High and higher: The Money in Marijuana!
In 1992, when Bill Clinton was running for president of the United
States, and was asked whether he had ever smoked marijuana, he responded
that he had, but that he did not inhale, reflecting the fear that being
viewed as a weed-smoker would lay low his presidential ambitions. How
times have changed! Today, smoking marijuana recreationally is legal in
nine states, and medical marijuana in twenty nine states, in the United
States. Outside the United States, much of Europe has always taken a
much more sanguine view of cannabis, and on October 17, 2018, Canada
will become the second country (after Uruguay) in the world to legalize
the recreational use of the product. In conjunction with this
development, new companies are entering the market, hoping to take
advantage of what they see as a “big” market, and excited investors are
rewarding them with large market capitalizations. I have never smoked
marijuana, but on my daily walks on the boardwalks of San Diego, I have
been inhaling a lot of second-hand smoke, leaving me a little light
headed as I write this post. So, read on at your own risk!
The Macro Big Picture
While there is much to debate about how this market will evolve over
time, and whether investors and businesses can make money of that
evolution, there is one fact that is not debatable. The cannabis market
will be a big one, in terms of users and revenues, drawing in large
numbers of the population. To get a sense of the growth in this
business, consider some nascent statistics from the soon-to-be legalized
Canadian recreational market:
- Lots of people smoke weed: According to the Canadian national census,
42.5% of Canadians have tried Marijuana and about 16% had used it in
the recent past (last 3 months), with the percentages climbing among
younger Canadians, where one in three being recent users.
- And spend money to do so: The
total revenues from recreational marijuana sales in Canada alone is
expected to be $7-8 billion in 2020 and grow at a healthy rate after
that. Some of this will represent a shifting from the illegal market
(estimated at close to $5 billion in 2017) and some of it will represent
new users drawn in its legal status.
There is also information that can be gleaned about the future of this
business from the states in the United States that have legalized
marijuana.
- In California, where
legalization occurred at the start of 2018, revenues from cannabis are
expected to be about $3.4 billion in 2018, but that is not a huge jump
from the $3 billion in revenues in the illegal market in 2017. One
reason, at least in California, is that legal marijuana, with testing,
regulation and taxes, is much more expensive than that obtained in the
illegal markets that existed pre-legalization.
- In Colorado, where recreational
marijuana use has been legal since 2014, the revenues from selling
marijuana have increased from $996 million in 2015 to $1,25 billion in
2016 to $1,47 billion in 2017, representing solid, but not spectacular,
growth. Marijuana-related businesses in Colorado have benefited from the
revenue growth but have, for the most part, been unable to convert that
growth into solid profits, partly because of the regulatory and tax
overlay that they have had to navigate.
With the limited data that we have from both Canada and the US states
that have legalized marijuana, here are some general conclusions that
come to mind.
- The illegal marijuana market will persist after legalization:
The illegal weed business will continue, even after legalization, for
many reasons. One is that legalization brings costs, regulations and
taxes, which make the cost of legal weed higher than its illegal
counterpart. The other is cultural, where a segment of long-time weed
smokers will be reluctant to give up their traditional ways of acquiring
and using weed. From a business standpoint, this will mean that the
legal weed businesses will have to share the market with unregulated and
untaxed competitors, reducing both revenues and profitability.
- There will be growth in recreational marijuana sales, but it will not be exponential:
For those who are expecting a sudden surge of new users, as a result of
legalization, the results from the parts of the world that have
legalized should be sobering. In most of these parts, to the extent that
society and law enforcement had already turned a blind eye to enforcing
marijuana laws before legalization, there was no sea change in legal
consequences from weed smoking.
- The medical marijuana market growth
will be driven more by research indicating its value in health care than
by popularity contests. The bad news is that this will require
navigating the time-consuming and cash-burning FDA regulatory approval
process but the good news is that once approved, there is less likely to
be pushback, cultural or legal, against its use. It is a safe
prediction that medical marijuana will be legal in all of the United
States far sooner than recreational marijuana.
