Title: Why a 16% Dividend Yield May Not Make This Marijuana Stock a Great Investment
In the not-so-distant past, the financial world believed marijuana presented an unprecedented growth opportunity. Companies associated with this budding sector were valuated highly, with AFC Gamma (AFCG 1.44%) being one of them. However, AFC Gamma isn't a grower; instead, it's a mortgage real estate investment trust (REIT), serving as a "pick-and-shovel" company. The initial opportunity they saw has seemingly vanished. What can we take away from this situation?
Overheated Markets
Investors, while typically rational in the long term, display irrational tendencies in the short term. This results in periods where new investment opportunities, like marijuana, receive sky-high valuations. Wall Street attempts to hop on board during the "early" days but often propels things to unsustainable levels. The outcome is usually a shakeout, with weaker entities bought out or shut down, leaving the strongest survivors. It's challenging to distinguish the long-term winners from the losers during these periods of excess.
As you witness an exciting new industry, remember the aforementioned pattern. Similar outcomes are unfolding in the electric-vehicle and space exploration markets, and this pattern has repeated itself numerous times in various sectors, including auto, biotech, and internet.
Seizing the Opportunity
AFC Gamma's primary focus was on the marijuana sector. As a mortgage REIT, its target audience was marijuana companies, a strategic move given the federal prohibition of marijuana, which keeps most banks at a safe distance. Providing mortgages for marijuana properties was AFC Gamma's niche, addressing a demand that traditional banks could not.
Changed Tides
While there is still significant long-term growth potential for marijuana, it faces challenges such as taxes, competition, and the preponderance of illegal marijuana sales. These factors necessitate a shakeout, leaving the strongest companies to thrive. AFC Gamma's predicament is choosing which marijuana companies to lend to and which to avoid during this period.
For almost a year, the company has declined to issue new loans. Meanwhile, AFC Gamma frets about the potential default of existing customers. At year-end 2022, it had one late loan, representing around 0.9% of its portfolio. In response, the company increased its loan loss reserve by 100%, indicating anticipation of further issues. This has contributed to the stock's plunge and a high dividend yield of 18%.
Assessing the Risk
AFC Gamma posted distributable earnings of $0.62 per share in the final quarter, with a planned first-quarter dividend of $0.56 per share. This equates to a staggering 90% payout ratio, offering limited room for hardships. The company's loan loss reserve growth and expected shakeout offer further cause for concern. Although AFC Gamma is contemplating venturing beyond the marijuana market, their primary focus definitely has its doubts.
Most investors should be cautious regarding this high-yield stock, but the story is worth tracking as it unfolds. This is essentially a textbook example of the Wall Street hype machine, demonstrated amid the inevitable conclusion that what often feels too good to be true, usually is.
Investors should be wary of overvalued industries, as history shows new sectors like marijuana, electric vehicles, and space exploration often see sky-high valuations due to irrational short-term behavior. Financial institutions, including AFC Gamma, looking to capitalize early can contribute to unsustainable levels, leading to a shakeout where weaker entities fail and stronger survivors emerge.
Finance has always involved assessing risk, and while AFC Gamma saw potential in the marijuana market by offering mortgages to marijuana properties, the federal prohibition and challenges presented by taxes, competition, and illegal sales necessitated careful consideration. The company's predicament in choosing which marijuana companies to lend to and avoiding defaults has resulted in a high dividend yield and concerns about its financial stability, making it a potentially risky high-yield stock for most investors.