The curtains continue to be drawn open for the cannabis sector’s grand re-entry onto the global stage. With thirty-four US States and nearly as many countries supporting legalization or decriminalization efforts, it is simply a matter of time before cannabis becomes a globally traded agricultural commodity. It is likely that cannabis proves to be the best performing asset class over the next decade and unlikely that any sector remains untouched by this plant in the years ahead.
The cannabis industry has been compared to alcohol, gambling, Chinese herbal medicine and the dot-com boom. While there are parallels one can draw to each of these industries, it is useful to view the industry through an emerging market lens. Cannabis exhibits many of the characteristics common to emerging markets. These include information opacity, fragmentation, trade barriers, price discovery, value discovery, regulatory uncertainty and consumer evolution. An attractive emerging market feature is the ability for an active and informed investment manager to generate alpha.
Wisdom often begins with epistemological modesty.
Cannabis emerging market characteristics include:
Information Opacity: Advertising restrictions along with a historically justified desire to keep business activities away from outside scrutiny have led to a relative lack of information transparency within the cannabis space. Private companies outnumber public companies by 80:1, further curtailing the amount of information companies need to make public.
Fragmentation: 32,000 private businesses across balkanized state marketplaces remain an indication of both the fervor as well as the nascent nature of the cannabis industry. As the industry continues its march toward maturity, expect high consolidation with moves toward oligopolistic balances within geographic sub-sectors.
Trade Barriers: It is unlikely that cannabis becomes the first federally legal substance that can’t be moved across state lines. It is more likely that cannabis trade barriers are removed along with prohibition and that the Pacific North-West regains its place as the overwhelming supplier of the nation’s cannabis. Genetics and know-how imply a sustainable consumer preference for high-quality California and Oregon flower, while commoditized single cannabinoid consumer goods will view source as relevant only in its ability to consistently deliver on purity and price.
Price Discovery: Regional volatility in the spot prices of biomass, isolate and distillate remains high even as the overall trend points to a price decline that is likely to be sustained until margins normalize across agricultural cultivation options. The passage of the Farm Bill will continue to have a meaningful impact on hemp-derived CBD pricing, and China alone could cause a global supply shock to the same if it chose to replace its current seed with a higher yielding variety.
Value Discovery: Early stage businesses are valued on promise rather than performance and look quite overvalued when the two don’t sync over time. Investor euphoria turns into impatience with adverse impact on those companies that need capital as a bridge to profitability. Investment moves from volume to value, a predictable process described well by Warren Buffet: Only when the tide goes out do you discover who’s been swimming naked. The cannabis industry is at the beginning stages of this process, one that will result in high consolidation over time.
Regulatory Uncertainty: Cannabis laws are passed on a state and county level, and 34 states have elected to remain in a federal-state conflict over their own medicinal or adult-use laws. Businesses thus need to comply with often conflicting local and state laws while defying federal law. Adding to this confusion is the number of jurisdictions in certain states. California alone has 539 governments across 58 counties and 482 municipalities, and each has its own view toward state legalization. Only 144 of California’s 482 municipalities and 18 of the 58 counties have opted to allow commercial cannabis activity, leaving 2/3rds of the state under effective prohibition. This industry grows more because of changing laws than changing habits, and companies are thus forced to accommodate the rising cost of compliance within a continually evolving legal and regulatory landscape.
Alpha Generation: While the above characteristics often make the cannabis landscape challenging to navigate, they also contribute to an environment rife with information asymmetry. It is precisely the type of environment in which involved and informed active investment managers can generate outsized portfolio returns. Alpha often lies in the space between perceived and actual risk, and the cannabis industry offers a large space for alpha to rest.
Constructing an adequately diversified portfolio in the constantly evolving and relatively undefined cannabis world requires knowledge, experience and discipline. Determining appropriate sector allocation into cannabis real estate, hemp, ancillary, non-hemp cannabis and international markets is simply the first step. Introducing sub-sector tactical tilts while hedging against inevitable margin compression is as important as understanding legislative impact at the local level.
Risk-adjusted return potential in cannabis resides at an impressive altitude, and investors willing to remain patient, prudent and pragmatic can be rewarded with a multi-generational wealth creation opportunity. The recent public company market correction has reintroduced some measure of valuation rationale to the investment landscape, generally useful in separating operators from promoters. Cannabis has a rightful place in any well diversified portfolio for its ability to promote social impact as well as generate outsized risk-adjusted returns as the industry continues its march toward maturity. It remains useful to remember that value based on core fundamentals is eminently more sustainable than prices driven by euphoria.
Some feel the rain; others simply get wet.