Cannabis: Alpha Through The Smoke
In the United States, retail cannabis is a $7 billion industry projected to approach $22 billion by 2021. The cannabis industry has over 12,000 licensed businesses, tens of thousands of unlicensed or ancillary businesses to support these, and at a 27% CAGR is doubling in size every 32 months. It is poised to add over 500,000 new jobs by 2020, projected to grow to $44 billion by 2026, and could reasonably exceed $100 billion in size as use of the plant becomes ubiquitous. Most of this not so much by changing habits but rather by simply legitimizing them.
High-growth industries drive the inevitable and incredible rush of new people, business, ideas, capital and innovation; the cannabis space is no exception. Individual businesses can capture a ~27% CAGR as well, though that task is replete with regulatory and operational challenges. A murky and rapidly evolving regulatory environment is affected by falling cannabis spot prices mixed with inefficient tax law.
The cannabis flower is one of the most expensive in the world with its 2016 average U.S. retail price topping $5,000/lb. This compares to $3.83/lb for spinach and $25/lb for high quality organic hops. An ounce of cannabis extract retails at ~$1,400, making it more expensive than an ounce of gold. Understanding the impending, inevitable and perhaps precipitous spot price decline is paramount to making informed investment decisions.
Cultivation facilities currently offer some of the highest margins and quickest investment returns. Big, beautiful kola buds are displayed in humidity-controlled glass jars and eyed by bright-eyed consumers at thousands of dispensaries across the country. Ultimately, we see these margins normalizing towards average agricultural margins as cannabis becomes commoditized, and we see flower as a share of cannabis product sales continuing its decline across the country. Only 6.7% of American tobacco smokers roll their own cigarettes and we expect similar statistics for cannabis as the pre-roll market matures towards premium flower utility. As cannabis continues its march towards commoditization, a smaller connoisseur market for ultra-premium flower cultivators will certainly remain.
A nascent regulatory environment that leaves participants with more questions than answers exacerbates what is rapidly becoming a challenging cannabis spot price decline. Cultivators are focused on cost reduction, vertical integration, dispensary acquisition and development of consumer products that have relative price inelasticity. The retail scene is additionally saddled by a largely undetermined licensing structure, intensified by a relative lack of banking solutions and a burdensome (280E) tax code.
Diversification and hedging are cornerstones of any effective capital deployment, and this certainly remains the case in the cannabis industry. Adequate portfolio-level sector diversification would include:
Distribution and Retail: Sustained Consumer Experience
License values are correlated to their current and potential patient populations. We ultimately see a large portion of cannabis sales moving on-line, and brick/mortar businesses that provide additional experiences are most likely to become shopping destinations.
Short-term potential with medium-long term upside
Consumer: Brand Values
Cannabis is known by strain rather than brand, and while we expect this branding void to be filled in a fragmented manner at first we also expect waves of consolidation with acceptance and legalization. Ultimately, oligopolies are the most stable competitive structure and surviving brands will most certainly have created trust, been nimble, provided consistency of experience, developed a core competency and embraced honesty, integrity and transparency as core values.
Medium-term potential with long term upside
Therapeutics: Health Benefits
Research continues to uncover ways in which the cannabis plant heals the body, mind and spirit. Therapeutics have the potential to be the largest sector in cannabis, and lofty valuations may be justified when combined with decades old patent expiration issues for Big Pharma.
Short term challenges with long-term scalability and high-value acquisition
Business Solutions: Top and Bottom Line Impact
Modern technological advances applied to this ancient and sacred plant will most certainly bring about large-scale innovation across the supply chain. Ancillary businesses with scalable impact have a unique opportunity due to competitive protection from federal regulation.
Medium-long term potential
Cultivation: Cost Reduction and Yield Enhancement
Margin compression is the most substantial risk to cannabis cultivation. Economies of scale along with an intense focus on cost reduction and yield enhancement will become increasingly important for survival. Agricultural technology solutions have been rapidly absorbed in an effort to maintain margins despite top-line impact.
Short-term profitability with longer term challenges
The cannabis industry is strife with opportunity, and as an uncorrelated and alternative asset class can provide outsized risk-adjusted returns while dampening overall portfolio volatility. If diversification is the only free lunch on wall street, adequate hedging is a requisite dessert. Adequate due diligence is as important in this industry as any that deserves your investment dollars.