The Cannabis Opportunity

Would you like to go back in time and invest in beer companies when the United States ended Prohibition in 1933?  You bet – the stocks returned 20% per year in the decade following legalization, nearly double the returns of the overall market.  There is a similar situation developing around the globe currently as legal restrictions on cannabis production and consumption are being lifted.

Unless you’ve been avoiding the financial media over the past few years, you’re aware of some of the extraordinary gains that have been made through investing in select cannabis-related stocks.

For example, take Canopy Growth (CGC), the largest cannabis company in the world. Canopy went public in 2014. Since that time, it has proved to be one of the market’s strongest performers.

During early 2014, Canopy was valued at just $20 million. As I write, that the stock has been a multi-bagger valued at $12 billion. (Aside: listen to our recent fun podcast on 100 bagger stocks.)

And as to its price gains, it’s gone from its IPO price of $2 per share, down to trading just above $1 per share, to nearly $35 per share as I write.

Other stocks, like Tilray have seen similar explosive moves, both up and down. Starting from an IPO price of $22 to a peak of $214, the stock has retraced all the way back to $43 for a drawdown of around 80% and counting. Ouch!

Behind this growth and market volatility is a tectonic shift in the global public’s view toward cannabis, resulting in major legislative reform that’s paving the way toward full legalization in countries around the globe. As this legalization continues to spread, researchers suggest it could result in a massive new industry with annual global revenues potentially hitting hundreds of billions if not over a trillion dollars.

The Cannabis Theme

At this point, let’s digress for a moment in order to discuss “thematic” investing, which is the category under which a cannabis investment would fall.

Thematic ideas are often “fun”, but in general, I don’t think they add any value to an investor in the long run. That’s why, to date, we haven’t launched a thematic fund at Cambria. However, that doesn’t mean that such a fund can’t be a great, profitable investment opportunity at certain times for various reasons.

All thematic investments tend to carry this “theme” label, but underneath this catch-all phrase, there can be significant differences in the nature of the investments themselves. For example, a thematic fund could focus on a specific sector, like healthcare, or a geographic region, like emerging Africa. Yet it could also apply to a philosophy, such as “Catholic values” or “environmental responsibility.” Given this wide spectrum of investments that all fall into “thematic investing” it’s impossible to characterize this entire market approach as either wise or foolish. For example, some themes have logical roots – for example, investing in biotech stocks that are focusing on cancer treatments; meanwhile, other themes are downright head-scratchers, say, investing only in companies located in Nashville.  Lots of times thematic funds are simply used to separate investors from their hard earned dollars by capturing the hot theme of the day.

Given this, it’s only fair to judge the value of a thematic investment on a case-by-case basis.

In our opinion, thematic investing generally makes the most sense when it aligns with one of three things: a factor… mean reversion… or substantive structural changes and/or impediments.

For example, let’s apply a factor – such as momentum – to a set of thematic funds. Applying momentum to sectors, commonly called a “sector rotation approach,” has been around forever. We detailed its appeal in our old white paper “Relative Strength Strategies for Investing” with back tested results all the way back to the 1920s.

Another factor (and likely the most famous) an investor could apply to thematic funds would be value. We wrote the book Global Value which investigated the effect of using long-term valuation metrics like the price-to-earnings ratio on country stock markets as a signal to rotate into the cheapest stock markets in the world. (The book is free to download here.)

Thematic investing would also make sense when it focuses on investments in which the underlying asset is in a big fat drawdown of 60-90%, or perhaps down multiple years in a row (fun coal and uranium stock examples).  Both setups usually set the stage for big gains in the future and we examined this strategy way back in our first book The Ivy Portfolio.

Notice none of these strategies really are a “set it and forget it” strategy.  They require active management to shift amongst various themes.  Is there a use case for a buy-and-hold long-term opportunity?

Perhaps, when structural reasons serve as a tailwind for the theme. For instance, the best performing stock industry of all time is likely tobacco stocks, but many investors avoid them for moral reasons. Ethics aside, the structural (in this case, “behavioral”) element of an addictive product resulted in major long-term outperformance for the tobacco theme.

Another example of a behavioral, or structural market condition that would favor a thematic investment relates to career risk. Think about investing in some of the cheapest countries in the world right now…what professional advisor in their right mind would be investing in Russia, and Greece?  Almost no one! Despite that, both stock markets are having monster years up around 30 and 40% year to date. Imagine telling your clients to buy these stocks, and a year from now they’re down 50%. You’re fired!  But if you buy the S&P 500, well, you can probably blame the Fed, or Trump, or who-knows-what.

