The Under-the-Radar Reason Marijuana Stocks Are Plunging

Jars filled with trimmed cannabis buds on a counter.

In a little over two months, Canada is set to change the world. Following the passage of the Cannabis Act on June 19, Canada will become the first industrialized country in the world to legalize recreational marijuana. In the process, it'll open the door to perhaps $5 billion in added annual sales, atop what the industry is already generating from domestic medical weed and exports to foreign countries where medicinal cannabis has been given the green light.

For a few years leading up to this moment, marijuana stocks have seemed, at times, unstoppable. Investors who had the wherewithal to stick with pot stocks for extended periods of time since mid-decade have seen triple- or even quadruple-digit returns.

The surface-scratching reasons pot stocks are plummeting

However, that's not been the case over the last six-and-a-half months. Over that time, the North American Marijuana Index, which tracks dozens of the most influential cannabis companies, has dropped by more than a third , from peak to trough. Considering that the revenue floodgates are about to open, this move lower appears to make little sense.

So, what gives? On the surface, there are a number of issues that could be to blame.

To begin with, we could blame Wall Street and retail investors for overhyping the industry. Anytime a new technology or product has come along that has serious growth potential, investors almost always overhype it and push valuations into the stratosphere. Examples include the advent of the internet, business-to-business commerce, decoding the human genome, 3D printing, and even blockchain technology. The cannabis industry will take time to mature, and this is a point that may have gone over the heads of industry enthusiasts.

Another issue might be the unknown supply and-demand outlook. Since there is no precedent to an industrialized country legalizing adult-use weed, no one has any concrete idea how much cannabis will be demanded or produced. Initially, it's expected that demand will outpace supply, which would be a good thing for per-gram dried cannabis prices, and therefore margins. But things could get trickier by 2020, when capacity expansion projects for nearly all growers are fully operational. By then, domestic oversupply could be unavoidable, and it's unclear if exports would be able to handle such a large amount of oversupply.

Even competition could be to blame. Roughly six months ago, the aggregate production capacity of all major marijuana players might have reached around 1 million kilograms annually, when at full capacity. At the rate the industry is proceeding, we could be looking at 3 million kilograms by 2020 or 2021. There's far more competition than investors realize, and that could wind up eating into margins and operating income.

This under-the-radar issue might be the true culprit

But the under-the-radar issue that could be most responsible for plunging marijuana stock prices might be dilution.

As a reminder, prior to the passage of the Cannabis Act, financial institutions basically had no dealings with pot stocks. Since weed was illegal at the federal level, banks ran the risk of criminal and/or financial penalties if they offered basic banking services to pot-based companies. This meant publicly traded marijuana stocks only had one quick source of capital: bought-deal offerings.

A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors in order to raise capital. Since production and operating cash flow have been minimal thus far, practically every pot stock has had to turn to bought-deal offerings to cover their capacity expansion projects, which can cost in excess of $100 million. This has resulted in a significant increase in the outstanding share count for most pot stocks, and therefore a decline in the per-share price.

Don't believe me? Here are three telltale examples.

Aurora Cannabis

Search the message boards, and there's perhaps no marijuana stock more polarizing than Aurora Cannabis (NASDAQOTH: ACBFF) . Aurora has been growing organically, via its Aurora Sky and Aurora Sun projects, via partnerships, as with its retrofit of greenhouses owned by Alfred Pedersen & Son in Denmark, and by acquisition, as with its buyouts of CanniMed Therapeutics and MedReleaf. All told, Aurora Cannabis has increased its annual production potential from just over 100,000 kilograms when the year began to around 570,000 kilograms of peak potential as of today.

However, in order to make this expansion a reality, the company has made it rain common stock. Numerous bought-deal offerings and share-based acquisitions have ballooned the outstanding share count of Aurora Cannabis.

ACBFF data by YCharts .

Notice that bifurcation shortly after the year began? That's when Aurora began its barrage of dilution . What you'll note is that while the company's market cap hasn't substantially dropped (i.e., investors still have relatively the same opinion of the company as they had at the beginning of the year), its share price has plummeted over this timeframe as its outstanding share count has ballooned.

Auxly Cannabis Group

Perhaps an even more glaring example of bought-deal-offering-based dilution destroying shareholder value is with Auxly Cannabis Group (NASDAQOTH: CBWTF) . Auxly is primarily a royalty company in the cannabis space. It supplies upfront capital for growers looking to expand, and in return, it receives a percentage of production yield at a below-market rate for an extended period of time.

Of late, though, Auxly has also been acquiring growing capacity of its own in an effort to exert more control over its costs (royalty deals tend to have near-fixed costs). Should dried cannabis be commoditized, these owned facilities should give Auxly more ability to reduce its per-gram production costs.

CBWTF data by YCharts .

However, the capital that Auxly Cannabis Group laid out to its licensed partners still needed to be raised via bought-deal offerings. As you can see, Auxly's market cap is virtually unchanged since the beginning of the year. However, thanks to rampant dilution, its share price has plunged by close to 70%. In other words, like Aurora Cannabis, investors have a pretty consistent view of Auxly Cannabis, as told by its market cap, but dilution has wreaked havoc on its share price.

Emerald Health Therapeutics

A final example of dilution crushing shareholder value in action can be seen with Emerald Health Therapeutics (NASDAQOTH: EMHTF) .

Emerald Health is undertaking an ambitious project that involves building out its Metro Vancouver greenhouse, as well as partnering with Village Farms International in a joint venture known as Pure Sunfarms, which could yield 75,000 kilograms of production by 2020. When at full capacity, Emerald Health should be able to produce more than 100,000 kilograms per year .

EMHTF data by YCharts .

But financing such a venture is costly, especially when Emerald Health had very little production to speak of prior to announcing its Pure Sunfarms joint venture. That meant turning to bought-deal offerings. As you'll see above, while the company's market cap has declined modestly since the year began, with investors questioning whether Emerald Health Therapeutics can keep up with other major players, its share price has declined by roughly two-thirds . In fact, you can actually see a steady incline in market cap between March and May, but at the same time, a steady drop in share price, reflective of dilution.

Worst of all, convertible debentures, stock options, and warrants could take years to be fully accounted for, meaning dilution may continue to adversely affect investors for years to come. While this might not be enough to keep investors completely away from marijuana stocks, it's certainly something for them to strongly consider.

10 stocks we like better than Aurora Cannabis Inc.

When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor , has quadrupled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Aurora Cannabis Inc. wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of June 4, 2018

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

More Related Articles

Sign up for Smart Investing to get the latest news, strategies and tips to help you invest smarter.