3 Reasons Marijuana Stocks Went Up in Smoke in 2018

This was a record-setting year for the marijuana industry, which put taboo views in the rearview mirror and transformed into a legitimate business model before our eyes.

To our north, Canada put an end to nine decades of recreational marijuana prohibition on Oct. 17. Although it's going to take a few years before production is able to meet domestic demand, this is an industry that's fully capable of $5 billion or more in added annual sales during the early part of the upcoming decade.

Within the U.S., it was a similar story. Even with the federal government holding firm on its Schedule I classification for pot (i.e., wholly illegal, prone to abuse, and not having any recognized benefits), two more states legalized medical marijuana (Utah and Missouri), with two others giving the green light to adult-use weed (Vermont and Michigan). Nearly two-thirds of U.S. states have now legalized marijuana in some capacity.

What a buzzkill

And yet, despite the cannabis industry gaining validity, marijuana stocks put up an absolute stink bomb in 2018. Through this past weekend, the Horizons Marijuana Life Sciences ETF, the very first publicly traded ETF, was down 45% year to date, and has given up better than three-quarters of its gains since inception. For context, it had, at one point, more than doubled since its debut in the spring of 2017.

Why has there been such a blatant bifurcation between broad-based cannabis news and the performance of pot stocks this year? Well, blame it on the following three factors.

1. A cannabis shortage will eat into sales and potential profits

The first big problem is that, despite regulators suggesting there would be no initial cannabis shortage come Oct. 17, pretty much everyone else could see that supply was insufficient to meet demand. And the reason supply isn't able to meet domestic demand is twofold.

For starters, it's going to take years for Canadian cannabis growers to complete their greenhouse projects, plant their crops, and sell their product. Although they've promised pie-in-the-sky production figures, no grower is anywhere near their peak production estimates.

Take Aurora Cannabis (NYSE: ACB), which is most likely going to be the top-producing pot stock once it has its capacity completely ramped up. Following Aurora's acquisition of ICC Labs in South America, the company could hit an author-estimated 700,000 kilograms in peak annual output. Yet, based on the company's latest quarterly filing, it was only producing about 10% of this amount on an annual run-rate basis as of November. It's going to be a while before Aurora can realize the potential of its capacity, and investors are finally coming to terms with that.

The second factor leading to a cannabis shortage is the red tape surrounding Health Canada. Canadian growers are required to receive a cultivation license before they can harvest cannabis, and a sales permit before they can rake in the dough, so to speak. The problem is, Health Canada was contending with a backlog of more than 500 cultivation licenses as of May. It could take months or years to approve or deny these requests. As for sales permits, they were taking an average of 341 days to process, as of May. This regulatory red tape could lead to reduced sale and profit forecasts for pot stocks.

2. Earnings actually matter now (and they weren't pretty)

The second reason marijuana stocks went up in smoke in 2018 is that the time for promises ended, and operating results actually began to matter. The issue is that these earnings results weren't very pretty, and they've had investors running for cover since about mid-October.

To be fair, virtually none of the recent earnings reports included any sales tied to the recreational legalization in Canada. There were a few stockpile announcements in a handful of reports, but nothing that amounted to more than a few hundred thousand dollars in revenue.

So, what did Wall Street and investors see in these earnings report? In general, high double-digit or triple-digit percentage sales growth, and in some rare instances profitability. But these profits were almost always a smoke-and-mirrors deception brought on by International Financial Reporting Standards (IFRS) accounting.

You see, under IFRS accounting, marijuana growers are treated as agricultural companies. And thus they're required to report on the estimated value of their crop throughout the growing cycle, as well as the estimated cost to sell their cannabis. In other words, the value of their crops can vacillate all over the place as growers make their most educated guesses. Perhaps most interesting, these fair-value adjustments to biological assets are made above the line. In the early going, it's led to a number of brand-name growers getting a profit boost from nothing more than IFRS accounting.

But on an operating basis, it's been a nightmare. Seven of Canada's largest growers combined to lose nearly $300 million in their most recent quarter, and it looks unlikely that most marijuana stocks will be profitable on a recurring basis anytime soon.

3. Share-based dilution

Third and finally, blame marijuana stocks for their capital-raising tactics.

To some extent, it's not the fault of pot stocks that financial institutions have mostly shunned the industry. Whether these banks fear criminal or financial penalties, or they simply don't see the marijuana industry succeeding, few pot stocks have been able to secure access to nondilutive financing options. The result has been a reliance on bought-deal offerings to raise capital.

A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors in order to raise capital. While these bought-deal offerings have always done the trick in raising the money necessary to expand capacity, develop new products, or make acquisitions, they also have a dark side for shareholders. Namely, they raise the outstanding share count of a company, which can weigh on a company's share price, as well as reduce earnings per share if a company is profitable.

Not to harp on Aurora Cannabis again, but it's the most readily available offender in the dilution department. Having financed many of its acquisitions with its common stock, and executing multiple bought-deal offerings to raise cash, Aurora's share count has ballooned from 16.2 million shares at the end of fiscal 2014 to probably north of 1 billion shares by sometime in the next quarter or two. Aurora's "growth-at-any-cost" business model is costing shareholders big-time.

Perhaps worst of all, none of these three factors shows any signs of changing in 2019, suggesting that a rebound in pot stocks could still be a ways off.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.