Ready to Exhale in the Cannabis Sector

[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.]

After a rip-roaring autumn rally, global cannabis stocks took a pause to refresh in December as the Georgia Senate runoff– and its historic ramifications— loomed large. It was a well-deserved respite after a remarkable recovery for the cannabis industry, which started 2020 wrestling for its existential identity and finished by adjusting its ample sails for The Perfect Storm.

I won’t pay homage to the previous destruction—the 92% decline in the Bloomberg Intelligence Global Cannabis Competitive Peers Index from January 2018 to March 2020—except to amplify that the barren landscape that pre-existed this secular bull was devoid of speculation. It’s not like people may have sold their holdings; after Pershing pulled the plug on cannabis-related securities in December 2019, most were forced to sell, and many never returned.

A wise man once said to give good news in doses and bad news at once, and I was reminded of that as I reflected on the last year. The conditional elements of the new cannabis normal and the whipping tailwinds that will drive the sector forward seemingly unfolded in slow motion, stacking cumulative positives atop each other until the point of recognition arrived in early January.

To recap the winds of change:

1. COVID19: As flagged in June, we expect a flurry of states to legalize cannabis to repair their broken budgets, and new jobs will be needed to replace those lost to the virus. The U.S. cannabis industry is uniquely positioned in both regards, with billions in tax-revenues and millions of jobs on top of the 300,000 U.S. cannabis employees already staffed (none of which are included in BLS statistics).

2. Social Justice: The Black Lives Matter movement has exposed the failed War on Drugs for what it was: a tool for racism. Anyone who has studied the history of the plant knows “marihuana” was weaponized as an immigration mechanism to stop Mexicans from entering Texas a century ago, and it’s been used to target people of color ever since. This will unwind, thankfully, although there is still much to do.

3. State-level initiatives: The clean sweep across New Jersey (adult-use), Arizona (adult-use), Montana (adult-use), South Dakota (adult-use and medical) and Mississippi (medical) was as lopsided as it was decisive. More than 16 million new customers will be added to the total addressable market (TAM) and soon, one-in-three Americans, or 109 million people, will live in a state where adult-use cannabis is legal.

4. The U.S. Senate: Saving the best for last, the granddaddy of all cannabis catalysts arrived when two Democratic senators swept the Georgia runoffs and completed an improbable blue wave. While other industries may benefit from this seismic shift, none have the regulatory arbitrages layered atop “growth @ value” multiples, which we expect to re-rate as professionals facilitate more efficient markets.

So, What Now?

 Heading into the Georgia run-off, our strategy was simple:

Blue sweep: democratize our U.S. cannabis exposure across the back-half of the MSO totem pole and barbell the FANG vs. the forgotten. On one side, stack the leaders that’ll attract institutional capital and on the other, the second and third-tier names that could have more beta. Let Canada run but trade ‘em from the long side / two-sided, while investing in US operators / trading around core positions.

GOP retains Senate: skew to the haves (FANG-type names) as the oligopoly builds bigger moats while remembering that U.S. cannabis will have a big year, no matter what. Between the looming east coast adoption, the updated Cole Memo, SAFE banking, those mis-priced multiples, and the increasing TAM, we believed 2021 was going to be solid no matter what; now, it could be special.

As the Georgia results crystallized, we spoke to multiple fund managers who were chomping at the bit to buy U.S. cannabis; and this is where it gets interesting because there are a lot more institutions than there are quality U.S. cannabis listings. While there is more supply on the horizon –capital raises and new issues – we remind ourselves that with few exceptions, institutions have yet to buy a single share.

We recently offered, when discussing U.S. cannabis, that investors should come for the fundamentals, stay for the regulatory arbitrages, and wait, just wait, until the barbarians bust through those gates. Once U.S. cannabis companies are able to access capital to fuel their growth curve, and once they list on U.S. exchanges, the migration will be underway, and this asset class will evolve into an economic engine.

That is now being priced-in, as evidenced by the early January rally in U.S. cannabis equities, and the surge in U.S. Cannabis ETF MSOS (NYSE: MSOS), which we advise. Launched September 2nd, MSOS assets under management (AUM) was $524M on January 14^th as individuals, hedge funds and family offices started onboarding the sector. This is only the beginning as people remain uneducated on the immense opportunities and view cannabis as a social lubricant rather than through the lens of wellness.

We intend to invest in the U.S. and trade Canada, with the exception of Village Farms (NASDAQ: VFF), which is our lone Canadian core. Still, we found it curious that the Canadian licensed producers (LPs) saw more upside beta in response to the U.S. Senate results than the U.S. multi-state operators (MSOs) that will directly benefit. We chalk this up to several dynamics:

1. Greater fools, of which there are many, who actually think Canadian LPs = U.S. exposure.
2. Liquid sympathy vehicles for hedge funds and institutions who can’t access U.S. names yet.
3. A third derivative read through on cross-border and international opportunities.
4. Canadian fundamentals upticked from 'blech!' to 'meh.' (what bottoms are made of).
5. Short covering (short interest down considerably from the highs but still a factor)

While a growing chorus of whispers is speculating that the next relief bill, presumably The Heroes Act, will include cannabis-friendly language, we’re less concerned with the timing and more focused on the off-sides market positioning. SAFE Banking, the repeal of 280E and safe harbor language for capital markets should all happen, creating asymmetric risk-reward in these initial stages of price discovery.

Lastly, I would note that in this fragile political spectrum, the 50-50 senate split should help mitigate radical agendas, whether it’s broader policy or the rate and pace of cannabis reform. That should bode well for step-function regulatory adoption to protects states’ rights and weave-in important social justice initiatives. An alphabet city of regulatory agencies will spice up the narrative, and there is of course broader market and socioeconomic risk, but if I can be frank: this is the best set-up I’ve ever seen.

I will qualify my enthusiasm by saying this: in phase one, where we are now, it’ll be the “shooting fish in a barrel” stage of the rally and everyone will feel smart. Phase II will be the judgment phase; who are the good stewards of capital and who are posers trying to climb aboard the next best thing? Markets are efficient, which will be a fierce ally during the upside rerating of the U.S. cannabis industry and a humbling comeuppance for those who cannot adapt, deliver, and scale with best practices.

If all market moves are characterized by three phases, we are seeing that play though in real-time. The historic end to the War on Drugs will be the epitaph for denial. The institutional migration will create an industrial powerhouse; and the coming wave of global research will demonstrate an efficacious agility that will illuminate a halo atop the entire consumer curve, as late-cycle adopters panic to get invested.

Some of you may have no idea what I'm talking about, I'm sure. But don't worry, you will one day.

[CB-1 holds a position in VFF, and served as an advisor to MSOS]