One year of legal cannabis

In August 2016, when Cora Mannen bought her first-ever stocks, her financial advisor placed the trade for her, but only reluctantly.

“He advised me against it,” recalls Mannen (not her real name), a teacher based in Thunder Bay, Ont. “He said it was very risky. I had to sign a letter saying that I was buying this company against his advice.”

The company? Mettrum, a player in Canada’s then fast-growing cannabis marketplace. Mannen, 46, had a personal interest in the industry: she has multiple sclerosis, and marijuana helps relieve her symptoms.

“I got a medical prescription from a cannabis clinic. The customer service was great. They were really organized, the branding was interesting and the product was really helpful for me. I thought, ‘This could be a money-maker.’”

In the three years since Mannen’s foray into the world of cannabis investing, plenty has changed. In October 2018, Canada legalized recreational marijuana. Oct. 17, 2019, will see “Cannabis 2.0,” the legal introduction of edibles (THC-infused foods and beverages), as well as topical creams, ointments, tinctures and other cannabis products. This change will open up a consumer market worth an estimated $2.7 billion, according to Deloitte Management Services LP.

There has also been regulatory movement in the United States, where marijuana is now legal in 11 states and the District of Columbia. The 2018 U.S. Farm Bill, which allows for much broader hemp cultivation, and the Secure and Fair Enforcement (SAFE) Banking Act, which, if passed, would give cannabis companies access to federally controlled banking systems, are creating room for legitimate cannabis businesses.

Growth, however, has come with bumps. The Canadian industry has been plagued by supply bottlenecks, flat consumption and losses. The Ontario Cannabis Retail Corp., for example — the provincial Crown corporation in charge of online sales and the wholesale distribution of recreational pot — reported a $42-million loss in the fiscal year ended March 31, 2019, which it attributed to startup costs.

The sector has also seen shakeups and scandal. In early July, Smiths Falls, Ont.-based Canopy Growth — the first publicly traded cannabis company in North America, with a $5-billion investment from U.S. alcohol maker Constellation Brands — ousted Bruce Linton, its co-founder and co-CEO.

CannTrust, based in Vaughan, Ont., also lost its CEO and had its licence suspended amidst investigations into growing in unlicensed rooms. Both stocks dropped sharply, a trend that mirrors the industry as a whole after a massive selloff this past summer. The North American Marijuana Index was down about 50% in early October since the market topped out with legalization last year.

Still, many portfolio managers and advisors remain bullish about the industry as a whole. “Month after month, quarter after quarter, the sector continues to grow,” says Bruce Campbell, founder of Kelowna, B.C.-based StoneCastle Investment Management Inc. and manager of its Cannabis Growth Fund, which launched just as Canada legalized recreational marijuana use. The fund has outperformed the sector to date by about 30%.

“Once we get real supply into the Canadian market and people have the choice of product, it’ll expand to the next level. Going forward, there’s tons of opportunity, in our eyes,” he says.

From the visionary CEO to a focus on strong management

How best to take advantage of that opportunity? Very carefully, suggests Brian Kadey, senior vice-president and investment advisor at Canaccord Genuity Wealth Management in Toronto. He likens the early days of the cannabis markets to the dot-com era, when any stock with “cannabis” in its name was likely to make money. Those days, he says, are behind us — and with them the model of the visionary CEO, like Linton, with a background in cannabis rather than more mainstream corporate experience.

“With the speculative money moving out of the sector, the survivors are the companies with strong management teams that have shown they can execute and generate real revenue and grow the business,” Kadey says. “In the cannabis space, that’s been especially challenging, because of the legal environment that these companies have been operating in.”

Kadey points to former hedge fund manager and current Jushi CEO Jim Cacioppo, who has strong experience in the distressed debt world, as an example of the experience he’s looking for.

Finding strong cannabis companies, especially with regulation evolving and new players constantly entering the market, requires higher levels of due diligence, says Kadey. “It’s definitely not a space where you can just rely on your research department, read a report and make a recommendation.” His wealth creation portfolio has identified — and is sticking with — five or six U.S. companies.

An international game

That Kadey’s cannabis portfolio is focused exclusively on the U.S. is telling. “Investors have known for a while that, long term, this is really an international game,” says Rishi Malkani, a partner in Deloitte’s M&A transaction services group in Toronto, and the lead partner managing the firm’s cannabis practice. “Canadian companies need to understand what the most attractive international markets are, and start making plays there. We’ve seen a lot of this already, with several of our Canadian companies branching out into [the U.S.], Europe and Israel,” among other places.

Campbell’s fund is invested in some Canadian companies but has increased its U.S. exposure “because, based on population alone, that market is 10 times the size of ours.” There are 220 licensed producers in Canada, almost 50 of which are publicly traded, he says. “Only about 15 in the States would qualify as large, multi-state operators, so there’s huge opportunity there.”

Volatility, he says, will continue until cannabis is legalized south of the border — or at least until the SAFE Act passes, “which will open the door to institutional investing. When that happens, the sector will go on a tear it’s never had before.”

In the meantime, he’s interested in the ability of Canadian companies to partner with international counterparts. He points to recent partnerships between London, Ont.-based Indiva and edibles company Bhang, based in Miami, or Kelowna’s Valens GroWorks’ recent announcement of an exclusive licence to distribute Seattle-based SO_RSE’s water-soluble emulsion technology, used to infuse products with hemp extracts.

Deloitte reported more than 700 M&A transactions in the cannabis space in 2018 alone, and Malkani expects to see activity continue in the coming years, both within Canada and internationally. “The common consensus is that there are far more Canadian cannabis companies now than there will be three or four years from now.”

