Who knew that marijuana would ever be considered an essential service? For those familiar with social gathering restrictions in Ontario — Canada’s largest province by population — it was a bit of a head scratcher to see both online and storefront marijuana dispensaries initially included on the provincial government’s list of essential businesses allowed to stay open, while retail and restaurants were forced to close.
Dispensary sales in Ontario and the United States spiked dramatically at the onset of the social gathering restrictions. For example, California, Colorado, and Washington state saw record spikes in adult use (i.e., recreational) marijuana sales during the week of March 15, 2020.
Since the initial exemption, an updated list of essential businesses was released in Ontario in early April, which has closed storefront marijuana sales. This shifts future sales under COVID-19 to the online order and delivery model that many other businesses, including restaurants, are now operating under.
All of sudden, what was viewed as a tertiary sector began to look a lot more like a consumer staple. Historically, when we see big sell-offs in the stock market, it corresponds with an even larger sell-off in marijuana stocks. Certainly on a one-year basis, marijuana stocks remain one of the poorest performing sectors, with the Horizons Marijuana Life Sciences Index ETF (“HMMJ”) down more than 69% on a year-over-basis for the period ending March 31, 2020.
However, the recent strong sales in retail marijuana seems to have energized the sector, with HMMJ delivering an approximately 21.5% return from its low in mid-March (March 18, 2020) to the end of the month (March 31, 2020). For the 1 month period ending March 31, 2020, HMMJ returned -15.28%.
Are 2020 Revenue Expectations Still On Track?
Statistical models, such as those of CIBC and BDS Analytics, seem to suggest the Canadian cannabis market – where the majority of publicly traded marijuana equities derive their revenue – will continue to grow. The challenge is that those revenue expectations are still a long way from some of the overstretched balance sheets of many of the licensed producers (“LPs”).
According to ArcView Research and BDS Analytics, two leading marijuana market surveyors, the Canadian markets surpassed the surveyors’ internal revenue projections in 2019, with medical and recreational sales topping CAD $1.6 billion (versus a $1.1 billion forecast). Their 2020 forecast, which was established before social distancing measures, was close to $3 billion. CIBC World Markets has issued a sales forecast of approximately $2 billion for 2020. Much of this additional revenue was expected to come from increased storefront dispensaries and sales of “Cannabis 2.0” goods, such as edibles and beverages.
The good news for investors is that the current valuations of many of the LPs now likely align with these revenue expectations. Valuations have come down from the previous quarter, while average sales across the underlying constituents of HMMJ are up significantly, on the quarter.
It’s also important to note that HMMJ provides some crucial diversification as the dispersion of the underlying holdings has been stark, with some stocks experiencing one-year losses in excess of 80%, while major holdings such as Scotts Miracle-Gro have stood firm during the sell-off, with a one-year return of more than 40%.
Source: Bloomberg as at March 31, 2020.
One of the problematic by-products of the sell-off in marijuana equities is that some producers are being compelled to rely on financing through debt markets, instead of engaging in new offerings and/or capital raises, which in some cases significantly reduces the earnings potential of mid-tier producers. Other producers have been able to retain strong war chests of cash from previous equity raises.
We could see further dispersion in the space as we start to see companies struggle; despite their rising revenues, their bottom line could be hobbled by outstanding debt. Determining who will take a leadership position in revenue in 2020 is difficult to ascertain, and is one of the reasons why taking the diversified approach through ETF ownership can potentially mitigate single-issuer risk (although it may limit the upside potential of owning an individual stock), especially if we see an uptick in business failures.
U.S. Market Continues to Grow
2019 highlighted that the U.S. market might be the dominant market for recreational and medical marijuana sales globally, despite marijuana remaining illegal at the federal level. According to BDS Analytics and ArcView Research, the U.S. Cannabis market sales closed in on nearly US$12.2 billion in sales in 2019, roughly ten times the sales generated within Canada. Key state recreational markets that have recently come online, such as Illinois and Michigan, will add about $700 million in annual revenue this year, according to ArcView and BDS Analytics. Those states join other major state markets such as California, Colorado, Nevada, and Washington state as key hubs for recreational sales.
New York, which had been looking at potentially legalizing cannabis in 2020 or 2021, will likely put those plans on hold as the state deals with the COVID-19 crisis.
Generally, the multi-state operators (“MSOs”) in the U.S. are relatively well-capitalized and have strong revenue growth. Again, according to ArcView Research and BDS Analytics, the largest publicly traded MSOs are all seeing revenue growth rates rise by double-digits per quarter. The growth is exponential, but on a relative valuation basis, these stocks continue to trade at a discount relative to many LPs, simply because the legal status of their businesses remain challenged by federal prohibition and accessing large-scale equity financing through both debt and equity is extremely challenging in this environment. In some cases, these constraints are limiting the expansion potential of these companies, resulting in stagnancy.
The other major challenge for these vertically integrated producers is the social distancing measures, which could significantly reduce storefront sales and create supply chain issues. It’s quite possible that actual sales could decline precipitously — particularly in major markets like California — with more stringent social distancing restrictions.
Compounding uncertainty around these stocks beyond the COVID-19 pandemic is that the presumptive Democratic nominee for U.S. president, former U.S. Vice President Joe Biden, has historically been against federal legalization of marijuana. Whether he shifts his policy stance before any nomination remains to be seen, but if the Democrats do not champion legalization, then it’s hard to imagine there being a lot of movement on the federal level beyond what has already been established. A Biden or another Trump presidency could swiftly reduce the growth prospects of U.S. MSOs to expand nationally, and limit their ability to generate more direct investment from the U.S. financial services sector.
More Concentrated Portfolios in Q2 2020
It seems that, in the short term, we may have reached a peak in marijuana stock performance. The huge pullback in valuations over the last year has substantially reduced the number of eligible stocks for inclusion in the indices that HMMJ and the Horizons US Marijuana Index ETF (“HMUS”) seek to replicate.
This most recent rebalance at the end of March 2020 was marked exclusively with deletions from both ETF portfolios, as many of these names fell through the minimum market-cap inclusion threshold for their indices, which is CAD$75 million.
Ultimately, this might be a net positive for unitholders, as both the U.S. and Canadian markets are likely going to require companies with strong market share and financing in order to withstand these challenging times. A more concentrated portfolio will provide greater exposure to true leaders in the sector.
HMMJ
HMMJ is the world’s first ETF offering direct exposure to North American-listed securities that have significant business activities in the marijuana industry. This quarter, four constituents were removed from HMMJ’s portfolio:
Deletions
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.
Rebalancing of the North American Marijuana Index, and consequently HMMJ, occurs each calendar quarter. At that point, all stocks eligible for inclusion in the index 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.
HMUS
Launched in April 2019, HMUS is the world’s first U.S.-focused marijuana index (or passively managed) ETF. 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.
This rebalance resulted in the removal of six companies from the portfolio:
Deletions
Rebalancing of the US Marijuana Companies Index, and consequently HMUS, occurs each calendar quarter. At that point, all stocks eligible for inclusion in the index 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
Performance Update as at March 31, 2020*
Source: Bloomberg, as at March 31, 2020. ** Since HMMJ’s inception on April 4, 2017.
All individual security performance is displayed in Canadian Dollars.
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.
As at February 28, 2020, Horizons Emerging Marijuana Growers Index ETF (“HMJR”) merged into Horizons US Marijuana Index ETF (“HMUS”).
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.