Getting High on Bubbles

In his famous speech on ‘Irrational Exuberance’, Greenspan commented about how difficult it was to recognize the characteristics of bubbles if we saw them. He reckoned back then that it’s not really possible.

The Maestro’s conclusion that one cannot time the top of a bubble is spot on. The timing of his famous speech, at the end of 1996, proves his own point, since the bull market didn’t end until three years later.

However Greenspan’s observation that bubbles cannot be recognized while they’re happening is wrong. Investors need to be vigilant for very large price gains that are not anchored on any fundamental changes, but rather on the expectation of vast profits in the future.

The inaugural topic of this column in January 2018 was about the crypto-currency bubble, calling it ‘one of the biggest bubbles of all time’. It was a lucky coincidence that the top of the bubble had happened just two weeks before the article was published, but it was easy enough to recognize all the signs of extreme euphoria.

There are still companies trying to cash-in on the crypto-bubble. The world’s biggest maker of computer equipment used to mine virtual money is preparing an IPO in Hong Kong this month. Given that the costs of mining bitcoin is around $6,000, the current price offers little reassurance to investors that the past profits will be sustained into the future. This IPO is a year late to the markets.

Now that the crypto-bubble has deflated quickly, the easy money has been searching for the next easy way to double their money in a short space of time. An investor doesn’t need to look too far before identifying one: cannabis stocks.

Multiple US states recently legalized cannabis, for medical as well as recreational use, causing an investment frenzy that has accelerated in recent months. A company called India Globalisation, a biopharmaceutical company that develops proprietary cannabinoid therapies was quoted at $0.50 per share two months ago, and hit a high of $14.58 on October 2^nd. Marijuana use for pain alleviation in chronically ill patients may be a potential investment thesis. But as with all bubbles, there are stranger variations of the legalization of this drug, like beverage companies. New Age Beverages announced last month that it will launch cannabis-based drinks this year. As expected, the stock jumped from $2 to $10 in five trading days. The frenzy for cannabis drinks is so large that reports surfaced that even Coca-Cola is thinking about launching their own version of such a drink.

Canopy Growth, a producer of medical marijuana, is one of the largest companies in this sector. It is currently worth US$13 billion, as its stock has gained 400% in the last 12 months.

Tilray, one of the ‘higher quality operators’ in this sector, did an IPO in the summer of this year at $17 a share, and hit a high of $300 last month, before losing half of its value to the current $165. It has a market cap of US$15 billion, justified by its “a very broad business plan” related to cannabis: it develops medicines, drugs, drops, and oil products. In order not to be outdone by Coke (which incidentally used cocaine in its drink up until 1903), it’s a good bet that they will add cannabis-based drinks to that list too.

Regular readers of my columns can probably guess at the sectors’ fundamentals. None of these companies are profitable. Tilray, the biggest company in the sector, is forecast to generate $40 million in revenues this year. It’s easy enough to recognize a bubble when all one needs is some basic calculations of what the current share price is implying.

For an investor to recoup their investment in Tilray, assuming that the company can grow its revenue by a compounded +50% every single year indefinitely (an assumption that would stretch even the most ardent bulls, but let’s say it’s possible), they would have to pay 100% of revenue as dividends for the next 13 years. Keep in mind that we’re talking about revenue, not even profits. Since no board of directors in the world would ever allow the above scenario, there are only two conclusions left. Either annual revenue growth will be significantly higher than +50% compounded forever, or the current share price is a bubble and will never realise a profit for investors.

No prizes for guessing the right answer.

In the January article on bitcoin I described a company called Long Island Ice Tea, which marked bitcoin’s price peak when it changed its name to Long Blockchain Corp, causing its stock to jump from $2 to $9 on the day. The shares are now trading at $0.18. A smarter move would have been for them to wait three months and announce production of cannabis drinks, which would have been a more plausible shift in strategy.

We do not know when this latest bubble will burst, but the safest route as with all bubbles is to steer clear.

By LEONARDO DRAGO

Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.