Why Investors Should Warm Up To Cannabis Investing

The cannabis sector recently set a new low. The New Cannabis Ventures Global Cannabis Stock Index, which was created at a value of 100 at the end of 2012, closed on 9/30 at an all-time low of $11.26. In October, it has lifted 11.5% to 12.55 as of 10/28:

I have been following the industry since early 2013 and run a subscription service, 420 Investor, that has focused exclusively on cannabis stocks since late 2013. In this article, I am going to discuss why the market has pulled back, how I expect the trends to improve and the way investors should and should not approach investing in the sector.

Why The Market Has Crashed

In 2020, the cannabis sector was hammered when COVID-19 emerged as a threat to our health and to our economy in the U.S. This was the case for stocks in general too. The cannabis sector had already been beaten up late in 2019 due to a regulatory crisis regarding vaping. The S&P 500 went on to quickly recover from its 2020-Q1 plunge and set a new all-time high, and cannabis stocks recovered but less sharply. In 2021, the S&P 500 price rallied 27%, and it closed about 119% higher than the lowest close in March 2020. The Global Cannabis Stock Index fell 26% in 2021, and it is down 61.8% thus far in 2022, which is a lot worse than the 17% decline in the S&P 500.

The large decline in cannabis stocks is partially related to the recent pullback in the overall market, but there are several other factors that have impacted investor sentiment. In 2020, the index was able to rally from its lows in March rather dramatically, ending the year up by 5.2%. The big driver of this was that the decline in Q1 had been driven by a concern that cannabis retailers would be shut down during COVID-19. This didn’t happen broadly, though, as many states deemed the provision of medical cannabis as an “essential service.” While it wasn’t easy to tell this initially, demand actually increased due to consumers no longer going into the office. A later understanding of the boost to demand and the subsequent decline in demand is one of the factors that has weighed on the sector.

The big run-up in late 2020 was due to the national elections, with the Democrats taking not only the Presidency but also maintaining control of the House and gaining control of the Senate. Investors were overly optimistic that pro-cannabis changes would take place soon at the federal level, but this hasn’t been the case at all.

Another factor has been weak growth in mature markets in the West, especially California. There are other states as well across the country where increasing supply and stabilizing or falling demand have resulted in price pressures. This is partially due to the economy, but also due to the maturation of the industry. Quite simply, suppliers are getting better. The big-picture factor in many markets is that the illicit market remains intact to a great extent. Also, some states don’t yet have enough stores open.

So, a lot of good happened to cannabis stocks that shouldn’t have taken place to the extent it did in late 2020 and early 2021, but the Global Cannabis Stock Index has declined by almost 85% since the peak in mid-February of 2021. Many factors have contributed, including price pressure and a failure of the Democrats to make any progress on the federal regulatory front.

Improvement Ahead

I believe that the fundamentals will improve in 2023. California has made some changes to their program and seems to be taking more of a stand against the illicit market. Perhaps more importantly, more cities and counties are allowing cannabis stores. Similarly, Illinois is finally adding more stores. I expect New Jersey, which recently began adult-use sales, will increase the number of stores. Importantly, New York will implement a program this year, and Virginia, which also has a medical program, will do so in 2024. The upcoming elections likely won’t help much, as the states are all relatively small, but there are other states legalizing or that could move to legalize.

President Biden, not a friend to the industry at all for the first almost two years of his Presidency, shocked the world with his call for reform at the federal level in early October. My bullish outlook doesn’t include the potential descheduling of cannabis or the potential rescheduling. If this takes place, it could wipe out the onerous 280E taxation (as long as cannabis is descheduled by the DEA or becomes Schedule III or higher, instead of Schedule I). At the same time, though, rescheduling creates a risk of FDA regulation of the industry, which could prove negative.

Another positive that could transpire is the move from the OTC to higher exchanges by American cannabis companies. There is no law that prevents the NASDAQ or NYSE from listing MSOs, but they choose to not take the risk. A change in the federal regulatory approach could allow them to be more comfortable listing the currently federally illegal companies. The recently announced move by Canopy Growth (CGC) to restructure the company so that it can close on three acquisitions in the U.S. could also open the door to MSOs uplisting. Similar to my view on 280E, I think that uplisting would be great, but it isn’t part of my reason to be more bullish than ever on the cannabis sector.

My bullishness is driven not only by a return to growth by the industry soon but also very low valuations. I think stocks are very cheap relative to where they have historically been valued. Most investors pay the most attention to American multi-state operators (“MSOs”), and the New Cannabis Ventures American Cannabis Operators Index is down a lot less than other parts of the market. In 2022, it has declined by 45.7%, considerably less than the -61.8% return in the Global Cannabis Stock Index. Though it is down only 74% as much as the overall cannabis market, it is down considerably more than stocks in general. When I look at the sector, the largest MSOs stand out as relatively expensive to others, especially Curaleaf (OTCPK:CURLF), which trades at 8.3X enterprise value divided by projected 2023 revenue and 2.4X projected 2023 adjusted EBITDA. The 12 MSOs I am tracking trade at an average of 6.3X projected 2023 revenue and 1.5X projected 2023 adjusted EBITDA. I find even Curaleaf’s valuation, while the highest by far, to be low enough that I expect the stock will rally.

I am most excited by the ancillary stocks, which have crashed hard on the back of the industry slowdown. Their customers are trying to curb spending, which has hurt the financial returns, but I don’t see competitive issues driving additional woes. I expect that as the industry expands and as new states go live on adult-use legal programs, the companies will experience better demand.

