3 Pot Stocks with High Upside Potential

It is believed that when it comes to periods of economic downturns, industries supported by inelastic demand fare better than others. One such industry is the marijuana market that appears to be holding up well at a time where businesses across industries are getting smoked. Cannabis producers are shielded from the vagaries of economic cycles as their market predominantly comprises those dependent on its consumption, whether for recreational or medicinal purposes.

The widening legalization and growing social acceptance of cannabis could continue to fuel the industry for a long time. The Canadian producers in particular are poised for growth as they continue to expand internationally, including south of the border. The U.S. is the largest market for cannabis and cannabis-derived products, especially CBD, a market that is projected to reach US$24 billion in size by 2025. “Cannabis companies are poised to see sales grow by nearly nine times through 2030 as legalization gains popularity and distribution widens,” says Morningstar research, projecting the U.S. recreational market to skyrocket from the current US$5.4 billion to a whopping US$68 billion by 2030, growing at a 25% annual clip. Similar demand is expected to drive the global medical marijuana market, projected to grow 18% annually to reach US$73.6 billion by 2027.

Leading cannabis producers are well-positioned to benefit from this trend. The following stocks with meaningful upside potential represent attractive investment opportunities for long-term investors with some risk tolerance.

Canadian cannabis producer, Aurora (ACB) cultivates and sells medicinal and recreational cannabis. While concentrated in Canada, the company has an international footprint across 25 countries where it has medical cannabis exporting agreements or cultivation facilities.

Predominantly a medical cannabis company, but Aurora has profited from the legalization of recreational weed in Canada. As a result, “recreational now accounts for nearly 50% of gross sales and has been rising, although this share is slightly lower than peers,” says a Morningstar equity report, projecting roughly 20% average annual growth for the entire Canadian market through 2030, driven by new consumers and those switching from black market to legal market.

Aurora’s global expansion offers lucrative opportunities “given higher realized prices and the growing acceptance of cannabis' medical benefits,” says Morningstar sector director, Kristoffer Inton, adding the pot grower is protected by strict regulations that new entrants must pass.

When the U.S. moves to legalize marijuana nationwide, it will become the fastest-growing cannabis market, estimated to be more than five times larger than the Canadian market. Currently, though, Aurora’s “only exposure is through hemp-derived CBD products through its May 2020 acquisition of Reliva, expected to close in June,” says Inton, who appraises the stock’s fair value to be $42.

The fair value estimate incorporates 27% annual volume growth for Aurora’s international medical business amid wider legalization and distribution. Inton cautions the emergence of cheaper suppliers in lower cost labour countries could squeeze volume, but assures Aurora’s production expansion into some of these countries helps protect its share.

A leading Canadian marijuana grower, Canopy (WEED) cultivates and sells medicinal and recreational cannabis and hemp. While Canada accounts for roughly 80% of its sales, the company has distribution and production licenses in more than a dozen countries. Canopy also holds an option to acquire the leading U.S. cannabis operator, Acreage Holdings, upon U.S. federal cannabis legalization.

Historically, Canopy was focused on medical cannabis in Canada, but more recently it has shifted focus to recreational sales following the 2018 legalization of marijuana in Canada. “Recreational cannabis now accounts for roughly 60% of cannabis sales,” says a Morningstar equity report, noting the 10% annual growth for the recreational market in Canada, powered by legalization, will help offset weakness in the medical market.

Canopy has a sizeable footprint in the international market. “Higher realized prices and growing acceptance of cannabis' medical benefits” have helped create a lucrative global market for medical marijuana which has benefitted Canopy, says Inton. Stringent regulations for entering these markets make it difficult for new entrants, which helps protect established players like Canopy, he adds. 

However, growers in countries with cheap labour could pose a significant threat to Canadian producers. “Canopy’s efforts to expand production into countries like Colombia and Lesotho should offset its cost-disadvantaged Canadian production,” assures Inton, who recently lowered the stock’s fair value from $60 to $41, to incorporate lower profitability reflected in disappointing fourth-quarter revenue.

Despite the reduced fair value, Inton asserts there is “positive risk-adjusted upside for Canopy” and that “profitability will still come as legal sales continue to grow.”

American cannabis pure-play, Curaleaf (CURA) produces and sells medicinal and recreational cannabis across 19 states. Unlike its Canadian peers, the company does not export into the global medical market.

Curaleaf’s presence in some of the most densely populated American states provides investors a strong exposure to the U.S. cannabis market, the fastest growing and largest potential market, says a Morningstar equity report. “Curaleaf has developed its footprint focusing on states with large populations and limited licenses, such as Massachusetts, New York, New Jersey, and Florida,” the report says.

The pot producer pivoted from the medical cannabis market to the recreation market through acquisitions of recreation cannabis-based businesses on the West Coast and Midwest. Moreover, the company is well-positioned to benefit as Americans are smoking more marijuana during the coronavirus pandemic to fight anxiety and stress.

The lack of international operations, however, precludes Curaleaf “from a lucrative global market that boasts higher realized prices and the growing acceptance of cannabis' medical benefits,” notes Inton, who pegs the stock’s fair value at US$13.50. That said, the U.S. market has the highest total potential and offers the largest growth of any market, he adds.

Despite operating in a challenging economic environment, Curaleaf continues to grow its revenue through innovative product development and store expansion. The company recently reported impressive first-quarter revenue growth of 28% sequentially to US$96.5 million and adjusted EBITDA of US$20 million, up 45% sequentially, with margins expanding to 21%. Inton forecasts revenue growth of roughly 33% per year through 2029.