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Marijuana investing. The straight dope

April 20, 2018

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Marijuana investing. The straight dope

Market Insights
Marijuana investing. The straight dopeIs all the buzz around marijuana investing deserved? How did the value of marijuana stocks get so high in the first place? Why are they currently on a bit of a low? And with valuations seemingly at a discount, is now a good time to get in on the action?

Clearly, there are potentially big risks, but also big rewards for investors in this fast-growing new industry. Legalization, whether in the fall, or sometime in 2019, seems inevitable at this point. How exactly might you add marijuana to your investment mix?

With Canadian investors in mind, we took an in-depth look at these questions.

Not that long ago it seemed that Canada might make their self-imposed legalization deadline of the summer of 2018. Those hopes have been mostly dashed. However, many companies, along their early investors are cautiously optimistic for a fall 2018 resolution. Possibly, it could happen as early as July.

Legalization isn’t as simple as when the House of Commons votes to create a new marketplace. Many politicians are enthusiastic about the upcoming tax revenue infusion. However, they know that there are many other considerations and costs involved.

The marijuana marketplace has grown up fast, even before legalization

When is the absolute best time to invest in the fast-growing marijuana industry? Actually, that was probably more than a year ago. As Canada’s Prime Minister campaigned on legalizing marijuana, investors poured money into cannabis companies. Some of these practically overnight, went from penny stocks into high-flying billion-dollar valuations.

For instance, the market cap of the top five cannabis stocks alone grew by 400%. Canopy Growth Corp., the leader in Canada, has a market cap of over $5 billion and if you got in early enough, you might have seen a 261% return on your investment. Aurora Cannabis had a slightly smaller market cap, but posted a 1-year return of 353%. PharmaCan Capital’s stock was up 385%.

The whole reason we saw such startling triple-digit returns for marijuana stocks in 2017 is because of deregulation — or at least, the anticipation of such a thing. The federal Liberal party in Canada ran on a platform of legalization. The thinking was to disrupt the black market, while simultaneously creating a wind fall of tax revenue. That cash infusion from a legalized marijuana industry could be substantial.

A bigger market than just Canada

It is a global opportunity — not merely confined to the Canadian marketplace. It is a unique situation though, where the usual big gorilla on the block, corporate America is a no-show. Notwithstanding legalization in individual American states like Colorado and California, American companies are still cut out of the competition by federal law.

That means, for once, Canadians can step over their southern cousins and become global leaders in a brand-new industry. This is green pasture territory. It is a dreamy prospect for investors looking for profitable ventures.

The marijuana industry includes over 85 companies with a combined market value of $30 billion. Some believe the global medicinal marijuana marketplace alone could be worth US$31.4 billion by 2021. According to Eight Capital, it could be worth $180 billion by 2025. Those who think Canadians might be latecomers to this market —medical cannabis programs started here as early as 2001. If anything, we’ve been trendsetters.

However, the phenomenal growth we seen so far isn’t likely to continue forever. Investors looking into this industry need to manage their expectations.

Marijuana investing today, is a diversification play. There’s volatility and you’re betting on companies that must prove their worth by generating sales.

What kind of sales? That’s the billion-dollar question. Not every marijuana start-up has all the answers. The elusive question of what the paying customers is really looking for is still up for debate.

Overview of the marijuana industry. Where we are at today

The marketplace can be divided up into segments. The first, smaller group is the smokers. But the second category includes a much broader way of consuming cannabis, through food, beverages, supplements or other means. Medical marijuana is a big potential area of growth, along with specialty products that cross over into the bigger food and beverage territory.

According to Evolve ETFs’ research, in 2015, there were just five countries where medical marijuana was legalized (or in the process of being legalized). By 2017, that shot up to 25 countries.

Canada is a leader in this sector. Medical marijuana was legalized in 1999. The big breakthrough though came in 2015 with new rules to allow value-added products. The Supreme Court deemed that restricting legal access to only dried products was unconstitutional. This opened-up the market with new product lines that transformed the medical marijuana landscape. Legalization will no doubt start another trend.

Some estimates put the number of adult Canadians who use recreational marijuana at about 20 percent of the population. The government is trying to get a better handle on the actual number by tracking the THC-laced product that winds up in our sewers. Canadians spent $5.7 billion on marijuana for medical and non-medical purposes in 2017. Market studies estimate the value of the Canadian recreational marijuana market in 2018 to be about $7.9 billion.

Indeed, beverages will likely be big business for the marijuana industry. Energy drinks and health supplements of every variety will be able to separate themselves from the pack by infusing them with marijuana extracts. Cannabinoid-infused beverages are already optimistically planned for launch in 2018. These products have huge potential for sales.

It could be an easy way for companies not normally associated with the marijuana industry to get a foot in the door in this growing industry. Alcohol giant, Constellations Brands, owner of Corona, purchased a 9.9% stake in Canopy Growth Corp (WEED.TSX).

Risks in marijuana investing

There are still many questions around the legalization process – and uncertainty is sure to prompt additional volatility.

There are still questions around the conditions under which government-mandated producers will be able to ply their trade. For instance, how will testing be carried out? What does quality control even mean for this product? What are the growing risks, such as with insects, pesticides and plant diseases?  

A lack of standards from the government and from the emerging companies isn’t helping matters. For instance, there is confusion around basic accounting.