Today, we believe there is an equally compelling opportunity setting up in the theme of cannabis stocks. To be clear, we view this as more of an opportunistic investment – a portfolio “tack-on” while the conditions are favorable. Of course, this opportunity and its favorable conditions may be with us for many years – such as tobacco.

We see cannabis investing as falling under the structural (or behavioral) category of reasons to own a thematic fund. There is still social stigma surrounding the industry, but also very real structural impediments from people even investing in the space.  In many cases, you literally cannot even buy these securities even if you wanted to…and to be clear, many don’t want to. (We’ve had a cannabis fund filed for over two years but never had a custodian willing to hold the stocks, despite the stocks being exchange traded!)

But that’s also presenting an opportunity.

In this short piece, we’re going to recap some of the highlights as to how we arrived at this point, look at the state of the market today, then spell out the potential opportunities available to those investors interested in being a part of this explosive growth.

How We’re Gotten Here

We’re experiencing a historic boom in the legalized cannabis investment sector. We can trace its origins back to 1996, when California voters approved Proposition 215, the first legislation legalizing cannabis for medical purposes at the state level.

Since then, cannabis legalization on the state level has grown, and has been intensifying in recent quarters. As I write, recreational cannabis is now legal in 11 states, with medical cannabis being legal in 33 states. This is hardly a surprise, as a 2018 poll from Pew Research reveals that most of Americans now support legalizing cannabis.

Related cannabis-legalization victories have also come in recent months, with one significant victory being the passing of the 2018 Farm Bill. This historic legislation legalized hemp. For decades, hemp was classified as a controlled substance under federal law, despite having no psychoactive effect. The bill’s passing has opened the door to explosive growth in the hemp-sourced CBD market. Additionally, Canada’s legalization of recreational cannabis in 2018 was a huge domino to fall as the zeitgeist continued to embrace this shift in attitude toward cannabis.

Despite these advancements, at present, cannabis is still illegal on the federal level in the United States.

That said, we’re seeing significant pressure for meaningful cannabis legislative reform. For example, there’s the STATES Act (Strengthening the Tenth Amendment Through Entrusting States), currently making its way through Congress. Its passing would give individual states the ability to make their own laws about cannabis legalization without federal interference. There’s also the SAFE Banking Act (Secure and Fair Enforcement Banking Act). It would enable banks and traditional financial institutions to service cannabis companies without fear of federal repercussions. Additionally, as I write, nearly every democratic 2020 presidential candidate has come out in favor of cannabis reform.

This groundswell of support points toward a clear takeaway: the legalized cannabis industry is not a short-lived fad, and offers the potential for significant gains as the industry evolves in the coming years – especially after the U.S. government either legalizes cannabis, or passes the STATES Act, which will free users and businesses from fear of repercussions when engaging in cannabis use.

So, what sort of gains are analysts suggesting?

What Analysts Are Saying About Industry Growth

According to CB1 Capital, the global market for cannabis and hemp was roughly $300 billion in 2018. (Todd was also an excellent guest on our podcast.) Looking forward, when factoring in cannabis and hemp in a wider array of end products and use-cases, the global market cap for cannabis-related companies is predicted to reach $1 trillion within a decade.  (For perspective, global alcohol sales are about $1.5 trillion, versus global box office sales of around $50 billion).

Most of the global demand for cannabis is still being met on the black market. But that also means there is a vast customer base just waiting to be tapped.  At the time of this writing, a recent Barclays report estimates that the size of the legal U.S. cannabis market is around $28 billion, climbing to $41 billion by 2028.

And it’s growing fast. Here in the United States, estimates peg the compound annual growth rate of the legal cannabis market at over 30%  growth through 2025.

Unlike short-lived investment fads, cannabis’s growth is just starting to be fueled by major corporate investment and institutional investors. For example, Constellation Brands (owner of alcoholic beverage brands such as Corona), has taken a 35% stake in Canopy Growth, a Canadian cannabis company mentioned earlier, which recently announced plans to buy the American cannabis group, Acreage Holdings. There’s also cigarette company, Altria, which has a $1.8 billion stake in cannabis producer, Cronos Group. Then there’s Budweiser, working on cannabis-infused drinks with cannabis company, Tilray. Meanwhile in the institutional investment space, we have the largest pension in the United States, CalPERS, owning a stake in cannabis company, Tilray.

