If you are invested in cannabis stocks, you likely just saw your portfolio value shrink dramatically along with your other stocks. In March, the Global Cannabis Stock Index fell 25%, while the S&P 500 fell 12.5%, its worst month in more than eleven years. Cannabis stocks fell 44%, while the S&P 500 lost 20% during the first three months of the year, and cannabis stocks remained under pressure in the first three days of April. Here is how things look so far for cannabis stocks in 2020, with the index now down 49.3%:

A chart of the New Cannabis Ventures Global Cannabis Stock Index

For cannabis investors, it’s been a tough two years, with the market down substantially from early 2018, when there was extreme enthusiasm following the legalization in California. As of April 3rd, it has declined 88% over the past 27 months, even as it rests above the closing low set on March 18th. I discussed six months ago how the vaping crisis had created a cannabis industry capital crunch, and the COVID-19 crisis has not only accelerated it, but it has also added some other challenges.

I recently shared my perspective on how the COVID-19 crisis could impact cannabis stocks, discussing not only the big picture but also how it could affect eight separate sub-sectors. The good news, in my view, is that the industry will likely have strong prospects as we emerge from the crisis, as the path to legalization is likely to be shorter as states seek tax revenue and jobs. Unfortunately, many cannabis companies, both private and public, may not make it that long, which makes security selection more important than ever.

At 420 Investor, I have been rapidly reducing exposure to names I consider more vulnerable and allocating towards those that I think are best positioned to weather the storm and capitalize on opportunities in the future. Before I share some ways readers can think about improving their portfolios, I want to discuss the near-term operational challenges and how some companies are already being effectively wiped out.

How COVID-19 is Creating Operational Challenges

One bright spot has been that almost all states have deemed cannabis retailers as providers of “essential services”, though there have been some notable exceptions, including Massachusetts, which shut down the sale except to medical patients, and the province of Ontario, which reversed its earlier position and forced retailers to close (and forced all sales to go to its own online store).

The main challenge has been the shift away from stores to delivery, an option that wasn’t previously available in many states, or to pick-up. While there was an early spike in sales in many markets, the inability to walk into stores will cut demand most likely. The costs of serving customers is likely to increase as well.

Another challenge for operators in some states is that tourism has halted. Colorado has summer and winter spikes due to tourist demand, but some other states or cities are extremely dependent on tourism and will suffer greatly. A prime example is Las Vegas, which has shut down completely. I profiled Planet 13 recently, and this company is particularly vulnerable in the near-term, as its 10% market share is heavily dependent upon the tourist population. There are many other companies that derive a substantial amount or even all of their revenue from the Nevada market.

In most states, construction is being permitted at this point, but this is another potential challenge for operators, many of which are in the process of bringing on additional production capacity or opening stores. Additionally, regulators aren’t able to move as quickly, and some zoning and permitting approvals may be slow. Lack of regulatory swiftness is likely to slow license transfers as well, hurting the ability of operators to close pending acquisitions.

COVID-19 Has Crippled or Killed Several Cannabis Companies

We have seen a substantial pick up in companies seeking protection from creditors. Just last week, Canadian licensed producers CannTrust and James Wagner Cultivation did so, joining a few others that have already taken that step, and there are many others likely headed that direction. A good example is RavenQuest Global, which lost one of its licenses after it was evicted from its facility in Alberta for failure to pay rent. The company’s website is no longer functioning.

In the United States, MedMen bit the bullet and took on debt with particularly onerous terms last week as it also brought in outside management with restructuring expertise. CBD marketer Green Growth Brands , which had recently announced the sale of its division, instead put it into receivership last week. Surna, a supplier of HVAC equipment, saw two of its three directors abruptly resign after it issued guidance that it may not survive the crisis.

It’s going to get a lot worse, unfortunately, as many companies are out of cash and are losing money. Some will price equity offerings at desperate levels, like Tilray did in March, while others will take on debt on onerous terms, as MedMen did. I described the take-under of Indus Holdings in March, a very cautionary story in my view that should leave investors quite concerned about this new threat.

Steps Cannabis Investors Should Consider Taking

I always remind my subscribers at 420 Investor in both good times and bad to be very careful about how much they allocate to the cannabis sector. In the past, when I have conducted surveys of the community, I have learned that many claim to have more than 75% of their entire investment portfolio in the sector, sometimes more than 100% by using margin. The first thing anyone should do, especially considering that the market has bounced sharply off the bottom set on March 18th, is to make sure that their allocation to the sector is appropriate for the amount of risk they can assume. While I think the future is bright for a small number of companies, the path between here and there could be quite rocky. Quite simply, investors should be prepared for even the relatively safer names to decline in the near-term, so the first step is to reduce exposure if you can’t afford to lose more money. This is likely something that applies to investors in the broad market as well.

I always pay attention to the financials, but it has never been more important. One has to have an understanding of how much cash, if any, a company will need, and how they may be able to get it (if at all). We have seen the relatively stronger companies access capital through sale/leaseback transactions, the issuance of debt and the sale of stock. The latter is the safest, in my view, but it can crush the stock. So, the second step is to understand cash needs in the near-term and gauge the ability to access capital.

Next, it’s not good enough to be aware of the cash, as often the cash is earmarked for things like debt repayment, capital expansion projects or even meeting short-term needs like accounts payable. In this environment, other short-term assets may not be realized, especially accounts receivable, as we are aware of slow pay in places like California and Nevada, and this was before the current pandemic crisis. So, the next step is to assess the balance sheet very closely. Be very careful relying upon cash values, as debt may be substantial, even if it isn’t due in the short-term. Companies that have debt due in 2022 are already facing substantial scrutiny. There are many companies with high cash balances but significant levels of debt along with operating losses, and the debt may prove to be too big of a burden.

My next point is that investors should be very aware of geographical risk. I shared the examples of Nevada and Massachusetts above, but things could change for the worse in other markets potentially. For example, I also profiled Liberty Health Sciences and Trulieve last month when I discussed profitable companies. So far, the Florida market that accounts for all of Liberty’s and nearly all of Trulieve’s revenue has been quite robust, but it is likely to slow as new potential patients struggle to register with the state. Additionally, while I don’t expect Florida to do so, it’s always possible that any city or state could move to close the operations of a cannabis company. So, investors should be careful not to take on too much geographical risk. More diversified companies may be a better option, though, of course, it’s important that they have relatively strong financials and access to capital.

Finally, be prepared for equity raises from even the relatively strongest companies. What this means to me is to not be over-exposed to the stock of any company, saving some gunpowder to buy the inevitable dip when the company does sell stock. While I don’t consider Tilray to be a relatively strong company, the recent action does indicate what can happen when a company does sell stock. In this case, the deal, which included shares of stock along with warrants, was priced at $4.76, and the stock fell to an all-time low of $2.43 just days later. Identifying the future winners doesn’t mean one has to go all-in today.

The Bottom Line

Tying it all together, the COVID-19 crisis has exacerbated the capital crunch that emerged for the industry in September, when the vaping crisis hit. It has also created some operational challenges that will likely hurt the growth in the short-term of even relatively healthy companies. The silver lining is that the industry should experience stronger growth than many other industries as the crisis ensues and will likely see enhanced future growth due to legalization being accelerated as a means to gain tax revenue and job growth for states. Unfortunately, the risks to poorly capitalized and unprofitable cannabis operators have increased dramatically, and many of these won’t benefit from that future growth. Investors should choose their cannabis stocks very carefully in this environment, trying to find those companies that will survive now and thrive with diminished competition in the future.

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