By all accounts, 2019 was a painful year for cannabis equity investors. The sector’s challenges were reflected in the Horizons Marijuana Life Sciences Index ETF (HMMJ), which was down approximately 35% on a year-to-date basis as of December 31, 2019. While more pain may lie ahead, the significant pullback in marijuana equities in the last 12 months has resulted in the dissolution of lesser companies, which should ultimately provide greater opportunity for marijuana stocks that can maintain viable businesses over the next 12 months.
The major concern going into 2019 was the high valuations of Canadian Licensed Producer (LP) stocks. These stocks had the monumental task of meeting high expectations on revenue growth relative to their valuations.
Of course, with a brand new national recreational market, revenue from Canadian LPs did grow exponentially. However, by the end of Q2 2019, it was clear that the pace of growth for LPs was not enough, and the market flipped more towards a hyper-focus on revenue and potential earnings growth.
A sector that had largely been valued on potential was now being valued on fundamentals, and when viewed through that lens, these companies just weren’t attractive because many of them had negative earnings. Unfairly or not, some of the bigger LPs that had stretched their balance sheet into investments outside of Canada were penalized for running higher levels of debt and poor earnings, despite building for longer-term growth.
Overall, recreational sales of cannabis in Canada have been a disappointment due to initial challenges with getting supply to market and poor retail storefront distribution in key markets like Ontario. The cannabis sector also likely has oversupply issues with declining wholesale prices, which has forced LPs to write down the value of their inventory.
Going into 2020, it’s quite likely that we will see some bankruptcies and exits from the sector, as a lot of equity financing for smaller cannabis companies has dried up and revenue from Canadian retail sales simply isn’t there.
Optimism in the cannabis sector
Optimism might sound crazy given how far the sector has fallen, but we are seeing major investment firms starting to call a bottom and stamp recommendation “buys” on the sector. These include CIBC, Bank of America Merrill Lynch and Cantor Fitzgerald.
Canada was an important market for marijuana because of its move to a fully-legal market, allowing companies to publicly list their stocks in Canada and take advantage of equity financing options. However, despite any disappointment with how its legalization actually played out, the marijuana sector opportunity is much bigger than Canada.
The strategic goal of many larger LPs was often to take that capital and reinvest it in non-Canadian opportunities, which are substantial. According to a June 2019 report from Arcview Market Research and BDS Analytics, the global legal cannabis market is on pace to exceed US$40 billion by 2024, assuming a compounded annual growth rate of approximately 20% per annum.
There is a lot of money to be made selling both recreational and medical marijuana in legal markets. The primary problem is that the main source of existing revenue is only in Canada at the moment.
Revenue and the associated earnings from Canadian marijuana retail sales have been poor, but most of that disappointment has now been priced into cannabis stocks, in our opinion. Larger names like Canopy, Aurora and Aphria should start to see revenue from global partnerships come on line next year, which could significantly improve revenue.
The chart below shows the key valuation metrics on the larger holdings in HMMJ, which show how much more “fairly” valued these stocks look even compared to three months ago. The price-to-book on HMMJ has dropped from 2.68 to 1.56, and the price to sales has dropped from 8.62 to 6.08 in about three months.
Source: Bloomberg as at December 27, 2019
On the individual names, the contrast can be even starker. There could be some outright failures, but overall, in our view, the sector looks a lot more attractive than at any point at which we’ve offered HMMJ.
Secondly, industry contraction and failures isn’t necessarily a bad thing. The first year of legalization in Canada has been a good test case to determine which companies actually have the business acumen to sustain a thriving business. Failures in such an environment are likely to happen, and when they do, they actually benefit the survivors, who should be able to exercise a little bit more control over sources of supply and price management.
This is not dissimilar to the early days of the internet, where there were numerous failures. However, the companies that stood the test of time built successful businesses, and the sector ultimately thrived. We are not suggesting that the marijuana sector has the same sort of upside as the global internet, but on a smaller scale, there is a real industry to be achieved globally and there should be companies that are going to capitalize on that.
Diversification across the cannabis sector has never been more important
One of the key benefits of HMMJ is the fact that it provides diversification.
As at December 31, 2019, the price return decline of HMMJ was more than 40%, but some of the big underlying holdings, such as Aurora and Tilray, saw declines in excess of 50%. In the case of a once-major holding, CannTrust, the losses were in excess of 80%. Investors who rolled the dice on holding a concentrated portfolio of individual stocks could have seen more substantial losses.
