Giving Thanks for U.S Cannabis

[Todd Harrison is the CIO and co-founder of CB1 Capital and a columnist for Investopedia. The views expressed herein are those of the author and do not necessarily reflect the views of Investopedia.]

It’s hard not to be thankful as a U.S cannabis investor. In February, global cannabis benchmarks had been crushed 92% the previous two years, Pershing had just pulled the custodian plug and regulations were choking oxygen (capital) and profits (via taxes) from operators. The specter of a status quo electoral outcome posed an additional threat to the industry, and that was before the virus arrived.

Even the most ardent optimists were hard-pressed to find lights at the end of the tunnel that weren’t affixed to the front of a train. It was a brutal stretch for companies and investors alike and many of us still have the scars to show for it. But nine months later, a gestation later, here we are, at the beginning of a new era: The United States of Cannabis.

Indeed, 2020 was a perfect storm for U.S Cannabis. The triple-lindy of COVID-19 (tax revs and jobs), social justice, and the elections (including a five-state sweep) shape-shifted the narrative and put an end to the War on Drugs. Importantly, leading U.S multi-state operators (MSO’s) also achieved operating leverage at scale during the back-half of the year, allowing them to not only beat but embarrass Wall Street estimates. 

Investors Focused on Fundamentals

We observed that fast money was betting on the election and smart money was focused on the fundamentals. Third-quarter earnings reinforced the strength of the underlying business trends with results that were even more impressive given the onerous tax structures and double-digit cost of capital. The complicated and uneven regulatory environment has among other things forged stellar management teams and operators that are poised to succeed as the barriers fall.

Meanwhile, investors have been conditioned to expect U.S cannabis stocks to sell-off after they report each quarter, and it briefly felt like that would happen again. But volume emerged and levels were defended as the street looked forward to several notable catalysts, which include:

1. Continued east coast adoption with New York, Pennsylvania, Connecticut, and Rhode Island leading the adult-use charge. Maryland, Virginia, and South Carolina are also posturing, with Arkansas, Florida, Missouri, New Mexico, North Dakota, Ohio, and Oklahoma on deck. Idaho and Nebraska are weighing medical-use legislation, demonstrating the nationwide bipartisan appeal.
2. The MORE Act passed the U.S House of Representatives. Historic and symbolic — and DOA in this session of the senate — it kept cannabis in the news cycle through early December and sent a message to the incoming administration that cannabis reform at the federal level is a priority.
3. UN reclassification. In reviewing a series of World Health Organization recommendations on cannabis and its derivatives, the Commission on Narcotic Drugs (CND) removed cannabis from Schedule IV of the 1961 Single Convention on Narcotic Drugs — where it was listed alongside addictive opioids, including heroin, and recognized as having little to no therapeutic purposes.
4. The incoming cabinet. Xavier Becerra has been named as the next federal secretary of health and human services (HHS) as we await the incoming Attorney General. Both will play a central role in reframing cannabis policies at the federal level and protecting states’ rights, including issuance of an updated Cole Memo early in the new year.
5. The two-seat Georgia Senate run-off, which should continue to lend a bid to U.S cannabis through year-end. A blue sweep would complete an improbable blue wave, which is widely is perceived to be the best-case outcome for U.S cannabis.

Looking Forward

As the U.S cannabis universe evolves, we expect a transfer of ownership as early investors and retail traders sell into a wave of hedge funds, family offices and U.S institutions (on the other side of SAFE banking). Based on numerous discussions with fund managers and institutional investors, we believe that this migration is edging ever closer to reality.

After the recent rallies many of these stocks enjoyed, we couldn’t blame them if they took a breather to digest some of the extended technical signals. With that said, we continue to believe that as more professionals enter the space and as the market becomes more efficient, the multiples on these stocks will re-rate to reflect the outstanding growth opportunities. 

Needham & Co. analyst Matt McGinley recently updated our single-favorite U.S cannabis chart to reflect the third-quarter results. Overall, sales growth increased from 91% to 112% and multiples increased from 9.2X to 13.1X, which is still a massive outlier vs. other industry groups, and further supports our “growth at value” fundamental thesis.

As continued state adoption increases the total addressable market, we believe the industry’s forward growth is sustainable. We further expect step-function regulatory change, the shape and speed of which will be determined by the Georgia run-off in January. It should be noted that if the GOP retains control of the Senate, incoming Banking Committee Chair Pat Toomey has already signaled his support for cannabis banking.

Complications are Coming

While there are numerous reasons to be excited, the new year won’t be all cream puffs and powdered sugar. The cannabis conversation will become more complicated as the regulatory agencies stick their hands in the proverbial pot and the battle between social justice and big business digs in. The health of the consumer will also be tested as the economic fall-out from the pandemic persists and the structural changes take root.

The growing pains will pass, and we believe the cannabis industry will help heal this nation in more ways than one: by providing billions of dollars in much-needed tax revenues for suddenly strapped states and municipalities, by creating more than a millions jobs for those displaced from other industries, and by unwinding the sordid history of racial injustices resulting from the weaponization of this amazing plant.

Through a pure investment lens, I will offer this: come for the fundamentals, stay for the regulatory arbitrages, and wait, just wait, until the barbarians bust through those gates. When U.S cannabis companies are able to access capital that will fuel their growth, and once they list on U.S exchanges, the migration will be complete, and the industry will be on its way.

This has been a remarkable year for the world at large and for a cannabis industry that was facing an existential crisis when it started. A wise man once said that the key to success is the ability to turn obstacles into opportunities. Given the economic and social pain and strain of 2020, leveraging the other side of that ride should benefit our space for years to come.

Happy and healthy holidays and wishing you a prosperous New Year.