Hey there, time traveller!
This article was published 20/5/2017 (279 days ago), so information in it may no longer be current.
Mark Twain might have never actually said history doesn’t repeat itself, but that it instead often rhymes. Yet this statement is an incredibly prescient observation of humanity’s lack of ability to learn from its mistakes... especially when it comes to investing.
Case in point is the present mania over marijuana stocks.
High on the promise of big profits, investors have been pouring billions into companies licensed to produce legal medical marijuana based on the pending legalization of the weed recreationally across the country — which would make Canada the first large, industrialized economy in the world to do so. (Uruguay is the first nation to have legalized cannabis for recreational consumption, by the way.)
Yet a local portfolio manager says what we’re seeing right now is a teachable moment in investor psychology. It’s a phenomenon that has played out countless times before — from the Dutch Tulip Bubble of the 1600s to the Dot-Com Bubble of the late ’90s and early 2000s.
"I’ve always been a student of investor psychology and it’s interesting because it really works against us when it comes to getting good returns on our investments," says Hardev Bains, president and portfolio manager with Lionridge Capital. "And this whole excitement over marijuana stocks is a very good example."
With every bubble, large swaths of investors, blind with greed, put their dollars in danger in the pursuit of big profits that never materialized.
They are cautionary lessons about the hazardous mix of greed and fear, and how investors are often driven more by emotion than by reason.
The portfolio Bains manages for his clients certainly wouldn’t include cannabis stocks as they are today. That’s because these firms don’t have good fundamentals.
While they may have growing revenues, they are not yet profitable for the most part. Yes, some have dominant market positions. And while their products and services are in high demand and likely to grow in the future, they are not reasonably valued. Consequently, an investor is paying too much to own them.
"We took a look at a few of them just on a sampling basis and over the last 12 months, and some of these stocks have tripled or quadrupled in their market price without any kind of earnings to show for it, so it’s all based on future earnings," Bains says.
"At the valuations they’re trading at, the amount the earnings are going to have to grow to justify them is very high."
All of this reefer madness reminds Bains of the Dot-Com Bubble, only smaller.
"We knew that technology was going to be a growth industry, but you had no idea who was going to be the winner or loser," he says.
"There was a lot of pain."
Yes, some companies did turn out to be great investments — such as Alphabet (also known as Google).
"But those companies that became winners at least had what we call ‘moats’ due to patents and proprietary technologies," Bains says.
And he’s not so sure the same argument can be made for cannabis companies that are ultimately producing a commodity.
Moreover, all of these marijuana firms — including the largest, Canopy Growth, with a market capitalization of more than $1 billion — are largely speculative. "We like situations where the upside outweighs the downside, but in a speculative bubble like this, it’s the opposite," he says.
"The downside appears to far outweigh the upside."
Still, the current drug-induced frenzy offers investors a chance to see investor psychology — the bad — in action. It is an example of what emotional levers get pulled, the wrong way, when investors get too worked up about the latest investment fad, Bains says.
To that end, he adds, "here are some of the psychological traps that people get caught by that cause them to lose a lot of money."
It’s pretty obvious this emotion — if you can call it that — can get investors into trouble.
Yet, even though we all know its potential perils, greed still gets the better of us more often than not when it comes to our portfolios.
"People have the tendency to want fast returns," Bains says.
"They see something that’s gone up three or four times in value in the last 12 months, and they want to jump in."
Hand in hand with greed is a psychological phenomenon called recency bias. "This applies not just to investing but to all kinds of things," he says. "We tend to take the most recent data about something and extrapolate forward." In this case, investors see that cannabis stocks have made early investors a mountain of cash.
"Then they assume that the past 12 months foretells what’s to come in the future: even higher share prices.
"But if you do some professional analysis and step back, you’d go, ‘No, this just doesn’t make sense,’ " he says.
"Stocks going up so much in the last 12 months should actually be seen as more of a negative than a positive."
The story effect
Compelling stories capture the imagination. Indeed, legalization of marijuana is a sexy bit of news. Who doesn’t enjoy images of tie-dyed, 21st-century hippies puffing away on doobies? The storyline sucks people in and they fail to do thoughtful analysis. The narrative is so strong they believe they have enough evidence, when in reality they have nothing but a two- to three-sentence anecdote. Even more troubling is the fact much of the information available to the investing public tends to be biased toward the upside. That’s because often the investment industry is more than happy to help investors jump on board the bud bandwagon.
"The investment industry, unfortunately, does cater to the mania," Bains says, citing the recent launch of a marijuana ETF (exchange traded funds) as evidence.
We like to think we’re independent thinkers and one-of-a-kind individuals. But we’re very interdependent social creatures who are biologically driven to be part of the group.
"There are a couple of psychological phenomena underlying this and one is called the confirmation effect," he says. "If someone else has made the decision and it seems like a lot of other people have made this decision, then we have a lot more confidence in making the same decision for ourselves."
The other driver is fear.
Usually, fear is the emotion that causes investors to flee en masse from markets during a crash. But that’s not what’s happening here.
"Instead, it’s the fear of missing out or the fear of falling behind," he says. "Everyone probably has one neighbour that claims to have jumped into marijuana stocks and made a ton of money."
When you hear about your neighbour making mad cash, then you start worrying about being left out. And that can drive you to invest in something you shouldn’t.
Just say ‘no’?
Bains says the marijuana industry does actually have a lot of promise.
"Anyone with common sense can understand that it will be a growth industry," he says. "The right companies that are run properly should be able to make a lot of money."
But for the time being, investing in publicly traded marijuana stocks is akin to gambling.
You’re betting on one horse over another. Some might be odds-on favourites, but that doesn’t guarantee profitability and success.
Cannabis stocks are "glamour stocks," he adds.
There’s a lot of hype around them. And while people have made money, those getting on board now have to ask, who is going to make a profit in the future?
The answer is likely the founders of these companies and investment firms helping them go public, but probably not you.
In other words, Bains says, "don’t let your profits go up in smoke."