In its latest rebalance, HMMJ reduced its holdings due to the fact that a number of the underlying holdings fell below the minimum market cap thresholds to be included in the index.
Generally, this should be viewed as a positive development, because these issuer weights had become insignificant relative to the sector.
Deletions
| Company Name | Ticker | Exchange |
| Heritage Cannabis Holdings Corp | CANN | Canadian Securities Exchange |
| Emerald Health Therapeutics | EMH | TSX Venture Exchange |
| Eve & Co Inc | EVE | TSX Venture Exchange |
| Fsd Pharma Inc | HUGE | Canadian Securities Exchange |
| 48North Cannabis Corp | NRTH | TSX Venture Exchange |
| Radient Technologies Inc | RTI | TSX Venture Exchange |
| Zenabis Global Inc | ZENA | Toronto Stock Exchange |
Rebalancing of the North American Marijuana Index, and consequently HMMJ, occurs each calendar quarter. At that point, all stocks eligible for inclusion are generally re-weighted by their respective market capitalization. The holdings of HMMJ and its current portfolio weights are regularly updated and available at https://horizonsetfs.com/HMMJ.
HMMJ is an index (or passively managed) ETF, which seeks to replicate, to the extent possible, the performance of the North American Marijuana Index, net of expenses. This index is designed to provide exposure to the performance of a basket of North American publicly listed life sciences companies with significant business activities in the marijuana industry. The North American Marijuana Index selects from a current universe of companies that have operations that may include one or more of biopharmaceuticals, medical manufacturing, distribution, bioproducts and other ancillary businesses related to the marijuana industry. Securities within HMMJ’s index generally have a market capitalization of greater than CAD $75 million.
Within HMMJ’s portfolio, this has resulted in the survival of the fittest: HMMJ’s holdings are now more concentrated on companies that are maintaining a strong position within the cannabis industry, despite difficult market conditions.
The Biggest Opportunity in Marijuana: U.S. Legalization
Despite hosting most of the listings and capital markets investment, Canada has likely lost its leadership position as the world’s marijuana sector leader. In particular, this may be largely due to the poor rollout of recreational marijuana sales at the provincial levels, which has resulted in supply issues, poor sales and a general apathy towards recreational marijuana use, especially relative to vibrant markets in the U.S. such as Colorado and California.
For 2020, the U.S. market is the market to follow, as it will remain the single largest recreational market globally, despite the fact that marijuana use remains illegal at the federal level.
The biggest catalyst of any movement going forward is U.S. legalization — or at the least liberalization — of marijuana laws at the federal level. Given the discrepancy in the potential size of the Canadian and U.S. markets, the multi-state operators (MSOs) seem quite undervalued, relative to Canada. For context, according to Arcview Research and BDS Analytics, if the U.S. market grows at its current pace with marijuana use fully legal in the current 11 states, the U.S. market could reach US$30 billion by 2024, which only accounts for growth of spending in legal state markets.
That’s already six times the size of the projected size of the Canadian market. Many of the U.S. MSOs are fully operational and generating revenue in these legal state markets.
Investors can access indirect exposure to the U.S. opportunity through HMMJ, or directly by investing in the Horizons US Marijuana Index ETF (HMUS). Through either ETF, investors can achieve diversified geographic exposure to the long term opportunity in the North American marijuana market.
In late September, U.S. Congress passed the Secure And Fair Enforcement (SAFE) Banking Act, which seeks to provide clarity to banks and credit unions that would provide banking and financial services for U.S. marijuana companies. From a political standpoint, there is still a long road ahead for this bill to become law – it will still need U.S. Senate approval – but it does potentially open the door for U.S. financial institutions to get more directly involved in the financing of marijuana cultivation and distribution companies, regardless of whether or not marijuana becomes legal at the federal level.
Symbolically, the initial passage of the SAFE Banking Act makes the likelihood of progress on the much broader sweeping Strengthening the Tenth Amendment Through Entrusting States (STATES) Act, more likely. The STATES Act is a bipartisan bill that, if passed, would protect marijuana businesses operating in legal states from federal interference.
The STATES Act would likely allow for marijuana companies to access financial services in a meaningful way, including potential listings with major U.S. stock exchanges. In many ways, this bill could have the same intended consequences as full-scale legalization, so it remains a potentially significant catalyst for the marijuana equity sector.