Financial statements from marijuana companies may be misleading. That’s the take from a Canadian Business report. Calculating gross margins, for instance, is difficult for a new industry:

“The market for tomatoes is well-established, prices are not in dispute, and a producer can enter into future sales contracts. That’s not the case with recreational marijuana sales, an industry that doesn’t even exist yet. Prices, costs, sales volumes and the quality of inventory are still very much up in the air.

There is additional uncertainty how legalization will be implemented in a responsible way.

For instance, if marijuana products are given roughly the same status as alcohol, how will that affect laws around driving under the influence? Currently, there is no reliable test that is the equivalent to a breathalyzer for alcohol. The only reliable method currently is a blood test. However, taking a roadside blood sample is illegal.

For now, if legally-buzzed Canadians enjoying “one more for the road” start driving in droves, this could create a public safety issue.

Getting regulation right

Licensing is another area where an inconsistent approach among provincial governments is likely to cause business problems. In particular demand may not meet supply needs.

Media reports have already highlighted a vast gap between the legal supply and expected demand, as indicated by the number of licensees. One reason for legalization is to eliminate the black market that benefits organized crime. Leaving expectant customers for the legal commodity in the lurch seems counterproductive.

At the same time, some prospective marijuana companies that can’t start selling right out of the gate may find themselves at a longer-term disadvantage.

Certainly, undersupply is a problem that could be resolved over the long term, as more licenses are approved… which brings us to the next, even bigger problem: oversupply.

As the retail price of legal recreational marijuana drops from $8 a gram down due to overproduction, that’s when we are likely to see a culling in the marketplace.

In this environment, there will be a few ways to come out on top. The first way is to be a super low-cost grower. There’s a lot of supply coming onto the market. Right now, we’re looking at $8 a gram. With increasing supply, that could be down to $3 or $4 a gram in the next year.

For recreational weed, a long-term supply gut is not just expected – it’s just about inevitable. By 2020, supply will double or triple expected  domestic demand.

At that point, successful players will survive by looking internationally and creating niche products.

Given the market cap, Canadian companies can’t just be focused on the Canadian market. They will have a few years to become global players. But they’ll be looking to regions like Europe, instead of the traditional US market.

As for product niches, forward-thinking companies will develop oils or beverage products. Every global beverage company should be looking at partnering with marijuana companies.

But let’s not put the cart before the horse. Before sales, legalization still must happen. That is taking a bit longer than investors had hoped.

Mitigating risks: Diversification in marijuana investing

Would you be comfortable with a level of risk where your investment could go up or down 10 percent in a single day? If not, then marijuana stocks are probably not for you. But that doesn’t mean you can’t invest.

“If you’re a new entrant to marijuana investing, then a diversified approach is the only way forward,” says Horizons ETFs Management (Canada) Inc. Senior Vice-President and Head of Sales Strategy Mark Noble. “There’s a lot of single stock risk, only rivalled by blockchain, given the newness of the space and the players.

North American investors have moved billions into these index funds that mitigate risk through diversification, while offering reduced fees – which can help improve returns over time.  We reviewed several of the leading marijuana ETFs currently available in Canada.

In this case, investors would be looking for an ETF which provides exposure to a basket of marijuana equities.

The Marijuana Opportunities Fund from Redwood Asset Management aims to give active exposure to the sector to deal with the predicted volatility. The ETF’s holdings have included a large range of companies such as Medreleaf Corp., Hydropothecary Corp. and Supreme Cannabis Co Inc.

Horizons Marijuana Life Sciences Index ETF, which is the world’s first marijuana ETF, includes publicly listed life sciences companies with significant business activities in the marijuana industry. It aims to replicate as much as possible the performance of the North American Medical Marijuana Index, net of expenses.

The goal: minimize risk in a highly speculative industry, Noble explains. “Looking at the underlying holdings and the value of the producer stocks, like Aurora. The prices on these stocks are exorbitant versus their earnings.”

SEED is another marijuana ETF available in Canada, different from Horizons’ product in that it is actively managed. It does not have a mandate of following a specific index. This allows it to be nimble and take advantage of specific opportunities as they arise. That’s another way to tackle the problem of risk – because right now, stocks are still highly speculative.

With risks, come rewards – possibly big ones.

There are consolidation opportunities and big pharma and tobacco companies may be considering marijuana. For the diversified equities investor, there may be ancillary opportunities. For instance, look to biopharmaceuticals, fertilizer, real estate for growers. Then there are other companies that are involved in the infrastructure of the industry.

Many who are just now getting involved in the marijuana industry will find it as hard to pick winners as it was for investors leading up to the dotcom tech bubble. For every Yahoo, there were many more examples of also-ran’s like Pets.com and Alta Vista.

This is an industry in its infancy. Current prices are being driven by speculation. They may not be representative of traditional valuation models. That explains why the sector has extreme volatility. However, investment risk can be reduced through diversification by using ETFs. Investors have the ability to choose between passive index tracking or professional active management.

“Our advice to clients is simple: ask yourself, why do you want to get in?” Noble says. “Fear of missing out? You want to get in on revenues already returned? You’re probably already too late to the party. All that pricing potential is already built into the stocks. That’s why diversification may be a smarter play. It’s not the secondary or tertiary reason. It’s the primary reason to get involved in marijuana investing.”

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