Dear fellow Fool,

Welcome to this special report on investing in cannabis stocks.

Despite home minister Sajid Javid calling for a review of the UK’s medical marijuana policy this summer, it seems highly unlikely that we’ll see recreational use decriminalised here in Britain anytime soon.

Likewise, we don’t believe we’ll have any cannabis-related shares listed on the London Stock Exchange for the foreseeable future.

But that’s certainly not the case elsewhere in the world, where the cannabis industry is undergoing a pivotal transformation.

Over the past several years, the industry has gained some traction with the legalisation of medical marijuana in Canada, and 30 states adopting some form of legalisation on a medical or recreational level in the US.

But of course the big news is that on 17^th October 2018, Canada legalised the adult use of recreational cannabis— ushering in a new era of legitimacy within the cannabis space.

Most importantly, Canada is the first major country to legalise recreational cannabis use on a national scale.

Many Canadian companies and opportunistic US businesses have been waiting for this moment, scaling their growing capacity and operations as quickly as possible to meet the anticipated demand for legal marijuana.

With legalisation in Canada now in effect, these companies can begin to compete for sales contracts, breadth of distribution, and brand positioning. That means we could quickly get a sense for which business models and strategies are sustainable, and which ones are likely to fizzle out.

In other words, up until this point, every cannabis company has been ‘talking the talk’. Many companies have claimed they will be the lowest-cost producers, grow the highest-quality product, and have the widest-reaching distribution and the best branding to resonate with consumers.

But thanks to Canadian legalisation, we will soon know which of these companies are ‘walking the walk’. This finally opens the door for us to apply our Foolish, long-term, business-focused approach to the cannabis space.

And that is precisely why we think now could be the time for Foolish investors to start adding to a basket of cannabis stocks within their own portfolios.

Cannabis Stocks

The Basket Approach

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For the foreseeable future, investing in cannabis companies will be unlike investing in most other industries. There are currently nearly 300 publicly traded cannabis companies jockeying for a winning position now that the use of recreational cannabis is legal in Canada.

In reality, we think most of these cannabis companies won’t exist as independent companies three years from now. There will be some consolidation through mergers and acquisitions (M&A) — as we’ve already seen this year, with Aurora Cannabis acquiring CanniMed and MedReleaf, and Canopy Growth purchasing Hiku Brands.

Up until now, cannabis companies of all sizes have had a relatively easy time raising cash. But with Canada’s legalisation now in effect, I suspect it will become increasingly difficult for these businesses to raise cash unless they are proving their strategy and business model is differentiated and gaining traction in the marketplace.

As a result, it seems inevitable that there will also be a fair share of companies that run out of cash, never become profitable, and go bust.

To be clear, this is undoubtedly still a risky arena for investors. Which is why we think it’s best to approach the cannabis space like a venture capitalist.

Venture capitalists invest in earlier-stage companies, often before they have demonstrated meaningful traction or scale. Venture capitalists put a lot of weight on qualitative factors like leadership team, vision, and the proposed game plan to become a leading business.

Venture capitalists also recognise that many of the companies they invest in will go up in smoke or fail to provide a meaningful return. For every 10 investments, they expect just one or two big winners to generate the majority of the returns.

I suspect we’ll see something similar play out with cannabis companies in the coming years. Most industry experts I’ve talked to suspect we’ll see anywhere from four to eight big global leaders emerge — similar to what we see in the alcohol or tobacco industries — along with some smaller niche players.

This is why we’re advocating investors take a ‘basket approach’ to cannabis stocks.

That’s because the vast majority of ‘pure play’ cannabis businesses are all in the early stages of their development.

Taking a basket approach — investing relatively small amounts into half-a-dozen or so promising looking companies — is important, because at this stage it is difficult (arguably impossible) to project which might ultimately become sustainable, long-term winners.

By starting with a basket of stocks, you can hopefully follow the progress of each company in the coming quarters and look to add to those that are proving their strategies and business models have staying power.

In short, we expect the majority of gains to come from just a relatively small percentage of the numerous cannabis businesses currently out there.

