Shares of the 10 largest Canadian cannabis producers have been bludgeoned, yielding an average negative return of more than 57%

The legalization of cannabis in Canada was supposed to be a catalyst — the most powerful one yet, investors and analysts alike thought — that would launch companies in the young but potent industry to new heights. Instead, nearly one year later, it has been a nightmare.

Since recreational cannabis became legal on Oct. 17, 2018, the shares of what were then the 10 largest Canadian cannabis producers by market capitalization have been bludgeoned, yielding an average negative return of more than 57 per cent for investors.

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Tilray Inc. alone has lost more than $14 billion in market cap, and Aurora Cannabis Inc. has shed $6.8 billion. Six of the Top 10 have lost at least half their value, with scandal-plagued CannTrust Holdings Inc. suffering such resounding losses that it no longer appears in the list. Of the 10, only Cronos Group Inc.’s market cap has grown over the past 12 months, though its share price has declined, like those of all the others on the list.

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Prior to legalization, cannabis stocks soared on the promise of massive growth and the tremendous momentum that retail investors brought as they poured into the sector. Now that excitement has been drained, said Richardson GMP portfolio manager Chris Kerlow, and it is unlikely to return.

“A psychological shift has take place from everyone wanting to own (cannabis) to everyone involved now feeling burned,” he said. “I think many investors are now over (cannabis).”

Legalization played out like a classic “buy the rumour, sell the news” situation, Kerlow said. In retrospect, there were warning signs that legalization could be a disappointment.

At the time of legalization, the Canadian cannabis industry, even with minimal international exposure, had already exceeded the combined market cap of the publicly traded grocery chains, Kerlow said.

“What that’s telling us is in the future, people are going to be buying more cannabis than groceries and that’s obviously not going to happen,” he said.

Most of the top cannabis firms were trading near all-time highs on Oct. 17, 2018. Aurora Cannabis Inc., Tilray and Aphria Inc. would hit their highest post-legalization levels one or two days later.

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The sector’s leaders immediately stumbled out of the gate and didn’t appear ready to handle consumer demand. A lack of inventory quickly led to massive delays for even the simplest orders to be filled. Aggressive expansion plans led to more investor doubts, this time about balance sheets and future profitability. And while most analysts held a positive outlook on legalization, skeptics at Veritas Investment Research Corp. warned about the end of the “cannabis rainbow.”

Looking back, Ninepoint Partners LP portfolio manager Charles Taerk said investors expected more dispensaries to be in place to meet the demand, an expectation that has still not materialized.

“A lack of dispensaries means a lack of education means a lack of sales growth that was initially anticipated,” said Taerk, who noted there are still only 25 legal cannabis retailers open in Ontario, although that number is expected to rise to 75 by the end of the year.

I think many investors are now over (cannabis) Richardson GMP portfolio manager Chris Kerlow

Regulations blocking advertising and enforced basic packaging have also made it difficult to establish brands in the space, he added.

With those restrictions in place, Taerk sees few catalysts that can alter the current trajectory of the leading names in the Canadian sector, which has led him to eliminate or significantly trim positions in most of them.

The largest change in his portfolio since legalization is that he is now underweight Canada altogether, with long positions in OrganiGram Holdings Inc. and MediPharm Labs Inc. being a couple of the few exceptions.

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Taerk in July exited his position in Canopy — a move that was once difficult to explain to anyone who was long on the sector — and has only been using put options to play the stock. His portfolio now focuses on cannabis companies in the United States, where he sees greater potential.

Like Taerk, GMP analyst Robert Fagan has taken more of an interest in the U.S., but doesn’t believe the Canadian market is broken.

Photo by Chris Roussakis/Bloomberg files

Critics say the sector is now trading on fundamentals instead of promise and that investors simply have not found the fundamentals worth betting on. But Fagan disputes the notion that cannabis companies’ struggles are due to a shift in how the stocks trade.

Although profitability is still lacking in the sector, he points to the increasing revenue generated by companies such as Hexo Corp., which reported $1.2 million in revenue for the three months ending April 30, 2018, but more than $15 million in the same time period a year later.

Similarly, Supreme Cannabis Company Inc., another Canadian company Fagan tracks, was losing $4 to $5 million a quarter in 2018, he said, and it is now profitable. But stronger fundamentals still haven’t allowed the company to escape losing close to half its market value since legalization.

Kerlow points to the CannTrust scandal as a “tipping point” that placed a stigma on the entire industry. The Vaughn, Ont.-based licensed producer was found to be growing cannabis in unlicensed rooms by Health Canada and has had multiple licences suspended as a result. The investigation and the stock’s collapse have shown investors just how much money they can lose by betting on the sector.

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The timing of the CannTrust news was not the best either, given that it took place in the months leading up to Cannabis 2.0, the second wave of legalization that will introduce edibles, beverages and extracts into the market. There is significantly less hype among investors today than there was a year ago and experts are mixed on what effect the new products will have on the sector.

Some investors might be tempted to reinvest in the market leaders — Canopy, Aurora and Tilray — given how much their valuations have fallen, but Taerk sees a different scenario, in which Cannabis 2.0 results in new interest in cannabis oil extractors such as MediPharm and Valens GroWorks Corp.

Mackie Research Capital Corp. analyst Greg McLeish recommends investors shift toward companies that have a strategy to deliver new products such as vapes and edibles to the market. But because of a 60-day notice period, most of those products won’t be seen in the market until late December.

Some analysts, including McLeish, are also shifting their focus toward smaller producers, who they think have a better shot at outsized growth than the sector’s juggernauts, which they see struggling to regain their former highs, especially without the investor buzz that boosted their share prices in the past

“I think that’s gone,” McLeish said.

Financial Post