Investors, he says, seem to be more focused than they were previously on revenue and, to some extent, earnings and margins. Strong intellectual property and trademarks are also appealing. “They seem to be looking [at companies] with a clear strategy, especially an international strategy, and management that has the ability to execute on that strategy.”

Malkani says consumer packaged goods companies will move in to capitalize on consumers’ interest in cannabis-based beauty products and edibles, while tobacco and alcohol companies, like Constellation, will continue to try to get into the game to avoid losing market share. M&A activity will see a sharp uptick when cannabis is legal federally in the U.S.

Edibles are exciting…

According to Deloitte, the introduction of edibles and related products is projected to add about $2.7 billion to the market, mostly by way of attracting new consumers — the “cannabis curious” — who see edibles as safer, more convenient and more socially acceptable than smoking, and who wouldn’t likely buy cannabis from under-the-table providers.

Campbell concurs. “The introduction of edibles will give us mass adoption. These are the people who probably were never going to buy some dried flower, roll it up and light it on fire. This could be the 40-something soccer mom who comes home at the end of the day and has a [cannabis-infused] beverage in order to unwind, rather than having a glass of wine.” The real opportunity, he says, lies in the companies who can build recognizable, go-to brands: Who will be the Red Bull of cannabis drinks?

Malkani advises would-be investors to temper their expectations, given the supply bottlenecks and regulatory confusion that characterized Cannabis 1.0, not to mention government restrictions on packaging, ingredients, labels and THC content. Regulations for these products will come into effect on Oct. 17, and the products will be available in stores as early as two months later, as licensed producers (LPs) must give 60 days’ notice to Health Canada of their intention to sell edibles, extracts or topicals.

Health Canada has stipulated that there should be no elements in a product that could be associated with alcoholic beverages or brands, and that edible products must not be “appealing to kids.” These rules could throw a spanner in the works for companies investing in non-alcoholic “canna-beer,” for example, or that want to produce chocolate, baked goods or other treats that naturally appeal to kids.

Gummies and candies will be approved on a case-by-case basis. Given the restrictions, Malkani imagines that these products will not be among the first released, with LPs starting off small and gauging the regulatory reaction. “It’ll be a slow rollout. I think cannabis companies realize that there are still some grey areas in the marketing rules. Nobody is purporting that they’re going to have 100% of their product out on the shelf for December 2019. So it’ll be a phased rollout, but it will be very well received.”

… but the real money will be in the medical marketplace

Recreational legalization may be capturing the imagination and attention of the media and investors, says Campbell. Over the long term, however, he says the real opportunity will be in “the true pharmaceutical market,” by which he means pure, prescription pharmaceuticals rather than medical marijuana to smoke: “That will be huge as time goes on and the technology and research catch up.”

That thesis makes sense from a numbers perspective, Campbell explains, as Canada is the first G7 country to legalize recreational marijuana. But more than 40 countries, with an addressable marketplace of 1.2 billion people, have some form of medical legalization, which allows for research and development as well as the possibility of exports. Further, he notes, medical products earn higher margins per gram than recreational products in Canada, as provincial corporations act as intermediaries between growers and producers.

Longer term, he’s watching for partnerships between cannabis and pharmaceutical companies with access to patients and clinical trials. Kadey, too, sees immense potential for cannabis-derived medical products: “If there’s a CBD [cannabidiol] strain that causes weight loss, that’s a $22-billion market in the United States. Imagine getting even 10% of that market? The opportunity for these companies is massive.”

The takeaway for investors, and their advisors

Cannabis is, and will continue to be, a volatile and risky sector, the experts agree, and not suitable for novice or conservative investors. Active management is key, stresses Campbell, especially in a marketplace that has so many startups and is still driven partly by hype rather than by solid management and performance.

He suggests using dollar-cost averaging to introduce suitable clients to the market, allocating a third as markets begin to recover from the summer’s losses, a third “at the next depths of despair” and the final third on the next recovery. “That way, clients will end up with a great overall cost and a good experience,” he says, and will be able to weather the lows with the knowledge that they’ve got a long-term plan.

Cannabis is like mining, oil and gas, and real estate, says Kadey. “They all go through the same cycles: the same greed at the top, when people think stocks are going to the moon, and the same lows when people give up on companies at the bottom. If you’re investing in these sectors, you want to make sure that your advisor has been through these cycles and can help guide you through them. Money management becomes very important as a cycle progresses — if you invest in a company and it goes up four times, you should be selling or at least taking back your capital, and not expecting it to go up 10 times.”

That’s the route that Mannen took with her cannabis stocks. After buying Mettrum, she later opened her own trading account and picked up Aphria, Aurora and MedReleaf. Although her advisor had warned against the initial investment, she says, “he also did work with me when the stocks started going up. Mettrum doubled within four months and I called him in a panic, not knowing what to do.”

Mannen ended up selling most of her cannabis shares in tranches as prices climbed, ending up with a return of approximately 180% over two years. Since then she’s been educating herself about stock investing, allocating about 10% of her overall portfolio to “experimenting.” But, she says, “I still like having the comfort of a financial advisor. This year, his returns are a lot better than mine.”

Mannen has since invested in other industries, but she’s open to buying the right cannabis stock — when she figures out what that is. “The money I made wasn’t based on the fundamentals. It was based on hype,” she says. “I inadvertently capitalized on the hype of the industry. And now, I’m trying to pay more attention to fundamentals.”