- Federal laws matter: If you are a
company in the weed business in one of the nine states that has
legalized recreational marijuana, you still face a quandary. While your
operations may be legal in the state that you operate in, you are at
risk any time your operations require you to cross state lines and as we
noted with Colorado businesses, when you pay federal taxes. Since most
financial service firms operate across state borders and are regulated
by Federal entities, it has also meant that even legal businesses in
this space have had trouble raising funding or borrowing money from
banks.
In spite of all of these caveats, there is optimism about growth in this
market, with the more conservative forecasters predicting that global
revenues from marijuana sales will increase to $70 billion in 2024,
triple the sales today, and the more daring ones predicting close to
$150 billion in sales.
The Business Question
If the marijuana market is likely to grow strongly, it should be a good
market to operate a business in, right? Not all big businesses are
profitable or value creating, since for a big business to be value
creating, it has to come with competitive advantages or barriers to
entry. If you are an investor in this space, you also have to start
thinking about how companies will set themselves apart from each other,
once the business matures. To see how companies in this business will
evolve, it is important that you separate the recreational from the
medical cannabis businesses, since each will face different challenges.
I. Recreational Cannabis
Like tobacco and alcohol, the recreational marijuana business will grow
with a wink and a nod towards its side costs, and potential to be a
gateway to more potent and addictive substances. Like tobacco and
alcohol, marijuana will face both constraints on who it can be sold to,
as well as lawsuits down the road. Before you take issue with me for
taking a negative view of marijuana, note that this is not a bad path to
follow, given that tobacco and alcohol have been solid money-makers for
decades. The question then becomes whether, like alcohol and tobacco,
cannabis will become a brand-name driven business, where having a
stronger brand name allows the winners to charge higher prices and earn
better margins, or whether it devolves into a commodity business, where
there is little to differentiate between the offerings of different
companies, leading to commoditization and low margins. If it is the
former, the most successful businesses in the space will bring marketing
and branding skills to the table and if it is the latter, it will be
economies of scale, and low-cost production that will be the
differentiator.
II. Medical Cannabis
The medical marijuana business will more closely resemble the
pharmaceutical business, where you will have to work with health care
regulations and economics. Success in this business will come from
finding a blockbuster cannabis-based drug that can then be sold at
premium prices. If our experience with young pharmaceutical and biotech
companies is an indicator, this would suggest that to succeed in this
business, a company will need continued access to capital from investors
with patience, a strong research presence and an understanding of the
regulatory approval process. The company will also generate more value
in health care systems where drug companies have pricing power, making
the US market a much more lucrative one than the Canadian one. The
differences between the two businesses are stark enough that you can
argue that it will be difficult for a company to operate in both
businesses without running into problems, sooner or later.
Investment considerations
So, should you invest in this business or stay away until it becomes
more mature? While there is an argument for waiting, if you are risk
averse, it will also mean that you will lose out on the biggest rewards.
If you are exploring your options today, you have to start by assessing
your investment choices and pick the one that you are most comfortable
with.
The Investment Landscape
This is a young and evolving business, with the Canadian legalization
drawing more firms into the market. Not only are the companies on the
list of public companies in the sector recent listings, but almost all
of them have small revenues and big losses. While that, by itself, is
likely to drive away old time value investors, it is worth noting that
at a this early stage in the business life cycle, these losses are a
feature, not a bug. Looking at just the top 10 companies, in terms of
market cap, on the cannabis business, here is what I see:
 |
| Largest Publicly Traded Cannabis Companies- October 2018 |
Note that the biggest company on the list is Tilray, a company that went
publicly only a few months ago, with revenues that barely register ($28
million) and operating losses. Tilray made the news right after its
IPO, with its stock price increasing ten-fold in the weeks after, before
losing almost half of its value in the weeks after. Canopy Growth, the
largest and most established company on this list, has the highest
revenues at $68 million. More generally, Canadian companies dominate the
list and all of them trade at astronomical multiples of book value.
