To say that the marijuana industry is flowering would be an understatement of epic proportions. In just a few years, the legal weed industry has exploded, with global sales expected to more than triple from a reported $5.4 billion in 2015, per Arcview Market Research and BDS Analytics, to an estimated $16.9 billion in 2019. By 2022, global pot revenue will nearly double again, hitting an estimated $31.3 billion.
This rapid sales growth, and the relatively steady popularity and growing acceptance of cannabis as a mainstream product, is what's driven investors to pile into marijuana stocks since the beginning of 2016. Many have seen their share prices rise by a triple- or quadruple-digit percentage in just over three years' time.
Image source: Getty Images.
This behavioral bias could come back to bite pot stock investors
But, as you can imagine, not every marijuana stock is going to be a winner. That's why pot stock investors have to be particularly diligent when researching these companies and avoid a behavioral bias that can easily crop up in this industry. The bias in question is an overly strong attraction to companies with single-digit, or sub-$1, share prices.
This investor thesis is based on the (incorrect) idea that owning more shares of stock (i.e., buying hundreds or thousands of shares of a company with a low share price) will give you a better chance of making money than buying into a stock that has, say, a $25, $50, or $100 share price.
If offered the opportunity to buy 100 shares of a $1 stock, or 1 share of a $100 stock, my suspicion is you'd be surprised at just how many folks would choose to own 100 shares of the $1 stock, with the belief that it's easier for a company to double from $1 to $2 than it is for a stock already trading at $100 to increase to $200. However, relying solely on share price while paying little mind to market cap (i.e., share price multiplied by outstanding shares) or underlying fundamentals is a recipe for disaster.
You see, the cannabis industry is in the unique spot of having limited access to capital for most of its existence. The passage of the Cannabis Act in June in Canada, and the subsequent legalization of adult-use weed in October, did finally open the door to traditional banking solutions for marijuana stocks located in Canada. But this doesn't mask the fact that nearly all pot stocks have had to issue their own stock, offer convertible debentures, or issue stock options and/or warrants in order to raise capital or finance acquisitions. As a result, the outstanding share count of quite a few popular pot stocks has ballooned. Thus, even with reasonably minuscule share prices, certain pot stocks may be much larger than you realize.
Image source: Getty Images.
There's more to investing than just share price
For example, both Auxly Cannabis Group (NASDAQOTH: CBWTF) and Aurora Cannabis (NYSE: ACB) are two popular plays in the marijuana industry. Auxly carried a share price of just $0.70 as of the closing bell on Wednesday, March 21, and is averaging 1.25 million shares traded daily, with Aurora Cannabis closing at $9.57 and averaging more than 29 million shares traded per day. On message boards, I regularly see posts wondering "why Aurora's share price is lower than Aphria's," or opining that Auxly's sub-$1 price is clearly a bargain "because it's below $1."
But what these investors are overlooking is the share-based dilution that's caused the share price of both stocks to remain in the single digits.
Auxly, despite being a true penny stock based on share price, has a $430 million market cap. That's because its outstanding share count has ballooned from 184.7 million, as of Sept. 30, 2017, to 565 million shares a year later, as of Sept. 30, 2018. By providing up-front capital to expanding grow farms in exchange for a percentage of their production at a below market cost, Auxly is one of the larger cannabis royalty companies in existence. But supplying this up-front capital meant issuing its own stock, thus tripling its share count on a year-over-year basis. Now, the company doesn't even need a $2 share price to hit a $1 billion market cap.
Image source: Getty Images.
Meanwhile, Aurora Cannabis has seen its outstanding share count shoot up from around 16 million shares at the end of fiscal 2014 (June 30, 2014), to 998.1 million shares as of Dec. 31, 2018. Aurora's acquisition-heavy strategy has seen the company lean on issuing its own stock to cover the cost of its deals. As a result, and following the closure of a few recent deals, the company has issued 1 billion shares in less than five years and has a nearly $10 billion market cap despite a single-digit share price.
In my personal view, it would be a lot tougher for Aurora Cannabis, a company liable to produce a sizable operating loss in fiscal 2019, to double in value to nearly $20 billion in market cap than it would for say CannTrust Holdings, with its $9.96 share price and $1.05 billion market cap, to double in size to $2.1 billion. They have virtually the same share price, but have very different outlooks, with CannTrust expected to sport a much lower forward price-to-earnings ratio than Aurora.
The point being that pot stock investors need to avoid becoming enamored with single-digit share prices. Rather, they'd be wise to pay attention to the underlying profit outlook for each company, as well as its market cap, when determining a fair valuation.
More From The Motley Fool
- 10 Best Stocks to Buy Today
- 3 Stocks That Are Absurdly Cheap Right Now
- 5 Warren Buffett Principles to Remember in a Volatile Stock Market
- The $16,728 Social Security Bonus You Cannot Afford to Miss
- The Must-Read Trump Quote on Social Security
- 10 Reasons Why I'm Selling All of My Apple Stock