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Stocks  | May 9, 2019

Believe it or not, marijuana stocks proved fallible in April, with the first tradable cannabis exchange-traded fund, the Horizons Marijuana Life Sciences ETF, falling by 1.6% during the month. Of course, there's no need to cry a river, with the ETF tripling the performance of the S&P 500 on a year-to-date basis.

However, a budding cannabis market doesn't mean you can simply throw a dart and select a winner. If anything, investors should be more critical of pot stocks now, with the industry still nascent and contending with numerous supply chain-based growing pains.

As I look at the more than 50 marijuana stocks I regularly follow, I see three that should be avoided like the plague in May.

Canopy Growth

The first pot stock that I'd suggest avoiding this month is, you know, only the largest marijuana stock in the world by market cap: Canopy Growth (NYSE: CGC).

Shares of Canopy Growth had a terrific April after receiving an upgrade from GMP Securities to buy, as well as announcing the $3.4 billion cash-and-stock acquisition of vertically integrated dispensary operator Acreage Holdings (NASDAQOTH: ACRGF), which is contingent on the U.S. federal government legalizing weed. Wall Street views Canopy's contingent deal to acquire Acreage as a means to enter the U.S. market on the relative cheap with momentum in the U.S. building. Acreage has licenses for retail, cultivation, or processing facilities in 20 states, assuming all pending acquisitions close.

As for me, I'm not too thrilled with Canopy Growth's near-term outlook. To offer another side to the above deal, there are zero assurances that the U.S. federal government will change its tune on cannabis. Republicans still control the Senate and Oval Office, and they've been historically more negative on the pot movement than Democrats or Independents -- not to mention that legalizing marijuana would have negative tax implications for the federal government, which is something most folks tends to overlook. In short, there's nothing that convinces me that Acreage is going to be acquired by Canopy.

Canopy Growth is also at the forefront of Canada's massive supply chain problems. Health Canada has been slow to approve cultivation licenses and sales permits; packaging solutions have kept raw cannabis awaiting processing sitting on the sidelines; and growers are still ramping up capacity. In January and February, cannabis store revenue fell in Canada, portending what should be a challenging quarter for most pot stocks. But it'll be especially rough for those companies most tied to the recreational market, such as Canopy Growth, which recognized almost 80% of total cannabis revenue from the adult-use market.

With losses expected to continue through fiscal 2020, I'm not finding any value to squeeze out of this $17 billion pot stock.

TILT Holdings

In terms of accounting red flags, TILT Holdings (NASDAQOTH: SVVTF) may have the most apropos company name.

TILT began trading in Canada on Dec. 6, 2018, after completing a reverse merger of four businesses. These businesses include a vertically integrated dispensary operator in Massachusetts, a Canadian grower that's applied for a cultivation license, a cannabis-delivery software company, and a company focused on customer-relationship management software.

As you might imagine, combining companies and determining whether a fair value was paid for/created when these businesses were merged is a bit of science and a lot of interpretation. On Dec. 5, 2018, just a day before trading commenced, the company released a 590-page listing application on SEDAR, Canada's securities regulatory agency. Contained within this manifesto was the company's pro forma balance sheet from June 30, 2018. It listed total assets of almost $905 million, with goodwill and intangible assets of $721 million, or roughly 80% of total assets. That should have been a big red flag for investors since it suggested that TILT's balance sheet was based more on hope than actual assets.

When TILT reported its fourth-quarter and full-year operating results for 2018 on May 1, the you-know-what hit the fan. The company took a one-time $496.4 million writedown, leading to a ghastly net loss of $552.1 million in 2018. Mind you, TILT Holdings' market cap is barely $220 million at the moment. 

The company's inability to properly value its merged businesses has crushed shareholders and reduced confidence in management. Needless to say, there's a big mountain to climb before TILT deserves buy consideration from investors.

22nd Century Group

The final pot stock you'd be wise to avoid in May (which is angled more as a tobacco play than a cannabis play in recent months) is another top-performer in April: 22nd Century Group (NYSEMKT: XXII).

22nd Century Group is a small-cap, $2 stock, so momentum does tend to swing its share price up and down with ease at times. In April, shares received a boost after executives refuted a short-seller attack on the company, and rose following the late-month announcement that the Food and Drug Administration (FDA) had completed a comprehensive inspection of the company's manufacturing facility where Very Low Nicotine Content (VLNC) tobacco cigarettes would be produced. This is one of many steps before hopefully getting the green light from the FDA to produce VLNC cigarettes. 

While this all probably seems exciting, I'm not in the last bit sold on the idea that 22nd Century Group's alternative tobacco product is going to be a hit. To begin with, consumers smoke tobacco products for the nicotine buzz. Reducing nicotine content by 97% to eliminate the addiction to nicotine may not sit well with tobacco users, even if the product is given the OK by the FDA.

The other concern here is that Scott Gottlieb has stepped down as the commissioner of the FDA. Gottlieb has been a proponent of tobacco reforms far more than any preceding FDA commissioner, and it's possible that his successors won't fight for lower nicotine content in tobacco cigarettes as he did. 22nd Century Group is pretty much reliant on FDA policy for its VLNC cigarette sales to take off -- and I'm not a big fan of investing based on FDA policy.

Ultimately, there's nothing about 22nd Century's plant-based technology for cannabis and hemp producers, or its VLNC cigarette model, that stands out as buy-worthy. That makes this momentum-based, money-losing stock easily avoidable in May.

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