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What Will Cannabis Stocks Do If U.S. Legalizes Pot? See Canada

The big decline in Canadian cannabis stocks right after legalization there in 2018 should raise caution for those excited by the prospects of U.S. legalization.

The cannabis space is once again alight with excitement about legalization efforts in a major North American country. Back in 2018, it was optimism about impending federal legalization in Canada, which sent local pot stocks such as Canopy Growth Corporation  (CGC) - Get Canopy Growth Corporation Report and Tilray  (TLRY) - Get Tilray Brands, Inc. Report soaring as hopes of a booming industry buoyed valuations that, in hindsight, were well beyond reason.

Now, recent optimism about growing state legalizations and the possibility of federal legalization in the U.S. has helped cause U.S. cannabis leaders Curaleaf CURLF and Trulieve  (TCNNF) - Get Trulieve Cannabis Corp. Report, as well as Canadian pot stock stalwarts such as Canopy, Tilray and Hexo Corp.  (HEXO) - Get HEXO Corp. Report, to each increase by triple-digit percentages in the past year, despite a recent pullback.

While the stellar performance of cannabis stocks since their nadir in 2020 has multiple contributing catalysts, including an expected emergence from COVID-19 lockdowns, optimism on U.S. legalization has certainly been a major contributing factor.

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In just the past few months, New Jersey, New York, Virginia and New Mexico have legalized cannabis consumption, bringing the total to 16 states and Washington D.C. More than double that number allow for medical marijuana, further suggesting broad societal acceptance and a move akin to that of the U.S.’s northern neighbors in Canada.

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“We believe our key learnings from operating in Canada will help us with the EU and the U.S. market once legalization happens,” Irwin Simon, CEO of Aphria  (APHA) - Get Aphria Inc Report, said on an April 12 earnings call, asserting that legalization is a question of when rather than if.

Simon is hardly the only executive with that perspective either, with many leaders in the industry joining hands to create the U.S. Cannabis Council to lobby for expedited legalization. Nor is Simon the only executive alluding to and salivating over the opportunity ahead.

"The Democratic sweep of the presidency and both houses of Congress represented a seminal moment for accelerating the path to liberalizing U.S. cannabis policy," said Boris Jordan, executive chairman of the US-based Curaleaf, in a March earnings call. "It's also worth noting that with the recent developments toward adult-use legalization in Mexico, combined with the current status of cannabis in Canada, the U.S. will be literally sandwiched between two large countries, moving forward increased liberalization of cannabis use."

Up in Smoke

However, Canada’s experience with the legalization of cannabis may also remind investors of the perils of over-optimism regarding liberalizing legal restrictions.

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For one point of reference, the Horizons Marijuana Life Sciences Index ETF HMMJ, which counts Canada’s largest cannabis companies among its holdings, declined nearly 50% from its pre-legalization peak in just the first two months following full legalization. As the reality of consistent losses in earnings reports eroded the exuberance of the pre-legalization period further, the ETF only fell further until at one point, it dropped to 80% below its high prior to legalization, in early 2020.

An academic paper on the Canadian cannabis bubble’s burst co-authored by Bradford Cornell, professor emeritus of finance and Aswath Damodaran, professor of finance at the NYU Stern School of Business, explained it as a sort of “delusion” about the immediate potential of the cannabis industry that investors were abruptly snapped out of as quarterly reports came due.

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“By October 2019, the assumptions regarding growth and profitability were being universally scaled back, business models were being questioned, and investors were reassessing the pricing of these companies,” the paper reads. “Given that there was no significant shift in fundamentals, the apparent explanation is that investors came to realize that the ‘big market’ was not going to deliver the previously expected growth rates or profitability for the expanding group of individual companies.”

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Tilray served as the starkest example of the bubble burst, falling from its peak, which was also driven by a short squeeze, of over $150 amidst the euphoric atmosphere a month prior to Canada’s official legalization, to about $5 per share two years after. It’s since rebounded significantly after the announcement of plans to merge with Aphria last December, but nonetheless remains well below its prior peak.

In hindsight, Canadian legalization appears to have been a classic case of “buy the rumor, sell the news.”

Lessons Learned?

To be sure, the learning curve for Canada as one of the first to nationalize legalize recreational cannabis was bound to be steep and thus prone to error.

“There was not enough supply to address demand in the period immediately following legalization,” explained Saleem Daya, a senior analyst at Nasdaq based in Toronto. “There was a substantial backlog in orders and producers were not initially sure what products or strains would be popular and where. This challenge quickly accelerated into a situation of oversupply.”

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He added that a fragmented legal framework, uncertain distribution capacity of many producers and limited retail footprint for cannabis greatly impacted the Canadian market and allowed the black market to remain robust. Also, uncertain footing in terms of financial support created significant issues for the emergent industry.

Daya cited the U.S. Senate’s renewed consideration of the SAFE Banking Act, an act protecting U.S. financial institutions that do business with companies in states where marijuana is legal from federal enforcement action, as a symbol that U.S. lawmakers are learning from the errors of their Canadian counterparts. On Monday, the House of Representatives voted 321-101 to pass the bill

Further, many of the U.S.-based cannabis companies are better-established businesses that are actually generating profits, rather than the persistent losses that pervaded Canada’s cannabis scene in 2018. Florida-based Trulieve and Massachusetts-based Curaleaf serve as prominent examples of cannabis companies that are already operating and profitable stateside, highlighting the key differentiation that helps in making the optimism more rational for U.S.-based companies.

Still, there remains ample caution in the Canadian rollout that investors should not get carried away investing in promising but unproven companies as a proxy for the sizable opportunity they see in cannabis. Instead, some careful stock picking might be best suited to the situation.

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"Focus on the quality of the business plan and execution to date, not future unrealistic goals," Michael Ruscetta, CEO of cannabis-focused financial service provider Trichome Financial, advised. "Focus on the ‘who’ as much as the ‘what’ -- there will be lots of teams looking to raise capital on unrealistic plans."