Well, it finally happened. Marijuana stocks got destroyed. Who could have seen it coming, right? In fairness, many knew they were overvalued. Today, I will walk through what I saw as they topped, rolled over, and ultimately trended significantly lower.
Combining some relatively simple technical and fundamental tools, the impending decline was a higher probability opportunity. I will walk through the sector trade, step by step.
Let’s get started…
March 2019
The trade started in March of this year as I commented on March 24th:
But I didn’t say this out of the blue. One key tool I use is a proprietary Algo that helps me determine extreme price action both on the upside and downside. I was getting signals of extreme retail participation in the space, and the sector had rallied almost 100% from the December 2018 low.
I highlighted the Algo in my articles on the Micron top (“The Micron Dump”) and the selloff in software stocks (“The Software Selloff”). The Algo is a useful tool to determine when participants have crowded to either side of the boat.
Furthermore, the stocks across the space were fundamentally at unsustainable levels. The chart below shows price-to-sales ratios in March of 2019 across three of the larger names in the space, Canopy Growth (CGC), Tilray (TLRY), and Cronos Group (CRON).
At Fusion Point, a major component of my work is not only trying to figure out what to trade, but also most importantly, “when” to trade it. Ultimately timing is everything, and perhaps this is no more truer than in financial markets.
Importantly, however, my approach doesn’t assume charts or price patterns (technical analysis) are the primary way to time things. I use a combination of a fundamental first approach that then uses price action to determine if any repricing is in play. A simplified version of this can be stated as what to trade, why to trade it, and when to do so. The what and the why are often a combination of valuation, sector, company research, and most importantly behavioral (Algo).
The when component is generally technical in nature, but it can be a combination of charts, intramarket analysis, sentiment, etc. The key is being holistic across an opportunity.
We have all heard how in the short term markets are a voting machine, and in the long run, a weighing machine. My approach is designed to capture this transition between the two.
March 27th, 2019
Back to the trade. TLRY, which was one of the most overvalued stocks in not only the market, but also that I’ve seen in decades, was setting up with a key technical pattern, a “descending triangle”.
Again, this pattern alone probably isn’t something I am extremely interested in with respect to making a large trading decision. When the underlying is at 144X sales; however, it suddenly becomes pretty interesting.
For non-technicians, what we are looking at is price making continually lower highs while holding the $64 level (descending triangle). The idea here is a break of the $64 level “should” lead to significantly lower prices as the market essentially exhausts.
April/May 2019
And certainly that is what we saw. By May the stock had broken down. I called this a pile of garbage from a market perspective, given not only the absurd valuation but also the constant pumping I often saw on TV and the swift nature of the break of $64.
Note within weeks of the initial break of $64 in April, the price quickly moved to $50 by May. As much as I enjoy these opportunities, I also do get personally frustrated by the constant misinformation and misleading I often see in capital markets. My comments often reflect some variety of this frustration.
A few weeks later, on May 14th, TLRY reported earnings. You can see how CNBC reported the numbers as some big “beat” that was causing the stock to “soar”. Keep in mind some of these outlets were some of the biggest promoters of this stock when it initially ran to $300.
A more sober look at the numbers from that report showed a very challenging story. The top line had nearly tripled, but losses grew. Important was the absolute fundamental numbers relative to the valuation.
Even with massive revenue growth, annualizing the quarterly sales numbers (even with assuming continued growth), you are miles and miles away from anything worth 4B dollars. I have seen this too many times to count, but the TV and many publications often focus on some meaningless metrics vs. the real story.
From here things went from bad to worse across the space…
June – Staying in a Trade
One question I often get is how do you stay in a trade? Although there are probably more traders on Twitter than on Seeking Alpha, this is still a concern even for those who are playing things from an intermediate- and longer-term time frame who want to pull out as much profit as possible. Ultimately if you don’t let your winners run, the math will never really work out.
There are a variety of ways to stay in a trade, but with respect to marijuana stocks there were two main ones for me.
First is time. I am always thinking how long “should” I stay in this trade, and that was a big thing with these stocks. I knew there was a lot of meat on the bone so to speak, so it would take time.
Second, valuation. In this case, these things were still stratospheric. Take a look at CGC in June. The price to sales ratio alone was still 61. This is a case where the fundamentals simply come first to technicals. In short, this was one where patience was likely to pay.
Meanwhile, operationally at CGC, although revenue was growing, and ample cash on the balance sheet, cash from operations was negative and growing. Although expansion in and of itself isn’t a negative, it was likely hard to justify the multiple under these conditions.
Back to the chart, after going sideways for nearly six weeks, CGC finally broke. There simply was more to go on these, and hopefully, the above puts in perspective how meaningless even a 7% decline is when a stock is so expensive. I know a few people moved on from these trades as price sort of stagnated, primarily in June.
August
By August, the June breakdown in CGC was barely recognizable. A 13% decline in a single day approximately six weeks later is a great lesson for trend traders as well as swing/position traders looking to really take something for a “full cycle”.
September
By September, the chart had completely taken over as trend traders were fully in charge. For technical skeptics, one thing to think about is as a multiple shifts and an asset re-rates, how price gets from point A to point B can be a very technical process.
Note the August gap down and fill before rolling back over. Here is where the technical approach becomes so useful as it works as a good management tool as a market moves towards the true “weight” of a stock.
October
And by October, we saw a culmination of the trade. You can see below not only the initial peak, but also more importantly the different stages of the trend. See the most recent wave down and some of the television commentary. I find it curious and slightly amusing that CNBC commented on vaping as if that had anything to do with this trade. Convenient for sure.
Valuation and Multiples
A quick thought for newer investors and traders. A big mistake I see people make is assume that revenue growth will drive a stock higher. This is one of the bigger logical traps I have seen.
Yes, revenue growth is a good factor to look at, and it is one of my nine fundamental factor models. But there is a lot more that goes into a rising stock and multiple than just the top line.
A good example here is this entire space over the last two years. Although this is an extreme example, simply see the percentage change in revenue vs. the percentage change in the price-to-sales multiple. This is a very common way in which I see retail often get sucked into poor risk reward situations.
Finally, at Fusion Point, we have just added the new “smart allocator”, a spreadsheet designed for longer-term investments that focus on my nine fundamental stock strategies, with longer-term charts for trade management, and my notes on the company strategy and story. I keep about 15-20 stock investment ideas from each factor strategy. I have also recently just added our first marijuana stock from the long side to the speculative bucket.
Performance
Performance continues to outperform at Fusion Point. There have been some significant downshifts in risk exposure in the last few months, offset by momentum/macro shorts and value-driven longs. I continue to look for opportunities utilizing fundamentals, technicals, and behavioral finance.
Thanks for reading…
Fusion Point Capital
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All marijuana stocks and sector shorts have been closed.
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