Episode #167: The Cannabis Opportunity

Episode #167: The Cannabis Opportunity

 

Guest: Episode #167 has no guest, It’s a Mebisode.

Date Recorded: 7/19/19     |     Run-Time: 16:21

Summary: Episode 167 is a Meb Short. In this episode, you’ll hear Meb discuss a fresh opportunity…The Cannabis Opportunity. Meb covers some of his thoughts on thematic investing and how we arrived at where we are today. He gets into the opportunity we have today, the large and loyal consumer base that exists for cannabis, and the parallels to alcohol and prohibition. He also gets into the makeup of the industry, what analysts are saying about growth, and some thoughts about portfolio implementation.

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Transcript of Episode 167:

Welcome Message: Welcome to the “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com

Meb: Hey, listeners. Today we have a super-short new Mebisode. I’m going to read a blog post. Blog post, that’s so 2014 to me, 2007 to me. I mean, I write as many blog posts these days that tend to be longer form, but I wrote a fun one as there’s an idea that we’ve been marinating on for a little while on a thematic concept. And I think it’s important and people will like it. So, without further ado, “The Cannabis Opportunity.”

Would you like to go back in time and invest in beer companies when the U.S. ended prohibition in the early 1930s? You bet. In fact, the stocks returned 20% per year in the decade following legalisation, and that’s about double the returns of the overall market. I think there’s a similar situation developing around the globe currently, as legal restrictions on cannabis production and consumption are being lifted.

So, unless you’ve been avoiding the financial media over the past few years and this podcast, you’re aware that there’s been some pretty extraordinary gains that have been made through investing in select cannabis-related stocks. For example, take Canopy Growth, the largest canopy company in the world. They went public back in 2014. And since that time, it has proved to be one of the market’s strongest performers. Canopy, in early 2014, was valued at just $20 million micro tiny cap. And as we record this today, the stock has been a multi-bagger valued at over $10 billion. And as an aside to the listeners, you can check out our recent fun podcast with Chris Meyer on “100 Bagger-Stocks” and his book, both a lot of fun.

Anyway, as the price gains that stock went from IPO price of 2 bucks a share down to trading just above $1 share, so, lost 50%, but then all the way up to 35 bucks, as we record this. Then there’s been other stocks like Tilray, seeing similar explosive moves both up and down. Starting from IPO price of 22 to a peak of 214. The stock has come all the way back down to the low 40s. That’s a big fat drawdown of 80% and counting…ouch, a lot of volatility both up and down. But behind this growth and market volatility is a tectonic shift in the global public’s view towards cannabis, resulting in major legislative reform that’s paved the way towards full legalisation in countries around the globe. And as this legalisation 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 in the future.

So, let’s talk about this cannabis theme. So, 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 fun, but in general, I don’t think they add any value to an investor in the long run. That’s why, today, we haven’t launched a thematic fund at my company. However, that doesn’t mean such a fund can’t be a great profitable investment opportunity at certain times and 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 investment themselves. For example, a thematic fund could focus on a specific sector, like healthcare, and there’s about 11 sectors in the U.S. stock market or geographic region like emerging markets or Emerging Africa. You can get really pretty granular. It could also apply to philosophy, such as Catholic values, or environmental responsibility. Given these wide spectrum investments that fall into the thematic investing theme, it’s impossible to characterise this entire market approach as either wise or foolish.

For example, some themes have logical roots, maybe investing in biotech stocks that are focusing on cancer treatments. Other themes are somewhat head-scratchers, say, investing only in companies located in Nashville. Lots of 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 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 in that market or opportunity. So, for example, let’s apply a factor such as a momentum. To set up thematic funds, applying a momentum to sectors, commonly referred to as a sector rotation approach, has been around forever. We detailed this approach in our old white paper “Relative Strength Strategies for Investing” which looked at all sorts of different sector rotation strategies with data, all the way going back to the 1920s. It’s a fun paper. It’s on SSRN, as well as our Cambria Investments website for free.

Another factor, and probably the most famous that everyone knows, that could be applied to the thematic funds would be value. You know, we wrote a book called “Global Value” which investigated the effects of using long term valuation metrics, like the P/E ratio, and specifically, the CAPE Ratio, on countries stock markets as a signal to rotate in and out of the cheapest stock markets in the world. The book is free to download on cambriainvestments.com, by the way. Thematic investing could also make sense when it focuses on investments in which the underlying asset is in a big, fat, whopping drawdown of 60% to 90% or more, or perhaps when it’s down multiple years in a row.

