019.

In Canada, licensed cannabis producers can supply both medical and recreational markets. However, to sell into the medical cannabis market, companies need a separate sales license. Canadian licensed producers who want in on the recreational cannabis market will need supply agreements with provincial governments whether their products are destined for brick-and-mortar retail or online sales. For example, Village Farms International’s (TSX:VFF,NASDAQ:VFF) joint venture partner Pure Sunfarms recently secured an amendment for a Health Canada license, which is expected to allow the company to sell branded dried cannabis directly to provincial distributors and private retailers in Ontario and British Columbia.

Takeaway

The legal cannabis market is on track to become a multi-billion dollar industry in the next few years. Investors who wish to capitalize on this growth have a unique opportunity to gain exposure through quality cannabis stocks. With the right strategies for practicing due diligence, investors can make well-informed decisions on which cannabis companies offer the best potential return on their investment.

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