The Investment Market Today

At the time of this writing, the cannabis investment market is disorganized, as any emerging sector would be. An investor looking to put money to work could focus on the cannabis growers, the full-service retailers dealing direct to consumers (“seed to store”), the companies focusing on the medicinal benefits of cannabis (for example, Epidiolex or Charlotte’s Web), companies focusing on CBD-infused products, or even companies offering infrastructure plays, such as the cannabis REIT, Innovative Industrial, among many other options.

Also characterizing this early stage of development is a great deal of consolidation as market share dominance remains up for grabs. In recent weeks, we’ve seen a string of consolidations – Canada’s Canopy Growth buying the American company, Acreage Holdings, and Curaleaf’s purchase of Cura Partners and Grassroots Inc, to create the world’s biggest cannabis company by revenue. There’s also been Cresco Labs intent to buy cannabis distributor Origin House, and Harvest Health & Recreation Inc acquiring Verano Holdings.

Yet this pivot toward cannabis isn’t just a North American phenomenon.

As mentioned earlier, cannabis is now legal in Canada. And as I write, Luxembourg is poised to become the first European country to legalize cannabis for recreational use. But what you may not know is that cannabis is either legal, decriminalized, or socially accepted in 26 countries around the globe.

This is truly a global movement, which bodes well for cannabis as a long-term, substantive investment market. There will eventually be expansion into two of the largest continental markets, Asia and Africa as well.

Looking Forward

It’s an exciting time to be an investor considering the cannabis sector.

One of the factors behind this massive investment growth is the realization that the majority of cannabis sales are still happening on the black market – in other words, despite the gains to date, the overwhelming majority of growth is still in front of us.

But as cannabis reform legislation continues to be enacted on the state level, and eventually the U.S. federal level, it makes sense to assume that this massive market share would rotate toward legal sales channels – meaning huge revenue growth for legal cannabis’s market leaders. And as the legal sales channels proliferate and new cannabis products are offered, new users will be willing to try cannabis, which will vastly expand the total addressable market of this industry.

It’s this opportunity that has cannabis investors excited about the coming decade. Imagine investing in the alcohol industry after Prohibition ended.

The reality is that the investment opportunity in front of us is a rarity. Cannabis already has an enormous and loyal consumer base. Yet, anti-cannabis laws around the globe have muted cannabis’s free-market supply/demand dynamic. And it’s only now that meaningful reform legislation is beginning to be enacted that we’re seeing what’s possible in terms of demand and market size. As an analogy, it almost feels as though we’re witnessing a massive dam being removed, making way for the flood that’s been long pent up.

Given this, as laws change, we anticipate the legalized cannabis industry will experience growth that vastly outpaces rates from developed, mature industries. That means investors today have the chance to make responsible “bets” on this emerging industry, potentially being rewarded by outsized returns.

That said, like any nascent investment industry, caution is required as there will be losing investments alongside the winning investments. (The recent problems at CannTrust are a great reminder.)  And just because there is growth tailwinds doesn’t mean an investor can be price agnostic, a lesson everyone learned (or should have!) a few times in the past 20 years.

Plus, there’s no certainty that today’s market share leaders will translate into tomorrow’s winning investments. For this reason, it makes sense to be diversified with broad exposure to the overall sector.

But the basic thesis for the opportunity remains. There are structural reasons many funds and investors will never invest in cannabis securities.  And with stocks having a current global market cap of less than $100 billion, there is plenty of room for multi-bagger growth potential in the sector.

Wrapping Up

If U.S. equities are, like we believe, trading at lofty valuations…and if we can draw somewhat accurate predictions about future returns based on starting valuations, which we think we can…then your average, bread-and-butter U.S. equity is going to underwhelm over the next decade.  We’ve stated a balanced US stocks and bonds portfolio is likely to return about 3-4% per annum over the next decade.

We’ve detailed many times over the past few years ideas to improve this situation, namely a global value approach to equities where valuations are much more reasonable, coupled with a global trend following approach to capitalize on momentum and trend where it arises.

We would also consider exploring a thematic industry poised to grow at nearly 30% a year.  As far as position sizing, it should be a tiny portion of your overall allocation.  My approach, which is similar in concept to the above ideas on mean reversion, would be to purchase a starter position, then also consider adding an additional “unit” if the stocks in the industry declined 60%, and another unit at 80%. And in all cases estimate a 10-year+ holding period (most of the post-Prohibition outperformance of the beer sector came at the end of the decade).  After all, many of these companies are pre-earnings, and some even pre-revenue!

It’s for these reasons we see cannabis as a potentially-lucrative addition to a portfolio…when approached responsibly.

Good investing.