Few investment themes have attracted more interest from newbie investors than cannabis. (No, we’ve never considered crypto in its current form to be much of an investment.) Along with strong retail investor interest comes extreme volatility reminiscent of meme stocks. Institutional investors can’t participate and provide stability because many don’t want to get involved with a product that remains illegal at the federal level. This translates into value to be unlocked once cannabis becomes fully legalized in the United States.
One of the most notable cannabis investment firms out there is Key Investment Partners (KIP). Based in the burgeoning cannabis hub of Denver Colorado, KIP invests opportunistically across all sub-sectors of the cannabis industry, with the intent of identifying high-growth, market-leading companies that are backed by exceptional management teams. To supplement their efforts, the firm produces rich reports on the state of cannabis in the States. Past themes we’ve covered from KIP’s reports include Investing in Ancillary Cannabis and When Will Cannabis Be Legalized? Today, we want to discuss their latest report – Cannabis 2.0: Investing in Today’s Regulated Industry – which looks at the value to be unlocked when legalization inevitably happens. More notable is the shift in KIP’s recommendation from only focusing on ancillary investments to also including plant-touching.
Is The Time Finally Nigh?
Exactly one year ago today, we asked the question – Is it Finally Time to Invest in U.S. Cannabis Stocks? It wasn’t, and the biggest most popular cannabis ETF – the AdvisorShares Pure US Cannabis ETF (MSOS) – has fallen 54% since then. KIP argues that the time to invest in cannabis is finally nigh, and offers up some reasons why.
The TAM for THC
KIP starts by pointing to the $90 billion global illicit market demand as the total addressable market, a number that may underestimate the opportunity. Some estimates point to the U.S. opportunity (the current black market) being $100 billion alone, though it could even be bigger. KIP describes an unknown population of individuals who won’t/can’t purchase cannabis illegally which makes the legal TAM even bigger. Perhaps the truth is somewhere in the middle. We’ve previously voiced concerns that the legal market may have some difficulty displacing the black market given the established supply chain, networks, and relationships based on trust. The State of California is an example of an environment where the black market isn’t rolling over easily.
So, what portion of the TAM has already been captured?
According to market research firm BDS Analytics (BDSA), sales of legal cannabis reached $23 billion in 2021, up 30% from the year prior. Growth is expected to continue along the same trajectory over the next five years (estimated values in black).
By 2026, close to one-third of the black market in the United States will be displaced by legal cannabis sales. Perhaps our concerns about cannabis stocks in a bear market are misplaced. While competition remains heated among multi-state operators (MSOs), it would be worse if weed were legal.
Mature Competition and M&A
Think about how much easier it would be for CrowdStrike to sell cybersecurity products if Microsoft wasn’t breathing down their neck. New entrants developing emerging technologies inevitably face competition from some of the largest names in their industry. In the case of cannabis, larger companies can’t start capturing market share because no corporate legal team would ever sign off on entering a market that’s illegal at the federal level. For a publicly traded company, that’s asking for trouble. This means today’s cannabis companies can operate without worrying about competing against larger companies.
When cannabis companies are enjoying rapid growth at much lower valuations than other sin stocks, one can expect rapid acquisitions to happen alongside legalization. The below table by KIP shows the year-on-year (YoY) sales growth for cannabis vs. sin stocks along with a price-to-sales (P/sales) ratio comparison (note that P/Sales is similar to our simple valuation ratio except it uses annual numbers while we use the latest quarterly number annualized).
Cannabis stocks represent bolt-on growth at depressed valuations for tobacco and alcohol companies. Rock bottom valuations for MSOs are not just caused by regulatory risks, but by a lack of participation from institutional investors.
Institutional Participation
The United States cannabis opportunity pales in comparison to the Canadian cannabis opportunity, but there’s more to the story than that. U.S. cannabis companies trade on the Canadian Securities Exchange (CSE) because of regulatory limitations which make it very difficult – if not impossible – for plant-touching cannabis companies to list on major U.S. exchanges. Listing in Canada isn’t a good substitute, as KIP estimates that less than 2% of listed cannabis securities floats in Canada are held by institutional investors. Liquidity plays a role too as U.S. exchanges have much more volume than Canadian exchanges.
KIP has seen about double the level of interest from institutional investors in 2022 as in previous years. They’re particularly optimistic that finally the government might start making some real progress towards legalization at a federal level which will lead to states being able to set their own laws.
For the first time in the U.S. Senate, Majority Leader Chuck Schumer in July introduced the Cannabis Administration and Opportunity Act, which would decriminalize cannabis on the federal level and allow states to set their own marijuana laws without fear of punishment from Washington.
Credit: Key Investment Partners
As the American public views cannabis more favorably over time, it’s more likely politicians latch on to this and propel legalization forward.
The Private Sector
KIP manages a portfolio of hand-picked cannabis startups that provide an opportunity that sidesteps the extreme volatility of Canadian-traded MSOs. Many of these companies have counterparts operating in legal industries that can be used to benchmark valuation and performance with some examples seen below.
Institutional investors and accredited retail investors might consider investing in startups which enjoy the same sorts of low valuations as publicly traded stocks. Just prepare to commit that capital for a longer period of time since venture capital firms don’t typically offer liquidity. Since these returns will have a weak correlation to the broader market, they’ll provide some diversification effect as an alternative asset class.
Expect to get very favorable terms as well. KIP estimates that private U.S. cannabis companies have annual capital needs of $35 billion to $53 billion, but are receiving only approximately $4 billion in funding. Obviously, regulatory limitations are responsible for that, but also the current bear market isn’t helping any. Even after legalization, vice clauses often prevent venture capital firms from funding “sin related” industries. An excessive demand for funding dollars always benefits the person with the money.
Our Cannabis Exposure
Legalization seems inevitable, an event that will send stocks “to the moon” after which there will be a rush of listings in the United States that will enjoy even more hype and momentum as institutional investors place their bets. Rational minds and even more rational AI algorithms will quickly arbitrage away excessive valuations so cannabis stocks trade at a reasonable premium to other sin stocks enjoying less growth. That’s the wild ride investors can expect when cannabis gets legalized, and it’s why we wanted a small amount of exposure to the excitement.
Paying proper attention to an investment theme gets a whole lot easier with skin in the game. After vetting the largest multi-state operators out there, one stood out. Our piece on Trulieve Stock: The Good, The Bad, and The Ugly explains why we decided to open a small position in hopes that their charismatic CEO wasn’t up to any shenanigans. So far so good, and we’ll look to add some shares if the price falls 50% below our cost basis or more. That may never happen, and we’re fine with that too. Never chase a stock because this bear market could still have a lot in the tank.
Conclusion
KIP believes the cannabis market is at an inflection point with massive growth expected over the next five to ten years. Such growth will lead to cannabis investments collectively outperforming other mature asset classes such as real estate, private equity, public equities, or fixed income. This assumes that cannabis investors have performed sufficient due diligence and analysis to navigate the pitfalls in the industry. That’s where KIP’s subject matter expertise comes into play. If you’re an accredited investor that wants to put capital to work, reach out to KIP’s principles here.
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