Cannabis Stocks

Our Investing Criteria

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As a Foolish investor, how do you go about identifying a potential ‘winning’ cannabis business from one that might simply ‘go up in smoke’?

Rather than just taking ‘pot luck’ (ahem!), we believe that applying the following three tests to your own cannabis stock research could help you build up a shortlist of promising looking investment opportunities.

The Three Key Traits

Here are the three key traits we think you need to be looking out for:

1. A differentiated strategy.

Just having a licence to grow or sell cannabis, for example, isn’t going to be much of a sustainable long-term differentiator — Health Canada (the government department responsible for Canada’s national public health) will most likely continue to hand out licences, and there could be plenty of competition for growing capacity.

As Fools, we specifically want to look for companies with a unique strategy and a different business model from the rest of the herd, increasing the odds that they can carve out a sustainable advantage in the years ahead.

2. Experienced and invested management team.

We also want to invest in companies guided by visionary and experienced leaders, whether that experience comes from the cannabis industry or other relevant industries like pharmaceuticals, alcoholic drinks, or consumer packaged goods.

We want leaders who have skin in the game themselves, owning a sizable percentage of the businesses they’re leading. After all, if management doesn’t believe in the company enough to invest/hold a substantial amount of its net worth in the business, why should we?

3. A healthy balance sheet.

Since the vast majority of cannabis companies are still burning through cash as they ramp up growing capacity or other aspects of their operations, we also need to be on the lookout for companies that have a healthy balance sheet to support continued reinvestment back into the business.

A stronger balance sheet should give a company more flexibility and a longer runway to continue reinvesting — a cash cushion until the company’s operations (we hope) eventually generate enough cash to sustain the business.

Cannabis Stocks

Expect Volatility… A Lot of Volatility!

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The lofty valuations of most cannabis companies are based not on historical fundamentals — because there is very little in the way of track records for any pure-play cannabis company — but on rosy expectations for future growth and profitability.

Virtually every cannabis company today is unprofitable and burning cash. And for good reason… with the floodgates to a multibillion-dollar industry now wide open in Canada, any wise company is likely still investing in infrastructure to ensure that it’s best positioned to take advantage of the predicted ‘green rush’.

However, with that sort of cash burn and unprofitability — combined with short operating histories and near non-existent track records — comes an added layer of risk.

In short, other than management projections and analyst/market expectations, there aren’t really any fundamentals supporting the valuations of most cannabis companies on the market today.

This means that it won’t take much for the share prices of cannabis companies to move a lot — both up and down — in a short amount of time. These sorts of companies will almost certainly be heavily influenced by headlines, speculation, and reflect the optimism or pessimism of the day.

How To Handle the Volatility

As any investor knows, volatility is inevitable with all stock market investments, but you can expect a whole other level of volatility with cannabis stocks until companies develop more of a track record — something that probably won’t happen until 2020 or even later.

So how should you prepare for this bumpy roller coaster ride?

Here is our three-step plan to embrace the volatility — so that you can try and let it work to your advantage.

1. Diversify with a basket of stocks.

As covered above, I strongly advocate investing in a minimum of half-a-dozen stocks as a starting point. The goal here is not to try and pick one or two winners just yet, because we simply don’t have enough information to base those decisions on — given that these companies have such limited operating histories.

Starting with a basket of cannabis stocks should help you to keep a long-term time horizon in mind — with the aim to hold these stocks for at least three years — as well as helping to mask the inevitable volatility of each individual holding.

2. Start small.

You need to be in this for the long haul. You’ll want to sit tight and remain focused on the progress of the basket of underlying businesses you’ve chosen to invest in. Each quarter, I’d strongly encourage you to review the performance of these businesses and see which companies — if any — are worthy of additional investment.

Volatility is inevitable, and the aim here is to start small —and then consider adding to any promising performers over time.

To paraphrase my friend and fellow US Fool, Tom Engle:

If a stock is going to be ‘the next big thing’, a little is all I need to own.
If it turns out to be a dud, a little is all I want to own.