As new companies flock into the market, the list of publicly traded
companies is only going to get longer, and at least for the foreseeable
future, most of them will continue to lose money. Adding to the chaos,
existing companies that have logical reasons to enter this business
(tobacco & alcohol in the recreational and pharmaceuticals in the
medical) but have held back will enter, as the stigma of being in the
business fades, and with it, the federal handicaps imposed for being in
the business. Put simply, this business, like many other young and
potentially big markets, seems to be in the throes of what I called
the big market delusion in a post that I had about online advertising companies a few years ago.
Trading and Investing
Like all young businesses, this segment is currently dominated by
trading and pricing, not investing and valuation. Put differently,
companies are being priced based upon the size of the potential market
and incremental information. Put simply, small and seemingly
insignificant news stories will cause big swings in stock prices. Thus,
there is no fundamental rationale you can give for why Tilray’s stock
has behaved the way it has since it's IPO. It is driven by mood and
momentum. If you are a good trader, this is a great time to play the
game, since you can use your skills at detecting momentum shifts to make
money as the stock goes up and again as it goes down. Since I am a
terrible trader, I will leave it up to to you to decide whether you want
to play the game.
If you are an investor, you want to invest on the expectation that there
is more value in these companies than you are paying up front, for your
equity stake. As I see it, here are your choices:
- The Concentrated Pick: Pick a
stock or two that you believe is most suited to succeed in the
business, as it matures. Thus, if you believe that the business is
going to get commoditized and that the winner will be the one with the
lowest costs, you should target a company like Canopy Growth, a company
that seems to be pushing towards making itself the low-cost leader in
the growth end of the business. If, in contrast, you believe that this
is a business where branding and marketing will set you apart, you
should focus on a company that is building itself up through marketing
and celebrity endorsements. To succeed at this strategy, you have to be
right on both your macro assessment and your company pick, but if you
are, this approach has the potential to have the biggest payoff.
- Spread your bets: If your views
about how the business will evolve are diffuse, but you do believe that
there will be strong overall revenue growth and ultimate profitability,
you can buy a portfolio of marijuana stocks. In fact, there is an ETF (MJ)
composed primarily of cannabis-related stocks, with a modest expense
ratio; its ten biggest holdings are all marijuana stocks, comprising 62%
of the portfolio. The upside is that you just have to be right, on
average, for this strategy to pay off, but the downside is that these
companies are all richly priced, given the overall optimism about the
market today. You also have to worry that the ultimate winner may not
be on the list of stocks that are listed today, but a new entrant who
has not shown up yet. If you are willing to wait for a correction, and
there will be one, you may be able to get into the ETF at a much more
reasonable price.
- The Indirect Play: Watch for
established players to also jump in, with tobacco and alcohol stocks
entering the recreational weed business, and pharmaceutical companies
the medical weed business. You may get a better payoff investing in
these established companies, many of which are priced for low growth and
declining margins. One example is Scott’s Miracle-Gro, for instance,
which has a growing weed subsidiary called Hawthorne Gardening. Another
is GW Pharmaceuticals that has cannabis-based drugs in production for
epilepsy and MS.
It may be indication of my age, but I really don’t have a strong enough
handle on this market and what makes it tick to make an early bet on
competitive advantages. So, I will pass on picking the one or two
winners in the market. Given how euphoric investors have been since the
legalization of weed in Canada in pushing up cannabis stock prices, I
think this is the wrong time to buy the ETF, especially since sector is
going to draw in new players. That leaves me with the third and final
choice, which is to invest in a company that is not viewed as being in
the business but has a significant stake in it nevertheless. At current
stock prices, neither Scott Miracle-Gro nor GW Pharmaceuticals looks
like a good bet (I valued Scott Miracle-Gro at about $55, below its
current stock price of $70.), but I think that my choices will get
richer in the years to come. I can wait, and while I do, I think I will
take another walk on the boardwalk!
