Everyone has probably had this conversation with a friend or family member in the last 4 to 6 months, it probably went something like, “I know this guy who’s made a killing in marijuana stocks, I’m thinking of jumping in…” or “I just got this hot tip, this marijuana company is gonna be huge!” and these are very reasonable reactions. But as investors, we first need to talk about 4 questions that have to be answered before we start seriously looking at investing in marijuana stocks. We have to look at them like we would process any other investment opportunity; using the 4 pillars of investing, which we have learned from great investors like Warren Buffett and Charlie Munger.
Question number 1: Do we understand the marijuana business?
It’s brand new here in Canada and there is very little in the way of operating history in most of the publicly listed companies, so this makes it very difficult to get a sense of what the businesses, as a whole, might be worth. We care about this because it’s how investing works at its very core. Remember, stocks are a real slice of ownership of a business and as owners of those shares of stock, we’re entitled to all the earnings that go with that slice. These earnings will be returned to us either through dividends or capital gains. As investors, we only care about the cash that the business will produce over its lifetime, and how much we are paying for that cash today.
“As investors, we only care about the cash that the business will produce over its lifetime, and how much we are paying for that cash today.”
Some other questions we might ask relating to the marijuana business are things like: Is marijuana a commodity? Or can it differentiate itself somehow? Are their patented strains? Does branding have a big part to play? Will customers be willing to pay a premium for one brand over another? What about unanswered regulatory questions? Federally, provincially, and at the city level? How does supply work? How easily can crops fail? Can they go bad? How loyal are customers? How big is the market? These are just some of the questions we need to be able to answer to get a good sense of what we’re getting ourselves into. As you can see, there’s a lot more to it then “It’s so hot right now”.
“…there’s a lot more to it then “It’s so hot right now”.
We then come to the second big question: Is there some type of durable competitive advantage, or what’s also called a moat, protecting the ‘castle’ in the individual marijuana company your looking at, or even the industry as whole?
If marijuana is a commodity like oil or coffee, low cost producers can do well, so who is the low cost producer and why are they able to be the low cost producer? Are they the biggest, so can they produce things the cheapest? Like Wal-Mart? Or Is there a secrets moat? Like Coca-Cola’s recipe, or Apple’s iPhone patents? Are there popular brands of weed that sell more than others that are maybe known for quality weed? This needs to as clear as possible before making an investment. Because without a competitive advantage, It’s very difficult to get a sense of what the company might earn, and this everything when it comes to investing.
The third question we need to ask ourselves is about our partners, the management team.
We need to think of our investments almost like a marriage. This management team will be handling a large portion of our wealth, so this is very important. We need to know if they are trustworthy and if their interests align with the us in how they get paid. Meaning are they paid more in salary or company stock? If it’s salary, they may not care as much about how the business goes, because they get paid regardless. If they’re paid in stock, they’re pay is much more closely tied to the business’s performance, and indirectly, your money.
We also need to know if they are good at what they do. To figure this out, some helpful numbers are ones such as ROE or “return on equity”, or ROIC, “return on invested capital” or “return on assets”, ROA. These numbers can help in showing us if the managers are good at what they do, and also give us insight as to how good the business is and if there are any moats built in. If there is a long history of these numbers being high, say 15% or more, usually there’s a good chance that Management is good, and even better, the business is good. If there is not much history, like with many of these marijuana companies, it’ll be all but impossible to get a clear picture. Ideally, you want the business to be so good that when management does something foolish, the business can survive and even thrive.
One examples of this is when Coca-cola introduce something called ‘new coke’, and customers hated it. But they were able to survive because of their great moats. They had moats like their brand name, a distribution network, and an excellent business model, where everyone along the supply line was happy. Coke makes the syrup, and then bottlers, shippers, and restaurants, and everyone in between is able to make money. These things saved them when the management made some pretty bad mistakes. We need to look at the management of these marijuana companies in same way.
Share dilution is a major issue with start-up companies. Companies will often issue lots of shares if they aren’t making a profit yet. They’ll use the money raised from the share issuance for a number of things, like paying the employees, investing in new equipment, paying down debt, etc. But share issuance can also be easily abused. For example: If you bought shares of Aurora Cannabis in 2014, your equity in the company would have shrunk by 97% because of share dilution!!!
And the fourth question, What should we pay for the stock?
Because, we can’t pay an infinite price. For example, we’ll use something like a rental apartment. (Now I know there is much more to real estate investing, but for simplicity’s sake, just bare with me.) Say we know we’re getting $10,000 per year in profit into our pocket from rent, after all expenses. We wouldn’t want to pay more than $100,000 that for the apartment, because we know that $10,000 we get in rent per year on $100,000 apartment is a great 10% return, or 10 times earnings. But that same $10,000 on say a $500,000 apartment becomes a 2% return, and isn’t such a great investment anymore. Because we’re paying 50 times earnings, we wouldn’t get our investment back, of $500,000, for another 50 years! As investors we need to stay rational, just because a rental property, or a marijuana company is selling for that much, doesn’t mean it’s worth that. Because remember, all we care about are real profits. We want to pay a reasonable price for real profits. And to my knowledge, no marijuana company has been able to make a profit yet and that’s a huge red flag as an investor.
“And to my knowledge, no marijuana company has been able to make a profit yet and that’s a huge red flag as an investor.”
And finally number 5, which is a more personal aspect that I add to this list: Don’t sell something you wouldn’t buy yourself.
This one is more to do with personal choice, but I think definitely has some value for keeping us out of trouble and sets us up for success. Often people will invest in businesses they don’t really believe in and only because there are promises of good profits. This can end up hurting you because your heart may not be in it, or it’s not very interesting for you to learn about. It also helps to keep your conscience clear knowing you’re not endorsing whatever the product is that you may disagree with. Remember, to be successful investing it must be a long term view, typically 2-3 years, sometimes longer. That’s a long time to own something you’re not super excited about, and to have your conscience eating at you during that time. It doesn’t seem worth it for a few extra dollars in your pocket.
I remember investing in an auto loan company, and not that there’s anything wrong with the services they’re providing, I think they can be very valuable to some people in the right instances, but more me personally, I realized I no longer believed in the product being sold. They were charging 15-25% interest for a product being sold to what I saw as mostly vulnerable people, this bothered my conscience because I felt like I was knowingly hurting people through what I perceived as predatory loans, so I decided to pull the plug and move on to something else.
So when thinking about weed stocks, it might be helpful to think about what your money is doing and if it aligns with your values and if you want to see what you’re investing in, being promoted in the world. Personally, I think I’m indifferent to marijuana, I just think overall, weed puts you at a disadvantage in life, and life is already hard as it is.