Pot Earnings: Look Beyond The Smoke-and-Mirrors
We’re still in the throes of second-quarter 2022 earnings season, and marijuana stocks overall have been rising in recent weeks, propelled by better-than-expected quarterly operating results.
It also helps that the U.S. House of Representatives passed legislation on April 1 that would federally decriminalize cannabis. The bill is stalled in the 50-50 Senate, but the historic significance of the House’s action has been a profit catalyst for marijuana companies.
Horizons Marijuana Life Sciences Index ETF (HMMJ), a benchmark marijuana exchange-traded fund, has generated a total return of 8.56% over the past month, compared to 4.64% for the SPDR S&P 500 ETF Trust (SPY), as of market close May 2.
But with some of these quarterly results, there’s less than meets the eye.
Welcome to Wall Street’s dirty little secret. I call it the earnings shell game.
Corporate managers habitually “game the refs” by low-balling forecasts, so they can more easily beat estimates and get a lift in share prices.
A company “wins” the game and enjoys a higher share price by posting unexpectedly positive numbers. But winning the game isn’t much use in predicting a company’s future competitiveness and cash flows.
This shell game occurs in all industries, but it’s especially prevalent in fast-growing disruptive industries such as marijuana, where justifying investor euphoria can often pose a problem.
Marijuana entrepreneurs have been crowing lately about exceeding earnings expectations. To be sure, marijuana companies are posting some of their healthiest quarterly operating numbers in years and much of the optimism in the sector is warranted.
Not surprisingly, marijuana earnings growth in the U.S. has been the most pronounced in the biggest markets. The following chart depicts the 10 largest state-level pot markets in America:
Come on baby, light my fire…
However, despite the good news on earnings, additional context is called for. According to the Harvard Business Review:
“Good earnings news can light a fire under a company’s stock, but if the company misses its number by even a penny, its stock is likely to get hammered. And many, if not most, senior executives have compensation packages tied to stock-price and earnings targets.
Both the paychecks and the reputations of securities analysts depend on accurately forecasting the quarterly earnings of the companies they cover. Investors, or at least traders, profit by correctly divining which companies will meet or exceed expectations and which will fall short. As for accounting firms, if they help a company meet its numbers—sometimes by ignoring, or even suggesting, some pretty dubious bits of bookkeeping legerdemain—then they can usually count on retaining the company’s lucrative auditing business and maybe pick up a consulting contract as well.”
Remain wary of the “better-than-expected” earnings shell game. Separate the hard data from the self-serving spin.
Momentum matters in marijuana investing. However, blindly buying momentum stocks is risky, like riding in an untested rocket. That’s why, as an investment advisor who specializes in the marijuana industry, I try to pinpoint sound pot stocks that keep risk to a minimum and are most likely to take off.
No simple formula can do this. Instead, I use my many years of experience to gauge which catalysts can create deep, fundamental change to a company’s sales and profits. And if companies don’t meet my standards of strong financial metrics and reasonable valuations, they don’t make the cut.
All the marijuana stocks I recommend are ready to launch based on new developments in their businesses. It might be a new product, a new significant customer or an acquisition that provides them with key technology. Whatever the news is, it must be powerful enough to improve earnings for an extended period.
Another important point: Wall Street often overlooks the critical role that revenue growth plays in earnings production. When revenue is rising, many operating blunders can be hidden. When revenue is slowing or declining, profit margins shrink rapidly as covering fixed operating expenses and interest payments becomes more difficult if the company has taken on debt to fund its growth.
This dynamic is often called reverse leverage, and we’ve seen a lot of it in the marijuana industry. It accounts for many of the pot sector’s bankruptcies, in which investors are left holding the bag.
When analyzing pot stocks, I spend a lot of time looking for companies with rising revenue, whether it is due to new products, acquired businesses or a secular trend driving revenue.
Research has shown the market often misses or under-reacts to these cues, especially in marijuana stocks that are outside the Standard & Poor’s 500. That’s when individual investors should jump in. My new book can guide you.
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