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Investment Outlook

Just because a marijuana company starts earning profits doesn’t mean it suddenly represents good value for investors. Here’s what you need to about when a former money-loser finally starts making money.

Right now, almost a year after legalization in Canada on October 17, 2018, most cannabis producers are still losing money on a day-to-day operating basis. Some have reported a profit in one or more quarters, but that’s generally due to one-time inventory write-ups or other accounting adjustments.

With recreational cannabis now legal in Canada, at some point, these producers will start showing small profits—and a positive price/earnings ratio (P/E).

(Typically, you calculate P/E’s  using a stock’s  current price as the ‘P’, and its earnings for the previous 12 months as the ‘E’. The general rule is that the lower a stock’s P/E, the better. A low P/E implies more profit for every dollar you invest.)

Of course, profits are better than losses. But when a former money-loser finally starts making money, the “handcuffs” go on. Suddenly it has a P/E, probably one that is sky-high (since it probably starts out making only a little “E”). Inevitably the killjoys (like us) then start calculating how fast it needs to grow to justify its current stock price, let alone go higher.

Meanwhile, the company’s management has to increasingly look at dull, non-uplifting matters like production, costs and deliveries, rather than ramble on about how wonderful things will be in a few years. Then too, once a company becomes profitable, it faces a new risk: the unexpected earnings downturn.

Of course, we do sometimes recommend stocks that have not yet begun making money—or are just turning profitable and have lofty P/E’s. But you need to keep risky stocks—like marijuana producers—to only a small part of your stock portfolio.

Overall, most successful investors find that they take on less risk and make higher profits by investing mainly in the middle of the P/E spectrum. Today, we’d say that would include P/E’s between—very roughly—10.0 and 25.0. You need to be cautious about buying stocks with P/E’s below 10.0 or above 25.0.

In stocks with unusually low or high P/E’s, surprises tend to be unpleasant.