Cannabis Stocks Are Likely Exiting a Bear Market

Cannabis stocks have been in a bear market since early 2021. From the peak closing high in February of 2024 at 92.48, they have dropped over 90%!

I was kind of excited in mid-2022 about the low prices, but I became cautious in late 2022. I have been expressing caution for a while, but recently became a lot more optimistic. I think that the sector could do a lot better in the months ahead. In this piece, I explain why cannabis stocks have performed so poorly and why I am more optimistic now. I conclude with a review of all the ways readers can stay on top of cannabis stocks.

The 2020 Bull Market Transitions to a Bear Market

2020 began with the cannabis sector already under pressure. In late 2019, a crisis regarding vaping hit, and many feared that this would hurt the publicly traded companies. The stocks were already selling off when the pandemic hit, and they were crushed afterwards. There were some store closings due to COVID, and investors feared that the whole industry would suffer.

At New Cannabis Ventures, which I started with a partner in 2015, our Global Cannabis Stock Index bottomed in March 2020 and then soared. There were two reasons for the move. First, cannabis sales were strong in the second half of the year. This wasn't too surprising in hindsight, as consumers were panicked about the future and turned to cannabis to help them cope. Of course, they were helped by being at home, having few ways to spend money, and not being drug-tested by their employers. In November of 2020, the Democrats took the presidency and both houses of Congress, and this resulted in too much optimism regarding the potential for federal legalization.

In 2020, the Global Cannabis Stock Index rose 5.2%. This was preceded by a 34.1% decline in 2019 and a 54.9% plunge in 2018. After the small gain in 2020, the index fell 26.0% in 2021 and a stunning 70.4% in 2022. In 2023, it fell 16.4%. So far in 2024, it is up 9.5%, though this lags the S&P 500 substantially and the more appropriate Russell 2000 Small-Cap Index marginally.

The Next Bull Market

While cannabis stocks are higher so far in 2024, this follows a massive contraction over the past 3 1/2 years. Additionally, the index has dropped 24.2% since April 30th, the recent peak. This was the day that the Drug Enforcement Agency (DEA) declared that it was officially rescheduling cannabis from Schedule 1 to Schedule 3.

This rescheduling, which is still expected to take place, will wipe out an onerous tax that was implemented in 1982 by Congress and President Reagan, 280E. According to the IRS:

Section 280E disallows all deductions or credits for any amount paid or incurred in carrying on any trade or business that consists of illegally trafficking in a Schedule I or II controlled substance within the meaning of the federal Controlled Substances Act.

American cannabis companies pay tax on gross profits and not net profits due to this old law. They can owe taxes even with negative operating income. The effective tax rates on profitable cannabis companies are much higher than the federal income tax rate.

I called out 280E in late 2022 at New Cannabis Ventures, suggesting that the market needed one of two catalysts to happen. The Global Cannabis Stock Index has dropped 27.1% since that piece was written. The market had been surging in late 2022 due to a move by President Biden regarding pardons by the federal government and the potential for rescheduling.

On 8/30/23, news hit that Biden's Department of Health & Human Services had recommended that the DEA move cannabis from Schedule 1 to Schedule 3, which would wipe out 280E. The market responded very favorably, but the DEA said and did nothing. Today, the index is up 19.7% since 8/28.

As I described above, the market surged in late April 2024 but then has plunged subsequently. Here is a year-to-date chart of the index:

It is still not know when the change will take place, but the DEA public comment period ended in July. It is not yet a done deal, but the DEA is very likely to proceed with its plans. It's a federal election year, and there is concern that Trump as President might not allow it to follow through. It seems extremely likely that Harris will continue, and it also seems likely that Trump would permit it.

The removal of 280E is about the only big benefit for investors that I see from rescheduling of cannabis, but it is a huge thing. The American cannabis companies tend to have substantial debt and insufficient cash flow to just pay that debt off if the tax remains. Cannabis stocks are valued typically by comparing the enterprise value (market cap plus net debt) relative to the adjusted EBITDA. The EBITDA will not change (the T is for taxes, which are excluded from that metric). Cash flow, though, will improve.

While adjusted EBITDA won't change, the current valuations are very low. I wrote about Ascend Wellness (AAWH) recently on this blog. The stock is up since then, but it still remains the cheapest American cannabis operator. I currently have a 14% position in my Beat the Global Cannabis Stock Index model portfolio at 420 Investor. That stock, the third-largest position in the model portfolio, is not part of that index currently.

So, after 3 1/2 years of falling prices, these stocks are lower in price. I find the valuations generally very reasonable for the entire sector. My model portfolio at 420 Investor currently has 33% exposure to American cannabis operators, 32% exposure to ancillary companies and 29% exposure to Canadian LPs. I find the valuations very low generally.

So, this potential elimination of an onerous tax could boost the market. It's easy to see how it would help those that pay the tax, the American cannabis companies. It doesn't help the Canadian companies, but some of those are cheap (not Canopy Growth or Tilray!). It does not directly benefit the ancillary companies, but having a healthier customer will be good for them in my view.

The cannabis market has had several bull markets (2013-2014, 2016-2018 and 2020-2021), and these moves have been very large. They always seem to go up more than I would expect. Sentiment for the sector is absolutely terrible right now. This doesn't surprise me! There are very few institutional investors participating in the cannabis sector currently. I believe low prices, the duration of the bear market, valuations and poor sentiment create the potential for these stocks to do very well ahead when 280E gets eliminated.

How to Stay on Top of Cannabis Stocks

I began focusing on the cannabis sector in 2013 and launched 420 Investor in August of that year. The goal I had was to educate people on the publicly-traded companies operating in the sector. I moved the service in late 2022 to Seeking Alpha, which I like tremendously. There is the full service, as well as a sub-service known as The Top Pick, which offers a lot but less than 420I for a lower price.

Speaking of Seeking Alpha, I began writing articles there in 2007, becoming one of their most popular contributors. I began writing on cannabis stocks there in 2013, mainly warning about the many penny stock scams. I became so busy at 420 Investor that I stopped writing at Seeking Alpha about any stocks, including cannabis stocks, in 2014. When I moved 420 Investor to Seeking Alpha in late 2022, I started sharing articles there about cannabis stocks weekly. You can see all of the 700+ articles I have shared, and this is a good way to stay on top of things for free (or as part of a low-fee service that Seeking Alpha offers.

The final way that readers can follow the cannabis sector is by following New Cannabis Ventures. Each week, I post a weekly newsletter, and this is free of charge and requires no registration.

So, I am offering lots of ways for investors or potential investors to stay on top of cannabis stocks. I own no cannabis stocks personally (potential conflict of interest), and New Cannabis Ventures has no paying clients right now. So, why am I discussing how cheap I believe cannabis stocks are? Well, I hope to drive subscribers to 420 Investor or readers to my Seeking Alpha articles. I also would like to boost my reputation as an industry analyst. I like cannabis, and I like cannabis stocks (not all of them!), but I am known for not being on board all the time with the price of the stocks. I have been very cautious now for almost two years, and things are quite different now.