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A year ago, the cannabis industry was struggling with the challenge of the vaping crisis, which effectively shut down access to capital for most companies in the sector. As we entered the year, I was optimistic about a few things, including the launch of adult-use cannabis in Illinois, which I discussed here and an “underappreciated catalyst” that wasn’t receiving much attention. Then, the pandemic hit, which appeared to be a much greater threat than the vaping crisis. By May, though, it was clear that we were in a bull market, and I shared three reasons in this space in July to be bullish looking ahead, including the booming demand for cannabis, more states legalizing and potential federal regulatory reform.
Here we are in October, and, while the market has rallied sharply from its lows in March, we remain down substantially year-to-date per the New Cannabis Ventures Global Cannabis Stock Index:
The exact trajectory of the market likely depends upon how events unfold over the next few months, but I continue to believe that we are in a sustainable bull market, especially for American stocks. It’s not possible to give an exact playbook at this time, but I wanted to share some ideas about how to go about investing in cannabis stocks in the months ahead.
Stay on Top of Sub-Sectors
Several months ago, I suggested that cannabis stocks were no longer trading in unison and discussed 10 Sub-Sectors that I employ when I am looking at the sector. This year has seen some stark differences. For example, many American cannabis operators are up year-to-date, while almost all Canadian licensed producers are down. Within Canada, the retailers have substantially outperformed the LPs. I find that many investors tend to be overly concentrated within a single sub-sector, and they are potentially missing out on other parts of the market.
Understand How to Differentiate Within Sub-Sectors
Even within the sub-sectors, investors will likely need to learn to differentiate the stocks better. For example, I recently wrote that California has turned the corner and could be the most dynamic market ahead. Most MSOs have limited exposure to this market, and there are just a few pure-plays worthy of consideration. Additionally, New Jersey may set off a wave of legalization on the East Coast, so investors should understand that some companies are more exposed than others to this dynamic. I also recently discussed how American operators focused on retail (as opposed to full vertical integration) may scale better. The point here is that there are differences between companies, and, with a more sophisticated investor base that is paying closer attention to fundamental metrics, it likely has never been more important to be doing individual company analysis. Other important points of differentiation to consider include strength of the balance sheet, access to capital and what exchange a stock trades on.
Play the Capital Raising Cycle
While the largest American operators have scaled up and even become profitable, I expect they will be looking to raise equity capital after relying almost exclusively on debt capital and sale-leasebacks over the last year. We have already seen all of the major MSOs file shelf-registrations, and Curaleaf and Trulieve both sold stock recently. It makes sense to me, as having a strong balance sheet will separate winning companies from others. At the same time, many smaller American operators and both large and small Canadian operators are in a need-to-raise mode. Investors need to be prepared to reduce specific holdings ahead of capital raises, which is easier said than done! I spend a lot of time trying to anticipate the equity offerings in advance but sometimes am surprised by both those that I predict not happening as well as those I miss. Conversely, in a bull market, buying the dip after a capital raise can be a solid strategy.
Fade Federal Legalization Rallies
My final point may be somewhat counter-intuitive, so let me explain my view on federal legalization. Should the Democrats gain control of the Senate and the White House, I can assure you that the bulls will kick it into high gear, as they will anticipate full legalization will transpire the day Joe Biden is inaugurated, if that’s the case. I would suggest that this is such a complex issue that implementing a program could take years. For a very good example of why I say so, one need look no further than Canada, which took a full three years from the time Justin Trudeau was elected Prime Minister until the first gram of cannabis was sold. Canada already had a federally legal medical program too. Interstate commerce will be a tough issue, and there are many more. So, don’t be afraid to sell into that rally! In any event, I have detailed some fabulous things that could transpire should the Democrats take control of the Senate, including the potential ability of consumers to use credit cards for purchases, producers to get mortgages from banks and issuers to be able to trade on major exchanges rather than in Canada.
Having followed the publicly-traded cannabis stocks for almost eight years, there is one thing I know for sure: This is an extremely volatile sector. Appreciating this one point will help one avoid putting too much money into the sector or any one name and overstaying one’s welcome in a particular stock or sub-sector.
After many fits and starts over the past few years, I think the sector is in a sustainable bull market. Historically, it has traded solely on hype, but now there are some solid fundamentals as well as a more sophisticated investor base. Looking ahead, though, the vaping crisis and the pandemic should remind us that things can change very quickly. In addition, I think a massive spike following the federal elections should the outcome point to a change in control of the Senate will be a sell-the-news event (for now). I also suggest investors be prepared for equity raises, which will create sell (and then buy) opportunities in different names. Finally, I continue to believe that investors will be rewarded for understanding that performance will vary among and within sub-sectors.