It’s been a painful quarter for marijuana sector equity investors, as both the Canadian and U.S. sectors have struggled to generate positive returns. Much of this stagnation can be attributed to the recent lack of positive industry or regulatory changes occurring that could potentially spur the sector forward.
Our view at Horizons ETFs is that both the marijuana and psychedelic sectors are long term investment themes, which while volatile, include companies that are generating real revenue and long-term growth. Like any emerging sector, these sectors can have a lot of growing pains, which is what we appear to be seeing right now.
Let’s take a look at some interesting catalysts that could provide some momentum to these sectors:
U.S. Still Driving Big Revenues
The fervor over North American marijuana stocks appears to have died down, but this doesn’t negate the fact that the marijuana business continues to grow globally. This is a structural challenge where most of the large growth is occurring in the United States; however, the companies that engage in U.S. cultivation and distribution, referred to as Multi-State Operators (“MSOs”), are not able to get U.S. stock listings due to the current state of federal regulations. This means a lot of the large-scale investment has gone into Canadian-listed Licensed Producers (“LPs”) which, for the most part, are unable to actively engage in growing and selling cannabis-related products in the U.S.
The U.S. cannabis market is expected to surpass $30 billion in revenue in 2022, according to Headset and MJBiz Daily. The vast majority of this revenue will come from the rapidly growing state recreational markets, despite the fact that marijuana usage and sale remains illegal at the federal level.
The challenge for Canadian LPs is that a lot of their valuations price in growth that assumes a level of expansion outside of Canada; However, right now, there does not appear to be a clear path for them to reliably enter the U.S. market. The Canadian LPs make up the bulk of the allocation of the Horizons Marijuana Life Sciences Index ETF (HMMJ).
This doesn’t mean that the LPs don’t have the ability to unlock their investment potential by eventually getting access to the U.S. market. Large tobacco and alcohol giants, such as Constellation, Altria and British American Tobacco, have substantial ownership stakes in leading Canadian names, such as Canopy Growth (Constellation), Organigram (British American Tobacco) and Cronos (Altria). All have substantial stakes in growing their global footprint and there are some interesting ways they can enter the U.S. marketplace.
Tilray, Canopy Growth and Cronos have already taken some action in creating optionable scenarios where they can purchase U.S. assets, such as MSOs, when/if legalization were to occur in the next few years. Canopy Growth has taken the most direct lead in this area by owning an option to buy large MSO Acreage Holdings and most recently, established another option to purchase edible manufacturer Wana Brands for $297.5 million. Federal legalization also brings in a more profound impact to the U.S. MSO market as it would allow for inter-state production and distribution of cannabis.
Right now, the prices in each state can vary widely (and the profits margins for MSOs) due to the fact that cannabis has to be grown within the respective state and sold within its borders. For limited license states, which tend to be on the East Coast (New Jersey and New York), fewer licenses have been issued and margins are higher on the indoor grown cannabis products.
Legalization actually threatens some of the MSOs profit margins as growers with scale would likely start to generate market share in those states by offering lower cost product. Canadian LPs still tend to have more capital and infrastructure to quickly build North American distribution hubs that could up-end the U.S. market. A lot of this remains uncertain until there is a clear path for legalization.
MSOs Get the SAFE Banking Act?
Clearly the MSOs have an advantage of actually being able to operate in the United States, even if they currently cannot list directly on a large U.S. stock exchange or access tier one banking services the way that Canadian LPs can. These stocks can be accessed through the Horizons U.S. Marijuana Index ETF (HMUS), which is the only index ETF in Canada which invests 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.
In April, The U.S. House of Representatives approved the Secure and Fair Enforcement (SAFE) Banking Act of 2021, also known as the SAFE Banking Act. On September 23, 2021, the U.S. House of Representatives passed an altered version of it again, for the fifth time. If this bill becomes law, it would mean that licensed cannabis producers and related businesses would be treated similarly to other legally operating entities. This law provides the possibility for financial institutions, such as banks, to conduct business with cannabis enterprises that are licensed in states which allow cannabis for either recreational or medical use. If passed at all levels of government, this legislation could open the door for U.S. MSOs to access their capital markets. Very quickly, there could be a significant reversal in flows towards U.S. companies actively engaged in growing their businesses.
The likelihood of the SAFE Banking Act being passed before legalization is still high, even though the legislation seems to be currently stalled.
Surprisingly, a stall in legislation will likely benefit MSOs (ie: HMUS) versus Canadian LPs (ie: HMMJ), simply because the MSOs can use capital to consolidate and build infrastructure within states that could be too large for foreign entities to compete with once there is legalization.
Valuations look compelling?
Source: Statistics Canada and MJ Biz as at June 30, 2021 (Most recent quarterly data).
CIBC Capital Markets has also highlighted that there is a lot of underlying growth coming from smaller producers rather than the industry’s leaders. Sales are growing, but the smaller and craft producers are taking a bigger proportional share of this growth. When comparing sales from September 2021 to January 2021, the top-10 ranked issuers (based on size) have seen an increase in sales of 13%, whereas outside the top 10 issuers, producers have increased sales by 73% in that time.
This is still an early industry, and leadership and brand has not yet been definitively established. This underscores the need for diversification that can be provided by an ETF where the leaders are held in larger weights but there are many smaller capitalized names that are eligible for inclusion in the ETFs underlying index, therefore potential ETF inclusion.
Valuation Metrics – HMMJ and Top 10 Holdings
Valuation Metrics – HMUS and Top 10 Holdings
While the growth in the U.S. market would likely be reflected more acutely in HMUS, HMMJ could also benefit from further legalization in the U.S. for a couple of reasons:
- HMMJ can add U.S. MSOs that partake in cannabis cultivation and production (which are currently included in its underlying index but not within HMMJ’s holdings) if/when federal legalization is allowed.
- Large holdings in HMMJ, such as Canopy Growth, have potential exposure to the U.S. marketplace. For example, Canopy would be able to fully acquire Acreage Holdings, a large MSO, upon any announcement of U.S. federal legalization, based on existing agreements.
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.
Certain statements may constitute a forward-looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events or otherwise, unless required by applicable law.
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. Neither HMMJ nor HMUS will 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 respective prospectus before investing.
HMMJ will not knowingly invest in any constituent issuers that have exposure to the medical or recreational marijuana market in the United States, unless or until it becomes legal. HMMJ will not be directly engaged in the manufacture, 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.