3. Keep your cannabis collection less than X% of your portfolio.

That ‘X%’ number will be different for each person. For some people the number might be as low as 1%, and others that figure might be much higher, depending on your personal appetite for risk, but we suggest an absolute maximum of 10%.

Don’t invest anything into cannabis stocks that you will need within three years. The purchase of any cannabis stock for your basket should only be made with the intention to hold for at least three years, and preferably far longer than that.

No one (not even The Motley Fool!), is able to predict short-term movements in share prices. So limit your search to finding legitimate looking businesses in the cannabis space with promising growth prospects for the next three years and beyond.

All investments in cannabis stocks should be made within the context of a diversified portfolio. As I’ve hopefully made clear, we expect to see a lot of volatility in the months and years ahead. We suggest you limit your cannabis investments to a percentage of your portfolio that lets you sleep well at night, rather than worrying about the inevitable ups and downs.

A Word About Buying Cannabis Shares

Once you log in into your brokerage account and look to trade cannabis stocks, you may notice that there are two or more ticker symbols available for the same company. This is because the majority of these stocks are Canadian companies and trade both on Canadian exchanges (either the Canadian Securities Exchange, TSX (Toronto Stock Exchange), or TSX Venture Exchange) and on the US OTC (‘Over the Counter’) exchange, NASDAQ or NYSE.

Keep in mind there may be differences in prices between OTC, NASDAQ or NYSE ticker symbols compared to the Canadian ticker symbol because the OTC symbol is listed in US dollars, whereas the Canadian ticker symbol is, understandably, listed in Canadian dollars. The long-term performance of the US listed versions is typically very close to the Canadian shares.

Depending on your brokerage account, you may also need to request special permissions from your broker to trade cannabis stocks — indeed some companies may not be available to trade at all on your broker’s platform. We recommend you contact your brokerage if you’re having trouble — if a stock is unavailable through your broker’s website, you may be able to request access to it via telephone trading. Please also keep in mind that your broker may charge you different rates to trade in international stocks compared to UK shares, there may be a periodic holding charges, and there is the additional risk posed to your investments from fluctuating exchange rates. Remember as well the time difference when you come to trade — you may find it better to look at these stocks when the North American markets are open, in the afternoon, UK time.

Remember: Use Limit Orders!

As you consider buying or selling any cannabis stocks, you need to be aware that many of these cannabis companies are still small caps and often have minimal volume. Since small caps can be thinly traded with very little volume — and the share price can pop dramatically when there is a sudden increase in new buyers — we strongly recommend that you use limit orders when making a purchase.

Using a limit order can protect you from paying a higher price due to a sudden (and often temporary) short-term spike in the share price.

Remember, we think you should be approaching any investment in cannabis stocks with a minimum time horizon of three years. So we encourage you to be patient as you start filling up your basket and to have the discipline to use limit orders as you establish positions.

Cannabis Stocks

What Next?

Now that you have a good feel for our Foolish approach to investing in cannabis stocks, let’s round things out by putting some of that newly acquired knowledge into action: just below we’re going to examine the investment thesis for one ‘pure-play’ business that I’ve been following for a while… and that as Fools we think you should be giving a wide berth!

One Cannabis Stock To Avoid
Aurora Cannabis (TSX:ACB)

Credit: Getty Images.

Overview

Aurora Cannabis (TSX:ACB) is one of the world’s largest cannabis companies today, currently producing and distributing certified organic medical cannabis in Canada. The company also has a presence or partnerships in several international countries.

Strategy

Aurora’s strategy can probably best be summed up as, ‘Get big as quickly as possible.’ By way of organic growth and several large-scale acquisitions, Aurora is aiming to position itself as one of the world’s largest cannabis producers, if not the largest. At the last count, Aurora had 45,800 active medical cannabis patients.

Earlier this year, Aurora acquired CanniMed for CAD$1.1 billion, and in July it closed on its CAD$3.2 billion acquisition of MedReleaf. Between Aurora and MedReleaf, the combined company would have 11 facilities — nine in Canada and two in Denmark — with a projected capacity of more than 570,000 kilos by the end of 2019.