We actually wrote about these setups in our first book “Ivy Portfolio” over a decade ago. It’s been kind of fun to watch some of these play out in real time. We’ve done some fun articles about asking for coal stocks, inner stockings, uranium stocks. We’ve talked about times when you’ve had entire asset classes that were down three, four or five years in a row. And usually these are setups when something’s down 60%, 80%, 90%, it’s usually a good time to go treasure hunting. And in fact, most of the time in history, we have looked at some of these setups. They’ve had pretty nice returns in the future years. Uranium, I think, is still in something like a 90% peak-to-trough drawdown. There may be some opportunity there.

But notice none of these strategies really are set and forget it. They require active management to shift among various themes. Is there a use case to, say, perhaps for a buy and hold opportunity? Perhaps, when structural reasons serve as a tailwind for the theme. So, for instance, the best performing stock industry of all time is tobacco stocks. But many investors avoid that industry for more reasons and probably rightfully so. Ethics aside, the structural, in this case, behavioural element of a product resulting in major long-term performance for the tobacco theme. Another example of a behavioural structural market condition that would favour thematic investing relates to career risk. Think about investing in some of the cheapest countries in the world right now. What professional adviser in their right mind would be investing in Russia, Greece, Turkey? Almost nobody. Despite that, Russia and Greek stock markets are having months or years up 30%, 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, well, you can probably blame the Fed, Trump, who knows what. So, today, we believe there’s an equally compelling opportunity setting up in the theme of cannabis securities. To be clear, we view this as more of an opportunistic investment, a portfolio tack on while the conditions are favourable. Of course, the opportunity as favourable conditions may be with us for many years, such as tobacco. We see cannabis investing as falling under the structural behavioural category of reasons to own a thematic fund. There’s still social stigma surrounding the industry, but also very real structural struggles from people even investing in the space. In many cases, you literally cannot even buy these stocks if you wanted to. And to be clear, many don’t want to. I’d say most don’t want to, but that also presents an opportunity.

So, in this short recording, 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, and spell out the potential opportunities available to those investors interested in being a part of this explosive growth. So, how did we get here? You know, we’ve experienced a historic boom in the legalised cannabis investment sector. We can really trace the origins back to ’96. California voters approved Prop 215, first legalisation legalising cannabis for medicinal purposes at the state level. Since then, legalisation at the state level has grown. There’s been an intensifying in recent quarters and months. As we record this, recreational cannabis is legal in over 10 states, with medicinal being legal in over 30 states. This is hardly a surprise, as most polls reveal that most Americans now support legalising cannabis.

So, related cannabis legislation victories have also come in recent months, a significant victory being the pass of the 2018 farm bill. This historic legislation legalised hemp for decades. Hemp was classified 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 source CBD market. Additionally, Canada’s legalisation of recreational cannabis in 2018 was a huge domino to fall as the zeitgeist continue to embrace the shift in attitude towards cannabis. Despite these advancements, at present cannabis is still illegal on the federal level in the U.S. That said, we’re seeing significant pressure for meaningful cannabis legislative reform. For example, there’s the STATES Act, currently making its way through Congress. Passing would give individual states the ability to make their own laws about cannabis legalisation without federal muddling. There’s also the SAFE Banking Act that 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 favour of cannabis reform. This groundswell of support points towards a clear takeaway. The legalise cannabis industry is not a short-lived fad and offers the potential for significant gains as the industry evolves in the coming months and years, especially after the U.S. government either legalises 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 in the industry are analysts suggesting? So, what are they suggesting about industry growth? According to CB1 Capital, which by the way is helmed by Todd Harrison, we had a great fun podcast with him in the archives, the global market for cannabis and hemp was roughly $300 billion in 2018. Now looking forward when factoring cannabis, hemp, and wider rave in products and use cases, the global market for cannabis-related companies is predicted to reach $1 trillion or more within a decade. And just for perspective, global alcohol sales are about $1.5 trillion, global box offer is about $50 billion. Most of the global demand for cannabis, however, 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 recording, a recent Barclays report estimates the size of the legal U.S. cannabis market around $28 billion, climbing over $40 billion in the next decade.

