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3 Pot Stocks Wall Street Thinks You Should Sell

Sean Williams, The Motley Fool

Though it may be hard to believe now, the marijuana industry was considered taboo just a short time ago. As recently as 2005, only a third of respondents in Gallup's cannabis survey favored legalizing pot, and just a handful of U.S. states had legalized the use of medical marijuana. Further, no country in the world had even thought about legalizing adult-use pot.

Today, an all-time record two out of three Americans favor legalization, with 33 states having legalized medical weed and 10 also allowing adult-use consumption. To our north, Canada became the first industrialized country in the world, and only the second overall (behind Uruguay), to legalize recreational marijuana this past October. With the green wave pushing forward, global sales estimates from the few Wall Street investment banks that have initiated coverage of the industry are on the rise.

A businessman in a suit pressing the sell button on a digital board.

Image source: Getty Images.

Three marijuana stocks that received the dubious sell rating from Wall Street

Of course, not every marijuana stock is getting a passing grade from Wall Street in the early going. Three pot stocks have received the dubious sell rating from Wall Street investment banks.

Cronos Group

If there were sort of a cream of the crop of underperformance, at least in the eyes of Wall Street, it would be Canadian grower Cronos Group (NASDAQ: CRON), which received the equivalent of a sell rating from Jefferies and BMO Capital Markets and the equivalent of a hold rating from Cowen Group, arguably the pot industry's biggest cheerleader.

Although analyst ratings typically have only a very short-term impact on a company's share price, this is one instance in which I wholeheartedly agree with Wall Street's analysis. Having referred to Cronos as the most overvalued of all pot stocks, I believe there are multiple reasons its share price could head significantly lower.

Arguably the biggest issue is that Cronos' production simply doesn't match up to that of its mid-cap and large-cap peers. Cronos' joint-venture project (which'll be complete by midyear), Peace Naturals, and its overseas grow sites perhaps have the potential to hit 120,000 kilos in peak annual output. Comparatively, investors could purchase a handful of growers yielding north of 100,000 kilos annually for less than a third of Cronos' market cap.

Cronos Group is also valued very aggressively on a fundamental basis. This is a company that's currently trading at more than 400 times next year's profit consensus from Wall Street and that hasn't done a particularly good job of expanding into overseas markets. International sales channels are going to be important when dried cannabis flower becomes oversupplied and commoditized domestically (likely by 2021 or 2022). Without ample international sales channels, Cronos Group could see its margins deteriorate.

Even factoring in the $1.8 billion in cash Cronos will receive from Altria once its equity investment closes, I'd opine that an attractive value for Cronos' stock is more than 50% lower than its current value, which makes Wall Street's sell recommendations all the more fitting.

A person holding a cannabis leaf in the middle of a grow farm.

Image source: Getty Images.

Tilray

Another cannabis grower drawing the ire of Wall Street investment banks is Tilray (NASDAQ: TLRY), which received a sell rating from Jefferies, along with a $61 price target, last week. This is yet another instance in which I believe Wall Street is correct.

On one hand, Tilray does have a prime focus on medical marijuana patients, which are a higher-margin base. These are customers that are far more willing to purchase alternative cannabis products, such as oils, which bear higher prices and much better margins than dried flower. Combine this with Tilray's superior medical branding and overseas push, and it's easy to see that the company does hold attractive value, but for the right price.

On the other hand, Tilray is probably going to be losing money hand over fist for the next year or two. Expanding capacity, conducting medical pot research, building up recreational weed brands, laying the groundwork in international markets, and potentially making acquisitions are going to push this company deep into the red for the time being.

Like Cronos Group, Tilray hasn't done nearly enough on the production front to suggest that it can compete with the big boys. With roughly 850,000 square feet of domestic capacity completed by the end of 2018, and around 250,000 square feet of capacity in overseas markets, this is a company with a nearly $7 billion market cap that has similar production to growers with a $700 million market cap. That doesn't make much sense.

Once again, even taking into account Tilray's partnerships and well-known brands, I agree that Tilray's stock should head lower.

A cannabis leaf lying atop carbonation in a glass, with cannabis leaves to the right of the glass.

Image source: Getty Images.

HEXO

However, when it comes to Quebec-based grower HEXO (NYSEMKT: HEXO), I'm a bit confused. HEXO received a sell rating from Jefferies, which expects 25% downside from the company's current price. But the company's prospects, in contrast to Tilray and Cronos Group, look much brighter relative to its valuation.

I suspect there are two reasons for Jefferies' subpar view of HEXO. First, HEXO hasn't done a lot with regard to expanding its brand into international markets. It's done a fine job of securing a massive supply deal in Quebec -- an aggregate of 200,000 kilos over a five-year span -- and within domestic provinces, but it hasn't made a name for itself outside of Canada.

There may also be concern that HEXO's joint venture with Molson Coors Brewing (NYSE: TAP) may not yield the desired results due to increasing competition in the nonalcoholic cannabis-infused beverage space. Although the joint venture (known as Truss) between Molson Coors and HEXO was announced in August 2018, these products won't be legally allowed for sale until probably October 2019. This gap gave Molson Coors' and HEXO's competition ample time to catch up, meaning it may not be the needle mover that investors have been expecting.

While I can understand Jefferies' point of view, I don't necessarily agree with it in this instance. HEXO is ahead of its similarly sized peers in terms of completing its capacity expansion; and while its yield looks to be around average or perhaps even a tad bit below average, it should have no problem hitting 108,000 kilos of production at its peak and potentially even turning a healthy profit in fiscal 2020.

To be clear, I'm not suggesting that HEXO is worth buying here. However, I certainly don't view it as a sell, either.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends HEXO. The Motley Fool has a disclosure policy.