Canopy Growth Is Rallying Again. But Is It a Dead Cat Bounce?

Canopy Growth (NASDAQ: CGC) is a Canadian marijuana company. When it first came public marijuana was a hot sector, but investor enthusiasm has waned. The stock has since declined to the point where it is a penny stock, trading around the $1 per share mark. That's the big-picture backdrop for the recent 25% price gain, but there's a lot more to understand before you consider investing in this company.

Canopy Growth's rally isn't as huge as it looks

Penny stocks are generally high-risk investments that most investors should avoid. Some companies come out of the penny stock realm and grow into sizable, important, and profitable businesses. But more often the shares of penny stocks trade for low prices for very good reasons. Many end up disappearing altogether, either because they get delisted or because they shut their doors. And a big percentage move in a penny stock is often a very small move dollar wise.

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For example, over the past month, Canopy Growth's stock traded for as low as $0.857 per share and as high as $1.38. That's a huge percentage difference, but it amounts to roughly $0.50. What would be mere trading noise for most socks can look like something hugely important for a penny stock. So the roughly 25% gain over the past month isn't necessarily a sign that this marijuana business has finally found its footing.

Canopy Growth has some good news to offer, with a caveat

To be fair, Canopy Growth has made some important changes in recent quarters. For example, it dramatically reduced its debt load, strengthening its financial position. That's a clear positive, given the company's ongoing losses. The negative here is that the recapitalization required the issuance of new stock, which diluted existing shareholders.

Shortly after that event Canopy Growth agreed to buy another company. That required even more shares to be issued, further diluting existing shareholders. The deal extends the company's reach in the medical marijuana space, which is positive, but money losing Canopy Growth is hardly working from a position of strength. Pairing up two small, struggling companies isn't necessarily going to create a winning business.

The dynamics of the marijuana sector are worrying, as well. For example, Canopy Growth has to contend with material taxes and regulation. Illicit drug sellers, which did not go away after marijuana use was legalized, do not face these same costs. That dynamic doesn't change even if marijuana's legal status changes in the United States. Moreover, there was an early land grab in the marijuana sector and competition remains pretty intense. There has been consolidation, noting Canopy Growth's own acquisition, but not enough to clear the playing field.

Canopy Growth's earnings history isn't good

Still, the real reason to avoid Canopy Growth, even after the recent rally, is that it hasn't proven it is a sustainably profitable business. In fact, the best it has offered is break-even earnings. And the last time it did that was in 2017. The ongoing losses are a very big indication of risk and pretty much forced the company's hand when it came to the recapitalization of the balance sheet highlighted above.

It is entirely possible that the company's recapitalization and recent acquisition represent a turning point. And that could be what is behind the recent stock advance. Or that advance could just be noise driven by overexuberant investors that have a short-term focus and that aren't looking at the big picture. It is too soon to tell. Most investors should probably avoid this penny stock for now. Until Canopy Growth has proven it has a sustainably profitable business, the risks here likely outweigh the potential rewards.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.