Aurora is securing supply agreements, joint ventures, and operations in several countries. The company wholly owns European wholesale importer, exporter, and distributor Pedanios, which will focus on the cultivation and sale of cannabis in Denmark, Sweden, Norway, Finland, and Iceland.

In Germany, Aurora has a supply agreement with Cannamedical Pharma. Over in Australia, Aurora has a joint venture with a partner called Indica, as well as a 22.9% interest in Cann Group. Aurora also has a supply agreement in South Africa and early activity in Brazil and the Cayman Islands.

Aurora’s management has aimed to accelerate its capacity growth and global reach through acquisitions. They’re now focused on lowering production costs, expanding international distribution, and building the company’s portfolio of brands.

Key Insiders

Co-founder Terry Booth remains with Aurora as CEO, currently owning 2% of shares outstanding. Fellow co-founder Stephen Dobler serves as president and owns 2.4% of the company. Chief corporate officer Cam Battley previously worked in the healthcare space, including time with Eli Lilly.

Notable board members include chairman Michael Singer, who has extensive experience in the pharmaceutical space, and Diane Jang, who has nearly three decades of experience with consumer- packaged goods.

The Foolish View

June 2018: History shows us that the majority of big acquisitions fail, or at least fail to create value — and so far this year, Aurora has made two huge acquisitions. Aurora’s cash burn over the past year was more than CAD$140 million, and these substantial acquisitions will either require more cash or a lot of dilution.

In fact, Aurora’s diluted share count has increased by 63% over the past year. And that’s before factoring in the MedReleaf deal. That’s a crazy amount of dilution, which raises the bar for how profitable Aurora will need to become if shareholders are ever going to benefit. (The higher the diluted share count, the more pressure on earnings per share… which is what really counts for shareholders.)

Management’s comments — and supposed due diligence — on these acquisitions only make us more nervous. Just take this snippet from an article in the Canadian Globe and Mail after the MedReleaf acquisition was announced:

During a news conference to unveil his signature deal, the chief executive of Aurora Cannabis Inc. was hailed as a ‘pioneer and visionary’ by his executive team.

Yet, when he was asked a simple question by an analyst, to explain which metrics he used to value his CAD$3.2-billion takeover of MedReleaf Corp., Terry Booth got a little tripped up.

“Metrics …” he said, trailing off. After an awkward silence, he conjured up half an answer. “That’s our secret.”

Yikes. And that isn’t even the best part:

Mr. Booth said he couldn’t divulge much because the valuation technique was his “secret sauce.” And when chief commercial officer Cam Battley was asked for cost savings from the merger, he didn’t have much to say, either. “We don’t have an exact calculation of the synergies,” he said. All he could offer was that the company’s chief financial officer and his team did the work, “and they all came out of that exercise with big smiles.”

I’ll get straight to the point: we need more than “secret metrics” and “big smiles” to justify enormous acquisitions. Plus, let’s remember there is no guarantee it will be a smooth (or inexpensive) process integrating these acquisitions into Aurora.

We’re not fans of Aurora’s ‘grow at all costs’ strategy, and future upside is likely minimal, given that the company’s market cap already exceeds $6 billion. We see safer and higher-conviction companies for investors elsewhere, and we recommend you avoid Aurora.

October 2018: Aurora continues to make a series of acquisitions, seemingly buying anything with a pulse and issuing stock (to finance acquisitions) like sweets. Aurora’s diluted share count has nearly doubled over the past year and increased 28x since 2014. It’s hard for us to see a future where individual shareholders benefit after multiple acquisitions and obscene levels of dilution. Our opinion on Aurora is unchanged and we recommend steering clear.

I do hope you’ve enjoyed reading this special report on cannabis stock investing, and hopefully feel better prepared to buckle up for what is sure to be a wild — sometimes scary — and exciting ride.

Foolishly,

David Kretzmann
Advisor, The Motley Fool

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Disclosure: Neither David Kretzmann nor The Motley Fool UK own any of the shares mentioned.