Evaluating Canadian Growth Opportunities: Why We Don't Own Cannabis Stocks

Robert Swanson's picture

Amid the recent frenzy surrounding marijuana stocks, we outline why Cambridge believes that staying true to our investment philosophy is a net positive in the long term.

Hardly a meeting goes by these days when we don’t get asked about cannabis stocks and why we don’t own any. Our explanation typically begins with a review of the attributes that Cambridge considers when making an investment, namely:

• An established business model with a competitive advantage

• A high rate of return on assets or invested capital

• An established management team with a track record of effective capital allocation

• A valuation that provides an attractive return/risk profile.

Despite our best efforts to explain our discipline to investors, we’re often met with disbelief that we wouldn’t make an exception to invest in this “tremendous opportunity”. On one occasion it was suggested that perhaps our process was too archaic for today’s dynamic investment environment.

The discussion around cannabis stocks tends to be polarizing. We’re not suggesting that investing in these stocks is bad necessarily, rather that they don’t fit the profile of the Cambridge investment process. So, for illustrative purposes, I’ll compare two rapidly growing Canadian companies to demonstrate our preference for one over the other.

Table 1 compares key financial metrics for Canada Goose (TSX:GOOS), a company we previously held in some of our institutional portfolios in 2018 and Canopy Growth (TSX:WEED), a leader in the cannabis sector. Figures are based on 2018 data and 2019 Bloomberg L.P. (“Bloomberg”) consensus estimates.

Canopy was listed in mid-2016 and began generating sales in 2017. Its current market capitalization is $21.8 billion, nearly three times that of Canada Goose’s valuation of $7.3 billion. Based on Bloomberg consensus estimates, Canada Goose is widely viewed as overvalued yet the stock trades at a fraction of Canopy.

Both companies have accelerating sales and high gross margins, but based on consensus expectations compiled by Bloomberg, Canopy may in the short to mid-term continue generating losses in operating income and earnings per share, and record negative free cash flow. Bloomberg consensus expectations for Canada Goose suggest they will grow earnings more than 50% in 2019, continue to generate attractive returns on equity and will have nearly $100 million of free cash flow to reinvest in their business. Based on the only comparable valuation metric, Price to Sales, Canopy trades at an expected multiple of 86 times versus 9 times for Canada Goose.

While it is difficult to predict the future of either company and the industries they compete in, it’s probably safe to say that Canopy has greater exposure to changing regulatory and competitive forces. The entire cannabis industry will be required to invest large amounts of capital to build these businesses, without the advantage of having uniquely differentiated products. As investment capital floods into the sector in the form of mergers and acquisitions, initial public offerings and secondary offerings, the ability to achieve attractive rates of return will become more challenging.

Cambridge has consistently adhered to our investment discipline. As quality fundamental investors, we remain focused on identifying durable, compounding businesses through our bottom-up research process. We remain committed to our investment process as we strive to grow wealth for our clients.


Robert Swanson
Principal & Portfolio Manager.

 

IMPORTANT INFORMATION

Robert Swanson is a Portfolio Manager to certain Cambridge funds. He does not have a material interest in the securities discussed herein; however, he is an investor in certain Cambridge funds which may hold these securities.

This commentary is published by CI Investments Inc. The contents of this piece are intended for informational purposes only and not to be used or construed as an endorsement or recommendation of any entity or security discussed. The information should not be construed as investment, tax, legal or accounting advice, and should not be relied upon in that regard. Inpiduals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors should consult their professional advisors prior to implementing any changes to their investment strategies. These investments may not be suitable to the circumstances of an investor. Some conditions apply.

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Published March 25, 2019

 


 

[1]The data shown is the increase in the closing price of the respective stock as at December 31, 2018 compared to the closing price as at December 31, 2017.

[2]The data shown is the decrease in the closing price of the respective stock as at December 31, 2018 compared to the closing price as at December 1, 2018.

Comments

Submitted by Dave Skillen on

Great blog post Bob. I get asked all the time from advisors, investors, clients and friends why I don't personally invest in Cannabis stocks and why Cambridge doesn't either. This is very helpful.

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