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Wall Street Expects These Pot Stocks to Drop by 22% to 44%

Sean Williams, The Motley Fool

Unless you've been living under a rock for the past couple of years, you're probably well aware that the green rush is underway. With the legalization of recreational marijuana in Canada this past October, as well as ongoing state-level legalizations in the U.S. and abroard, sales estimates for the cannabis industry are growing like a weed. Between 2017 and 2022, Arcview Market Research and BDS Analytics foresee global sales spiking from less than $10 billion to more than $31 billion -- and investors want their cut.

In January, following a rare rough quarter for pot stocks, more than a dozen marijuana stocks galloped higher by at least 50%. Many have continued their romp higher through February and much of March, leaving the broader market eating their dust.

But as pot stock valuations soar, investors are left to wonder how much upside is too much in a relatively short time frame. Although Wall Street coverage of cannabis stocks is still spotty at best, most marijuana stocks offer modest upside, based on Wall Street's consensus price targets. However, three red-hot pot stocks are fully expected to lose between 22% and 44% of their value, if Wall Street's consensus price targets prove accurate.

An up-close look at flowering cannabis plants.

Image source: Getty Images.

Cronos Group

In terms of price target pessimism, no marijuana stock raises more doubt on Wall Street than Cronos Group (NASDAQ: CRON). With two underperform ratings from Wall Street analysts, the average price target implies a drop in Cronos' stock of 44%.

The big reason Cronos Group has performed so well since early December is the closure of a $1.8 billion equity investment from tobacco giant Altria (NYSE: MO). Altria has been struggling with declining tobacco cigarette shipping volumes for years in the U.S., and investing in Cronos gives the company access to a faster-growing product channel. Altria and Cronos could also partner up on cannabis-based vape products throughout North America. Plus, with Altria now owning a 45% stake in Cronos, some folks believe a buyout is likely.

But even with a large cash infusion and the possibility of a buyout on the distant horizon, it doesn't mask a number of deficiencies that Cronos brings to the table. For example, the roughly 120,000 kilograms in peak annual output the company is currently on track for would only slot it in as the eighth-largest Canadian producer. Investors could instead opt for at least three other cannabis growers with similar peak yields that have market caps that are a quarter (or less) that of Cronos.

This is also a company that's struggled to push into overseas markets. Whereas Aurora Cannabis and Canopy Growth are in 24 countries and more than a dozen countries, respectively, Cronos Group has growing operations in Australia and Israel, and distribution in Poland and Germany. This isn't what we'd expect of a company that has global ambitions. Additionally, if domestic dried flower does become oversupplied within the next two years, Cronos Group could struggle to find outlets to move excess production.

Long story short, I didn't refer to Cronos Group as "the most overvalued pot stock" for nothing.

An outdoor cannabis-growing greenhouse with fans.

Image source: Getty Images.

Village Farms International

There's not a single pot stock that's been hotter since the year began than Village Farms International (NASDAQ: VFF). Through the closing bell on March 19, Village Farms was just a few pennies from having quintupled in value on a year-to-date basis. But, according to Wall Street's consensus price target, it's now slated to drop by 22%.

How does a company surge nearly 400% in a matter of 11 weeks? Part of the answer comes from Village Farms' successful move from the over-the-counter (OTC) exchange to the Nasdaq. Uplisting has been popular among pot stocks over the past year, and it provides added visibility and volume-based liquidity that wouldn't be possible on the OTC exchange. Further, Wall Street investment banks are more apt to offer coverage and/or invest in companies listed on major exchanges as opposed to the OTC exchange.

Unlike most marijuana companies, Village Farms International also has a fallback: its vegetable-growing business. Prior to forming a joint venture with Emerald Health Therapeutics (NASDAQOTH: EMHTF), known as Pure Sunfarms, Village Farms was already generating more than $150 million in sales each year from its vegetable business. Should its cannabis venture with Emerald Health not turn out as bountiful as expected, investors still have a solid foundation to fall back on.

But does a 400% rally make sense in less than three months? Well, no. Although Pure Sunfarms' retrofit is on track -- and the cannabis venture returned an extremely small profit following its first sale -- Village Farms' core vegetable-growing operation is a low-margin snoozer. Yes, the lack of share-based dilution is a nice change compared to most pot stocks, but Pure Sunfarms hasn't demonstrated enough as of yet to support continued bullishness for either Village Farms or Emerald Health.

A dollar sign shadow cast atop a pile of cannabis leaves.

Image source: Getty Images.

Innovative Industrial Properties

Another red-hot marijuana stock that's shot well past Wall Street's price target expectations is cannabis real estate investment trust (REIT) Innovative Industrial Properties (NYSE: IIPR). Having closed at nearly $90 on Tuesday, shares of the company have practically doubled in 2019, are up 430% since debuting in December 2016 on the New York Stock Exchange, and are 29% higher than the consensus Wall Street price target.

The buzz surrounding Innovative Industrial Properties is simple to understand: No pure-play marijuana stock is more profitable on a per-share basis. As a company that acquires land and facilities used in the cultivation and/or processing of medical cannabis, its costs are relatively low, while its cash flow is predictable.

Innovative Industrial Properties currently owns 13 properties in 11 states, with a goal of acquiring about five new assets a year. Each lease agreement stretches for between 15 and 20 years, with a rental increase rate of 3.25% built in, as well as a 1.5% management fee tied to the rental rate. This way, IIP, as the company is also known, can grow its adjusted funds from operations by modest organic means, as well as through acquisitions. An average return on invested capital of 15.1% suggests a complete payback on investments in less than five years.

But I do understand where Wall Street is coming from. At close to 45 times forward earnings, that's very rich for a REIT that's only built to grow organically by a little more than 3% a year. Also, should IIP choose to raise additional capital to purchase new properties (which is likely), it'll need to issue more shares, thereby diluting the value of existing investors. While Innovative Industrial Properties is clearly the most attractive of the three pot stocks mentioned here, a pause would seem to be in order.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool recommends Innovative Industrial Properties and Nasdaq. The Motley Fool has a disclosure policy.