Waiting to inhale? Cannabis stocks like Tilray are only going to go higher

The cannabis industry has come a long way since the passage of the Compassionate Use Act of 1996, when California became the first state to legalize the distribution of medical marijuana to patients with chronic illnesses.

In the four years following California’s hallmark legislation, Washington, Oregon, Alaska, Maine, and Washington, DC passed legislation legalizing the use of medical marijuana. Today, 30 states have legalized medical marijuana while nine states, the District of Columbia and the Northern Mariana Islands have taken the additional step of legalizing its adult use on a recreational basis.

Now, with 30 states legalizing cannabis in some form, and, according to a Gallup poll released in late October 2017, 64% of Americans supported legalizing marijuana for both recreational and medicinal use, one would expect the federal government to revisit their position on marijuana being listed alongside LSD and Ecstasy as a Schedule 1 drug under the Controlled Substance Act (CSA). 

But, so far, neither President Trump nor Attorney General Jeff Sessions have been willing to discuss the possibility of decriminalizing, rescheduling or de-scheduling cannabis at the federal level.

The key risk few investors are monitoring

If you ask a US-based cannabis investor what’s needed for the industry to evolve and grow into the economic powerhouse many expect it to become, they’ll likely tell you the government needs to reschedule marijuana.

After all, if cannabis were reclassified as Schedule II under the CSA, the government would be admitting that marijuana does have medical benefits.

But there’s a catch.

Schedule II drugs are still affected by US tax code 280E, which disallows businesses — that sell a federally illegal substance — from deducting ordinary business expenses from gross income. Put another way: Moving marijuana to a Schedule II drug won’t help US-based cannabis businesses come out of the regulatory shadows and expand their activities.

A second problem with reclassifying cannabis as a Schedule II drug is the US Food and Drug Administration would become responsible for approving the marketing and packaging for medical marijuana companies. And that means companies would be susceptible to inspections of their manufacturing and processing facilities and expected to undergo costly clinical trials to prove their drugs are safe and effective.

For example, if medical marijuana is being prescribed for a patient with PTSD or glaucoma, the FDA could, and likely would, require a series of exorbitantly expensive and lengthy clinical trials to prove cannabis is doing precisely what the medical marijuana company is advertising it does. And as biotech investors know all too well, most small-cap companies lack the resources to pay for years of clinical trials to back up their drug claims.   

The bottom line is reclassifying cannabis as a Schedule II substance would not be a good thing for the industry. The only way to unleash the full economic potential of the cannabis industry is to de-schedule the drug at the federal level. Unfortunately, taking a schedule I drug and de-scheduling it in one fell swoop seems like a tall order.

Speculative bubble or economic awakening?

In mid-August Constellation Brands (NYSE:STZ) stunned the cannabis industry when it announced it was investing an additional $4 billion into Canopy Growth (NYSE:CGC). But as odd as it may seem, the multi-week, 115% advance in Canopy Growth shares that followed because of the Constellation Brands investment isn’t what’s on the minds of cannabis investors.

While Constellation Brands may be responsible for the initial bout of bullish momentum that’s fueled the recent rise in cannabis stocks, it was last week’s volatility in shares of Canadian marijuana producer Tilray Inc (Nasdaq:TLRY) that set the industry alight and stirred the speculative juices of the investment community. 

After closing a bit above $29 on August 15, 2018, the day Constellation announced its investment in Canopy Growth, Tilray began building momentum and closed above $65 just two weeks later.

But the move to $65 from $29 was only the beginning.

By September 17, Tilray was above $120, and two days after that the stock reached an intraday high of $300. Most observers began using Tilray’s out-of-control price momentum to justify labeling the cannabis industry as a runaway speculative bubble.

And when Tilray fell back to $100 just three days after reaching $300, it seemed safe to assume that the cannabis bubble that began to reflate when Constellation Brands announced their $4 billion investment in Canopy Growth, had officially popped.

But what if there’s another explanation?

I believe that Tilray’s stock rallied the way it did due to several factors.

First and foremost is the fact that US-based traders unwilling to invest in stocks trading on the OTC bulletin board or the Canadian Securities Exchange only have a few choices to pick from to fill their quota for cannabis investments. And with only a handful of cannabis stocks trading on the NYSE and Nasdaq, there’s very little supply to meet an already large and growing demand.

The second factor in Tilray’s upside explosion is that when the stock listed on the Nasdaq, it only made a tiny percentage of its float available to trade. The result is its shares can be driven higher and lower with small order sizes.

A final contributing factor to Tilray’s meteoric rise is that traders began selling the stock short (via common stock and the use of options) and were continually forced to cover their money-losing bets as the stock continued to shoot higher. The short covering merely increased net demand for shares, thereby sending prices even higher.

A silver lining for cannabis investors

When Tilray’s stock collapsed more than 60% over a four-day stretch from September 19 through September 24, the vast majority of the cannabis sector remained unaffected.

To put that into perspective, when the dotcom bubble burst in early 2000, nearly every company that had any connection whatsoever to the internet suffered the same fate. Those companies that managed to avoid bankruptcy still saw their shares decline by as much as 60% to 80%.

But what we saw during the dotcom collapse is not occurring in the cannabis industry.

Stocks like CannaRoyalty Corp (OTCMKTS:CNNRF), KushCo (OTCMKTS:KSHB), Canopy Growth Corp (NYSE:CGC), and Pyxus International (NYSE:PYX) all closed on September 24 at three-month closing highs.

So, while Tilray was caught up in its speculative bubble and eventual collapse, many other cannabis companies appear to be part of an economic awakening that’s still in its early innings.

The bottom line is US-based investors need to pay attention to how the federal government handles a future re-scheduling or de-scheduling of cannabis, as this will have an immediate and massive impact in how investment dollars are allocated. However, the recent hype-filled price action that surrounded shares of Tilray does not appear to have dampened the prospects of this still immature and momentum-driven industry. 

And that, in my view, makes the bull case for investing in the cannabis industry even stronger than it was a few weeks ago when Constellation Brands threw its cards on Canopy Growth’s table.

At the time of publication, Byrne had no positions in any of the stocks mentioned.

Story by ProactiveInvestors