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  • Writer's pictureTed Ohashi

Why are Cannabis stocks falling with legalization coming soon?

If you invest in cannabis stocks, you can learn a lot and make a higher return by understanding and applying well known investment principles. When you invest in a brand new sector like cannabis, it is a constant learning experience. We gather information about products and services that didn’t exist previously and try to figure out how the stock market will react to completely unique developments. Of course the converse is also true. There are many lessons to be learned by applying tried and true stock market investment concepts to a pioneering industry like cannabis. We can improve our investment returns by understanding the basics.

In our recent interview with Chris Naprawa, President of Khiron Life (TSXV: KHRN) said, “We all studied “efficient markets” in business school and I haven’t seen proof of it in the real world in the past 15 years. I’m not aware of it in practice.” What Naprawa means is the “efficient market theory” that still forms a major part of business school curriculums and investment thinking today says at any given time stock prices reflect all available information. This means a stock’s current price is a good approximation of its “fair value.” But Naprawa says he hasn’t seen this in 15 years of professional investment practice and explains why a stock like Khiron doesn’t discount all available information and can be greatly undervalued.

I agree. One important development in investment theory in the more recent past is called Behavioural Finance. The “efficient market theory” referred to above assumes all investors act rationally. A perfectly rational investor will buy more stocks if prices fall. We all know that’s not right. Behavioural Finance says we have to take into account the way people actually react to financial events, in other words, we have to look at investor’s irrational behaviours. When we do, it explains many things going on in the cannabis stocks right now.

Let’s look at a couple of findings that will help us understand the cannabis stocks today. Behavioural finance analysts have studied human behaviour and found if there are two events that are equally important, the more recent one is a greater influence on how you act than the older one. This makes sense. You can probably relate to this yourself. A second finding is people would far rather avoid a certain percentage loss of money than experience the same percentage gain. Again a practical truth that explains why people are more risk averse when stock prices are falling. They like to win but they hate to lose even more.

One question we are often asked these days is how can the cannabis stocks be falling when legalization is just around the corner? This is what we see.

Here is the long term chart of the Let’s Toke Business Marijuana Composite Index plotted relative to the Toronto Stock Exchange Index. By rising to the right, the cannabis stocks have been outperforming the average Canadian stock. Why are people selling cannabis stocks right now? We can see over time, the cannabis stocks have been rising in price faster or falling in price more slowly than average. Most recently, cannabis stocks have been declining faster in price than average and this effects people’s financial behaviour more than the long-term results which is that cannabis stocks have performed much better than average. But since people are effected more by recent results, they only are influenced more by short term losses than long term gains.

The next chart shows the LTB Composite in absolute terms. When the graph is rising, prices are rising and when the graph is falling, prices are falling. As prices have been falling, people have been losing money and because they are risk averse they often sell in an attempt to stem their losses. Also because they are risk averse and see stock prices have been falling, they aren’t buying either. So more sellers than buyers is a formula for falling prices and that is what has been happening and will likely continue to happen. At least that’s what we expect for the balance of the summer.

When will the decline in prices end? Our experience is extended downtrends in stock prices are like bad movies. Just when you think it will never end it does. We find there are two ways longer price declines come to an end. First, quietly as selling peters out and buying gradually takes over. The second is when it is triggered by an event. If both coincide we can get a rapid recovery as was the case when the last prolonged decline in cannabis stock prices that ran from around Xmas 2016 until September 2017 was coming to an end and Constellation Brands (NYSE: STZ) took an interest in Canopy Growth (TSX: WEED).

We could see a similar rebound this year. To set the stage we will need the market decline to slow and begin to flatten out post-Labour Day and into October when legalization becomes effective in Canada.

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