Any movement forward on either implicit or explicit liberalization of federal marijuana regulations would likely result in a significant shot in the arm for the entire global sector. We would anticipate upon such news that both Canadian LPs and U.S. MSOs would rally.
Like HMMJ, HMUS saw a contraction in its holdings due to a pullback in valuations.
HMUS seeks to replicate, to the extent possible, the performance of the US Marijuana Companies Index, net of expenses. This index is designed to provide exposure to the performance of a basket of publicly-listed companies having significant business activities in, or significant exposure to, the marijuana or hemp industries in the United States. Constituents of this index are selected from Canadian and U.S. exchanges. While some securities may be listed on major North American exchanges, the majority of the securities currently trade on North American exchanges that include, but are not limited to, the Canadian Securities Exchange and the Aequitas NEO Exchange.
The HMUS rebalance resulted in the removal of seven companies:
Deletions
| Company Name | Ticker | Exchange |
| Chemesis International Inc | CSI | Canadian Securities Exchange |
| Dixie Brands Inc | DIXI | Canadian Securities Exchange |
| 4front Ventures Corp | FFNT | Canadian Securities Exchange |
| High Tide Inc | HITI | Canadian Securities Exchange |
| Rubicon Organics Inc | ROMJ | Canadian Securities Exchange |
| Sol Global Investments Corp | SOL | Canadian Securities Exchange |
| 1933 Industries Inc | TGIF | Canadian Securities Exchange |
Rebalancing of the US Marijuana Companies Index, and consequently HMUS, occurs each calendar quarter. At that point, all stocks eligible for inclusion are generally re-weighted by their respective market capitalization. The holdings of HMUS and its current portfolio weights are regularly updated and available at https://horizonsetfs.com/HMUS.
The Cannabis Trail: Bumpy, winding —but profitable?
The marijuana equity sector has demonstrated that it is volatile, and all investors probably now understand how volatile things can be. We would not anticipate 2020 to be any different; there are still far too many companies operating in the sector currently chasing too little revenue. This doesn’t mean that investors in cannabis might not generate positive returns in 2020. A combination of possibly increased rollout of U.S. legalization at the state-level — and potentially the federal level — and new sources of non-Canadian revenue for larger Canadian LPs could result in the sector bouncing back.
Our ETFs offer a liquid and transparent way for investors to get exposure to the marijuana sector, with the added benefit of a potential yield, which has increased with the sector volatility since it is derived from securities lending revenue. In our view, ETFs like HMMJ and HMUS offer the most straightforward way to stay in the sector, with the added benefits of diversification and a potential income from securities lending, which could cushion some of the volatility that is likely to continue over the next 12 months.
Investors might be spooked about entering or staying in the cannabis sector, but it’s important to keep in mind that this is a nascent industry that isn’t going away anytime soon. The Canadian companies that have maintained viable businesses until now could benefit from partnerships in non-Canadian markets, while the U.S. — which analysts estimate will be a US$30 billion market by 2024, or six times bigger than Canadian market— is a region to watch closely, as lawmakers clarify marijuana laws at state and federal levels. So, with the hard lessons learned from 2019, 2020 may not be the year to give up on cannabis completely.
Performance Update as at December 31, 2019*
| 1 Month | 3 Month | 6 Months | YTD | 1 Year | Annualized Since Inception** |
|
| HMMJ | -1.95% | -24.19% | -49.48% | -33.82% | -33.82% | 1.22% |
| NAMMAR Index | 0.62% | -17.49% | -47.25% | -31.51% | -31.51% | -4.65% |
* Source: Bloomberg, as at December 31, 2019. ** Since HMMJ’s inception on April 4, 2017.
The indicated rates of return are the historical annual compounded total returns, including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Additionally, index returns do not take into account management, operating or trading expenses that may be incurred in replicating the index. The rates of return above are not indicative of future returns. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. The index is not directly investible.
The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.
There are risks associated with HMUS. HMUS is expected to invest in the Marijuana industry in certain U.S. states that have legalized marijuana for therapeutic or adult-use, which is currently illegal under U.S. federal law. HMUS will passively invest in companies involved in the marijuana industry in the U.S. where local state law regulates and permits such activities, as well as in companies involved in the Canadian legal Marijuana industry. HMUS will not be directly engaged in the manufacture, importation, possession, use, sale or distribution of marijuana in either Canada or the U.S. Please read the full risk disclosure in the prospectus before investing.