Currencies in Peril

We discussed the future of Turkish Lira in a previous article, but this is far from an isolated case of a currency in crisis –  Argentina peso, Indonesian rupiah, South African rand, Chilean peso, Iranian rial, Russian ruble, and even Chinese yuan have all been falling, albeit some more dramatically than others.

Here, we analyze how reserve-ratios and debt levels in relation to GDP can provide some insight into the risks associated with a particular currency.

A fundamental threat running through global financial markets is the ballooning of US dollar denominated debt worldwide – increasing from $600 billion to over $2 trillion in 2000, and reaching $12 trillion in 2018.  Generally this trend is seen as the fundamental problem at the root of all pending crises: bubbles are bursting all around the world due to countries’ inability to meet debt obligations, and more importantly the inability to defend currencies when they come under pressure.

Bank of International Settlements (BIS) has 11 countries on a watch-list – five high-risk, Turkey, Chile, Argentina, Mexico, and Indonesia, and six moderate-risk, South Africa, Brazil, Russia, Malaysia, South Korea, and India.  China and Saudi Arabia are listed as examples of no-risk countries.  These high and moderate-risk countries have to be taken seriously as together they account for more than 60% of the total USD denominated debt worldwide.

There are two key factors to consider when analyzing a country’s currency: firstly, the USD debt level and the size of reserves that could cover that debt in the long run (as well as the liquidity of those reserves to fend off any runs on a currency in the short term); and secondly, the debt-to-GDP ratios of a country as a whole.

In the case of the Turkish lira, foreign reserves can cover little more than half of Turkey’s USD-denominated debt (according to the Bank of International Settlements 54%); Chile and Argentina are even more exposed, with reserves at 37% and 48% of USD debt respectively; Mexico and Indonesia are only slightly better-off at 66% and 72% respectively.  Needless to say, the ability of these 5 countries to cover their total external debt is even more limited (15-25%).

The moderate-risk countries have enough reserves to cover their USD debt – South Africa 133%, Brazil 202%, Russia 242%, Malaysia 255%, South Korea 336%, and India 390% – but fall short of covering their total external debt.

Compare these figures with those from China, a country identified as no-risk and one that holds reserves that are six-times its USD debt and double its total external debt, or with the oil-rich Saudi Arabia, with reserve ratios standing at 4.5 times its USD debt and 2.7 times its total external debt.

Debt-to-GDP ratios (both USD and total external), is also a critical measure of a country’s indebtedness.  Among the 5 highest-risk countries, Mexico can cover two-thirds its USD debt from reserves – seemingly better-off than Chile, Argentina and Turkey – however, Mexico is even more exposed than what this may suggest.  Its external debt (39% of GDP) is not as high as Chile at 66%, Turkey at 55% or Argentina at 40%, but at 60% of its total external debt, its USD denominated debt is 25% of GDP, behind Chili at 36% but higher than Turkey at 24%, Argentina at 20%, and Indonesia at 15%.  Moreover, the size of its USD debt is second highest behind China’s, bearing in mind that China’s USD debt is a mere 4% of GDP.

This is the type of analysis required when trying to identify high-risk situations (opportunities depending on your perspective) but often, further consideration is required: Indonesia, for example, has an external debt-load in relation to GDP of only 35%, lowest among the 5 high-risk countries, and less than half of that is USD denominated (16% of GDP), and its reserves are large enough to cover 72% of its USD debt (highest ratio among the 5); however, since its reserves are still rather limited, Indonesia is still highly exposed, and its currency decline (more than 10% this year) is an indication of this vulnerability.

Compared to the high-risk countries, the six considered moderate-risk all have relatively low levels of USD denominated debt (South Africa, Russia and Malaysia at 11-13% of GDP, South Korea and Brazil at 8-9%, and India as low as 4%) and they have enough reserves to cover their USD denominated debt (India with a margin of 4:1, South Korea 3.4:1, Russia and Malaysia around 2.5:1, Brazil 2:1, and South Africa at 1.3:1).