So, that’s growing fast in the U.S. that estimates compound annual growth 30% per year again through the next decade. Unlike some short-lived fads, cannabis growth is just a starting point to be fuelled by major corporate investment and institutional investors. For example, Constellation Brands, owner of the alcoholic beverage brands such as Corona, is taking a 35% stake in Canopy Growth, the Canadian cannabis company mentioned earlier, which recently announced plans to buy the American cannabis group, Acreage Holdings. There’s also the cigarette company, Altria, which is at almost $2 billion stake in cannabis producer, Kronos Group. And then there’s Bird, working on cannabis-infused drinks with a cannabis company, Tilray. Meanwhile, in the institutional investment space, we have the largest pension in the U.S., CalPERS, owning a stake in Tilray as well.

So, if you look at the investment market today at the time of this podcast, the cannabis investment market is totally disorganised as any emerging sector might be. An investor looking to put money to work could focus on the cannabis growers, the full service retailers dealing direct to consumers, what you may call seed to store, the companies focusing on the medicinal benefits of cannabis, companies focusing on CBD products, or even companies offering infrastructure plays, such as a cannabis wreath, among many others. Also characterising the 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 in consolidations. Canada’s Canopy Growth buying the American company, Acreage, Curaleaf purchasing of Cura Partners, and Grassroots create the world’s biggest cannabis company by revenue. There’s also been Cresco. They intend to buy cannabis distributor, Origin House, Harvest Health acquiring Verano Holdings.

This is actually a truly a global movement, which bodes well for cannabis as a long-term investment market. There will eventually be expansion into two of the largest continental markets, Asia and Africa as well. So, as we look forward, it’s exciting time to be an investor in the cannabis sector. One of the factors behind this massive growth is realisation the majority of sales are still happening on the black market. So, in other words, despite the gains today, the overwhelming majority of growth could be 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 would rotate towards legal sales channels, meaning huge revenue growth for the cannabis market leaders.

And as the legal sales channels proliferate, and new cannabis products are offered, new users will be willing to try the product, which will vastly expand the total addressable market of this industry. If this opportunity that has cannabis investors excited about the coming decades, 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 the free market supply and demand dynamic. And it’s only now that meaningful reform legislation is beginning to be enacted. What we’re seeing is what seems possible in terms of demand 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 long pent up.

Given this, as laws change, we anticipate the legalised cannabis industry will experience growth that vastly outpaces rates from the developed, mature industries. It means investors today will have the chance to make responsible bets on this emerging industry, potentially being rewarded by outsized returns. That said, like any early investment industry, caution is required as there’ll be losing investments alongside the winning ones. The recent problems at CannTrust are a great reminder. And just because there’s 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 a broad exposure to the overall sector. But the basis thesis for the opportunity remains. There are structural reasons why many funds and investors will never invest in cannabis securities. And with stocks having a current global market cap of, say, less than $100 billion, there’s plenty of room for multi-bagger growth in the sector.

All right. So, wrapping up, where does cannabis fit overall in your portfolio? As we look around the landscape today, as we’ve been talking a lot over the past five years, and if U.S. equities are like we believe, trading at fairly 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 U.S. stocks and bonds portfolio is likely to return about 3%, 4% per year over the next decade. Not awful, not negative, but not close historically to the 8% to 10% we’re used to. We’ve detailed many times in the past on the podcast, and the blog, in the books over the years on ways to improve the situation. Namely, we believe a global value approach to stocks or valuations are much more reasonable, coupled with a global trend following approach to capitalise on momentum and trend where it rises, like the Trinity Concepts, can help buffer low valuations just in the U.S.

We would also consider exploring a thematic industry, poised to grow at nearly 30% per year. And as far as position sizing and where this fits in, it should probably be a tiny portion of your overall allocation. My approach, which is similar in concept to the ideas we presented already on mean reversion, when we were talking about coal and uranium stocks, here’s an idea. It’d be to purchase, say, a starter position and call it one unit for you whether that’s 5%, or 1%, or 0.1%. Then also consider adding an additional unit. If the stocks in the industry decline, say 60%, maybe another unit at 80%. And in all cases, estimate a 10-year plus holding period. And if you go back to 1930s, most of the post-prohibition outperformance of the beer sector actually came at the end of the decade.

After all, many of these companies are not only pre-earnings. Some of them are even pre-revenue. So, you need to have a pretty long-time horizon when overviewing a industry opportunity like this. So, it’s for these reasons we see cannabis as a potentially lucrative addition to portfolio when approached responsibly. Thanks for listening, friends, and good investing.

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