Deconstructed: Diversified Cannabis Investment Portfolio
Written in 1986 by Gary Brinson, Randolph Hood and Gilbert Beebower, ‘Determinants of Portfolio Performance’ suggested that risk-adjusted return optimization is best achieved via capital allocation across asset classes with low correlation. While investors have since taken issue with the fundamental focus of the paper being volatility rather than return, there is little debate that market return, asset allocation and individual security selection remain the three primary determinants of portfolio return. Market return constitutes the ‘beta’ of a portfolio, while sector and security selection contribute to ‘alpha’. Prior to security selection, asset allocation driven by a focus on diversification across low-correlation asset classes remains paramount. Simply stated, asset allocation involves adjusting portfolio exposure across different asset classes and different sectors within each asset class.
Traditional asset classes include stocks and bonds while alternative asset classes include real estate, commodities, foreign exchange, art and other collectibles. Investors are well served to view cannabis as an alternative asset class and to carefully consider sector diversification as an essential alpha generation strategy. There are over 12,000 businesses that are licensed to operate within the cannabis supply chain and perhaps nearly 20,000 unlicensed businesses that operate in the moat created by federal policy around the cannabis castle.
Hope, fear and greed impact portfolio return more than any recession
Capital placement decision-makers can effectively isolate direct federal risk via separation of plant-touching and ancillary exposure in portfolio construction.
Plant-touching Portfolio Sectors
Cultivation: Indoor, outdoor, and greenhouse cultivation provides cannabis flower to consumers and manufacturers alike. While prices and margins remain attractive, investors are well served to understand future valuation and sector impact from cannabis spot price volatility.
Extraction: Extraction is the process of creating desirable byproducts from plants while leaving behind undesirable compounds and plant matter. Cannabinoids and terpenes are extracted to provide aroma, flavor and effect. Most extraction methods utilize butane, ethanol or super-critical CO2 to produce concentrates such as oils, kief, hash and rosin. The extract category is one of the fastest growing in the U.S. today.
Manufacturing: Infused bath salts, terpene-infused cannabis beer and slow-release topical patches are just a few of the recent innovations in the infused products category. In the short to medium term, one can expect positive margin impact from cultivation technology innovation.
Testing: Testing involves the scientific measurement of cannabinoids and includes microbiological analysis, pesticide screening and residual solvent detection. With a deep taproot and miles of secondary roots, cannabis is an effective bio-dynamic accumulator plant and gathers micronutrients, macronutrients and minerals to store in its leaves. Labs are enjoying escalating demand and healthy margins as legalization has made testing increasingly mandatory.
Distribution: Distribution is an asset heavy sector focused on the process of moving product from business to business. Relationships are as important as effective logistics in driving market share; expect heavy consolidation in this sector over time.
Retail: Gatekeepers to consumable cannabis products, storefronts and delivery provide ease and enhance the consumer experience. While we expect brick and mortar retail to experience its laden challenges over time, this sector has a generous runway to educate new consumers and to evolve the consumer experience.
Ancillary Portfolio Sectors
Real Estate: Collateralized hard assets with profitable tenants add outsized return potential to a mature investment market. Dedicated and sophisticated capital sources benefit from healthy current income in addition to long-term capital appreciation.
Healthcare: Biotechnology, nootropic development and genomic breakthroughs add to the health-enhancing possibilities of this ancient plant. Given its ability to impact ~700 disease states, cannabis will revolutionize healthcare as we know it. Valuations are reflective of the premiums successful companies might deserve and command in a post-legalization M&A cycle.
Finance: Banking, crypto-currency, insurance, investment groups, payment solutions and funds are all part of this important and high-growth sector. The U.S. federal stance combined with the need for these services has led to significant innovation in the space. Expect growth to escalate with legislative progress.
Business and Professional Services: These services include office administration, career placement assistance, security, inventory tracking, compliance, cleaning, waste disposal and environmental remediation. This remains a highly fragmented space with many nascent opportunities and few regional players currently emerging.
Agricultural Technology: Consistent and expected price declines have led to great adoption of automation for yield enhancement and cost reduction. Technological advances will continue to drive commoditization and increase distance from the connoisseur market. Time horizons and spot price forecasting are important investment considerations.
Technology, Media and Telecom (TMT): Investable TMT sub-sectors include software, hardware, advertising, broadcasting, publication, e-commerce, artificial intelligence and robotics. Rapid technological innovation fueled by high margins is having a measurable impact on all rungs of the supply chain ladder while improving consumer experience immensely. Those companies that can capitalize on data collection will be well rewarded.
Consumer: There is a large market that is represented by consumption devices, clothing, lifestyle accessories, gifts, memorabilia and collectibles. For every dollar spent on cannabis, it is estimated that nearly five dollars are spent around it and consumer spending constitutes a healthy percentage of the total.
As this industry continues its rapid growth, additional sector expansion will be driven by the industrial adoption of hemp as well as mainstream acceptance of this original superfood. A diversified investment approach with an eye to hedging form the basis for systematic portfolio construction. Low correlation with other investable asset classes ultimately serves to reduce overall portfolio volatility, increasing the health of our investment portfolios as this plant continues to improve the health of our human portfolio.