Their total external debt exposure, however, is much higher in relation to GDP; in fact, Malaysia’s at 68% of GDP is higher than any of the high-risk countries, while South Africa at 52% is only below Chili and Turkey.  The remaining 4, Russia at 33% of GDP, Brazil at 32% and South Korea at 28% are only slightly below Mexico and Indonesia, while India at 20% is lower.  South Korea and Russia have enough reserves to cover most of their external debts, and India is not much farther behind them.  Brazil and Malaysia can cover about half their total external debt, while South Africa is below 30%, closer to the high-risk group.

Reserve-ratios provide some guidance in assessing overall risk levels but do not provide enough information to gauge the state of a particular currency to buy or sell at any particular moment, at least not in any informed way.  As we examined in more detail in the case of Turkey, the currency crisis the country faces is the outcome of deeper financial and economic forces at work; moreover, its socio-political instability is playing a huge role in driving the value of its currency through capital flows (limiting inbound investment while boosting outbound flight).

Currency-crises are typically expressions of wider financial or economic difficulties facing the countries involved.  Their ability to pull out of crises depends on their capacity to stabilize their economies and restore healthy growth, and in this regard socio-political conditions play as much role as the economic fundamentals.  To pass judgment on the future of any currency, be it in high or moderate risk countries, we must understand the broader context through further analysis on a country by country basis.

Cannabis Stocks: A boom or bust?

Call it the green-rush or an unsustainable-bubble, the cannabis investment scene in Canada is an intriguing market for active investors and passive observers alike.  Are we witnessing a “boom” in a newly legalizing industry, or is it a “bubble” that is bound to burst like the .com bubble of the 1990s?

If you’re a follower of the Canaccord Genuity Cannabis Index (CGCI) you might have been euphoric to observe the recent one year increase of 400-450% to September, 2018.  As the Canadian legalization date approached, CGCI’s performance climbed even higher – up 90% in the first half of September (50% above August levels).  However, in the week following Canadian legalization (October 17th, 2018) the market began to fall – 30% decline in the North American Marijuana Index (NAMI).  Many casual investors saw a significant losses, and it has caused many to look upon the cannabis industry with less enthusiasm.

Before passing judgment let’s put the stock price trends in perspective.  NAMI had indeed plunged in the latter part of October, 2018 but it was still double the value it carried through most of 2017, and it has since started to recover, not to the interim October peak but still to the highest levels since February, 2018.  CGCI also experienced a correction but still managed to maintain a valuation roughly double the previous year (not including the huge gains beginning in late summer.  The cannabis industry is now considered ready for a near-term bounce.  Thus, what was experienced in October was a correction, not a bubble bursting.

There were elements of irrational exuberance through 2018, with investors jumping into an intuitively appealing market that they did not quite understand.  The cannabis industry holds a lot of growth potential and will continue to attract new investment, but don’t count on an across the board boom.  One must invest wisely, as there will be plenty of unworthy prospects and considerable volatility ahead.  To realize significant gains in the years to come, one must understand where the industry is headed and how it is going to get there, formulate a strategy, and invest accordingly.  We will get to the industry landscape and how it is expected to evolve in the coming years in another article, but here let’s focus on the stock scene.

An investment firm, Canaccord, with a keen interest in the market and the emerging industry around it, estimates the financial transactions in the last 4 quarters to be close to $5 billion.  There were large items in this basket, $600 million for Canopy and $200 million+ investments for Aphria, Tilray and Aurora – also many smaller ones, especially in the $10-15 million range.  However, this total does not include yet to be realized commitments like the $5 billion Canopy got from Constellation Brands.  Thus, by any standard, transaction volumes are significant.