One thing that I am watching closely is the race for Governor in Texas. Democrat Beto O’Rourke is challenging the existing Governor, Republican Greg Abbott. I am a Texan and voted on 10/29 ahead of the election of 11/8. Recent polls suggest that the race is somewhat close, and I think that an O’Rourke win would be great for the entire cannabis industry. The chances of O’Rouke winning are pretty low, unfortunately. I haven’t seen many people discussing this possibility, but O’Rourke supports adult-use legalization for the state, which has a pretty bad medical cannabis program now. While it has improved since launching in 2015 by adding conditions that enable patients to participate and doubling the THC cap to a too-low 1%, the program only has 632 doctors that prescribe and only 36,651 patients as of September. That’s only 0.12% of the state’s population.

Why I am excited about how things could play out with an O’Rourke victory is that Abbott is very much against cannabis. Moving ahead towards adult-use legalization under O’Rourke could be great for the industry. Currently, there are only three companies licensed to produce and distribute medical cannabis products in the state. I expect that the current operators elsewhere will be able to enter the state, which could create the best adult-use program. Texas doesn’t charge state income taxes and has a great regulatory approach relative to other states. There are a lot of lessons that have been learned since Colorado implemented the first adult-use program at the beginning of 2014, and I believe that Texas will learn from the many mistakes that have been made thus far across the country.

While Texas perhaps legalizing is just a potential bonus with not great odds of happening, it could be big. The other reasons I am optimistic don’t require anything but time. Cannabis remains a growth industry!

Be aware that earnings season, which starts this week, probably won’t provide a lot of upside relative to expectations, but I think that if things aren’t worse than expected, many investors will begin to add stocks over the course of the year and in early 2023. One issue that killed the rally from July was the overall stock market breaking down badly in September. I continue to warn my subscribers that the “big bad bear” may bite us. It is difficult, in my view, for investors to embrace our sector while the overall stock market is moving lower.

How to Position

In almost a decade of following this sector, I have noticed that investors tend to choose producers and sellers over ancillary companies, and I think that this can be a mistake. Right now, I have the majority of my model portfolios at 420 Investor in companies that generate revenue selling goods and services to cannabis companies. This is a large overweight relative to their index. We run an index focused on this sub-sector at New Cannabis Ventures, and the Ancillary Cannabis Index is down 71.7% in 2022 and down almost 82% since it was created at the end of March 2021. I like this sub-sector the most for many reasons, including valuation, the non-exposure to the onerous taxation that direct cannabis companies face (280E), and the better liquidity due to their listing on higher exchanges.

I am a bit underweight MSOs because I currently have no exposure to the five largest names. One that really stands out as expensive to its peers is Curaleaf, the largest one, as I described above. While I am currently avoiding these top names, I do have large exposure to the second tier, which appears a lot cheaper to me. As I look out, I am aware that legalization could be very beneficial for all of these companies, but I am not yet convinced that federal legalization will happen soon. In the status quo, some of the largest companies are going to struggle to complete M&A or expand operations in certain markets, while the Tier 2 names should have an easier time (and may also be acquired by larger MSOs or other companies in the future). I think that some of the smaller but still large MSOs look considerably more attractive than the largest names currently.

I have a lot less exposure to the index in the sub-sector of Canadian LPs, where I own just two names in my model portfolios. Both names are trading below tangible book value and have high and growing revenue and seemingly good valuations. I think that the Canadian market is very tough, and I see investors wasting their time with the leaders, which have included Aurora Cannabis (ACB), Canopy Growth (CGC), and Tilray (TLRY). One that I don’t own but like is Cronos Group (CRON), which I continue to think could (should) be acquired by Altria Group (MO).

The Global Cannabis Stock Index includes some other sub-sectors that I don’t invest in currently in my model portfolios. CBD has been hung up in FDA regulatory review for quite some time and has gotten very competitive. I think that the FDA could improve it, but I am not going to be involved until there is news of a potential change. There are biotech names as well. I was a big fan of GW Pharma and owned it in my model portfolios when Jazz Pharmaceuticals (JAZZ) bought it, but I don’t own it or any biotech now.

While I like the idea of ETFs and trade in them personally along with common stocks (all outside of the cannabis sector), we have warned our readers at NCV about how poorly constructed cannabis-focused ETFs have been. Most recently, we pointed to the largest ETF in the sector, the AdvisorShares Pure US Cannabis ETF (MSOS) is overly exposed to just the top MSOs. I advised my subscribers to avoid this ETF for now, and I want to warn readers that I think there are much better ways to capitalize on cannabis.

Conclusion

I have gotten more bullish this year as the prices have imploded, but I didn’t predict the massive decline in cannabis stocks this year. My swing-trading model portfolio, launched in late 2013 and limited to long-only strategies, is down 45% year-to-date, which is terrible but less of a decline than the overall cannabis market. Since inception, it has gained 1523%, and this includes the big loss thus far in 2022 and also a gain of 16.6% in 2021 despite the declining market for cannabis stocks. My two long-term focused and fully invested model portfolios are down a lot less than their benchmark, falling about 54% in 2022 thus far.

Many reading this may have already invested in the cannabis sector. Some may have left after making money, while most have probably lost money. I think that this is a fantastic time to revisit, as the opportunities ahead are great and the prices near an all-time low and a good value. Many readers are avid investors who haven’t ever bought the cannabis sector at all. I think that this is a great time to start to research and to consider investing. With that said, I think investors should be very careful about how they invest in the sector. Not all stocks look as attractive as some, and the ETFs appear to be very flawed.