Among the 350-400 securities in the marijuana stock universe, only a few are on NYSE or Nasdaq; many more are listed on Canadian exchanges (TSX, CSE and TSXV), while plenty more trade on over-the-counter boards.  There are heaps of private placements in the pipeline – mostly start-ups, but also ones with track-records that are preparing for a public listing on senior exchanges rather than enduring OTC-trading for months or years to come.

NAMI, referred to above, has a base of 34 companies – 18 in its Canadian Index and 16 more in the US one.  The Canadian group has a combined market cap of roughly $35 billion, while the American one is about $10 billion.  CGCI is based on 10 companies that are in NAMI as well – 5 of these (3 on NYSE or Nasdaq, 2 on TSX) have market caps of more than a billion (currently Canopy is at $13.2 billion, Tilray $11 billion and Aurora at $8.4 billion, others are in the $1-1.5 billion range).  Of these firms, largest 3 constitute close to 80% of the CGCI-base and are all Canadian.  In contrast the largest US-based marijuana company, GW Pharma, has a market cap of about $4 billion.  Among the other 15 in the US Index only one is just shy of a billion, all the others below $500 million.

The 36 firms that are indexed (CGCI or NAMI) are now valued at more than $45 billion; at their peak in October or January they were close to $60 billion.  What is driving these valuations to these levels?  Simply put, it has nothing to do with earnings; rather it is based almost entirely on growth potential as the legal market opens.

Some do have positive earnings, like Aphria and CannTrust, with market caps at $2.9 billion and $700 million respectively.  Their price-earnings (PE) ratios are 86 and 44, high but not unheard of in the tech-world.  A few others are also revenue-positive but trading at astronomical valuations with meager earnings – Aurora, 2nd largest in market cap, has a PE ratio of 769, Cronos with $1.5 billion market cap at 869, OrganiGram with $740 million market cap at 1900.

Some analysts are optimistic that this situation will change within a year or two.  Canaccord-Genuity, for example, projects an average PE ratio of 30 for the top-9 cannabis companies into 2019, declining further to 16 in 2020.  This is probably wishful thinking; a dramatic turnaround will occur in the future, but it will not be that soon.  Most investors are aware of this reality, and are not expecting huge earnings in the short term.  At this stage, cannabis companies are investing and spending free cash-flow on corporate infrastructures: they are ramping for growth and will normalize their earnings once they mature.

A more realistic valuation measure for this industry, at least at these early stages, is revenue-multiples.  Canaccord does project expected valuations to revenue ratios – for the top-nine 9-times revenue in 2019 and 6-times in 2020.  These targets may not be achieved in the next couple of years, but ratios will improve and eventually get there.  This is a more suitable measure for this industry (at least at this stage) as large cannabis companies follow more or less the same model; scaling up growth capacity at similar unit-costs.  Most of their revenues are derived from growing-and-selling cannabis into a fairly competitive market, where most buyers have access to multiple suppliers.

This is the industry’s core business model, but companies will follow different diversification and vertical integration strategies thereby diverging from the norm.  By then the industry would have matured to place more emphasis on conventional ratios like PE.  Along the way some producers will do better than others but the results can be tracked against standard norms. These issues will make more sense against the background we are going to provide in a subsequent article – where the industry is, at these early stages, and where it’s headed.

To sum up the cannabis-stock discussion, there has been an investment flood into the industry, by both institutional and retail investors.  This is an emerging industry at fairly early stages of development with very strong growth potential, a natural magnet for new investment.  The valuations may seem hyped up but the recent plunge in stock prices should be seen as a market correction with a likely bounce to follow, rather than bursting bubble.

In time existing players will strengthen and grow while many others emerge.  There will be plenty of stocks in the offering but investors and traders must understand the companies they are betting on – market positioning, growth strategies, strengths and weaknesses.  There will also be plenty of IPO and private-placement opportunities in which to participate, but investing in them will require more knowledge – there may be more winners than losers but avoiding the latter will require careful analysis.  This is not a space we would recommend for novice speculators allocating their funds blindly, but there is money to be made for informed investors.