MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS
December 31, 2018
What a difference a quarter makes. At the end of September 2018, following the previous rebalance of the Horizons Marijuana Life Sciences Index ETF (HMMJ) and the Horizons Emerging Marijuana Growers Index ETF (HMJR), we had been very cautious in our rebalancing commentary, highlighting many of the risks of this sector after the euphoria of recreational legalization wore-off.
Unfortunately, most of these concerns were well-founded, as the Marijuana sector is down significantly for the three-month period ending December 18, 2018.
What changed from the euphoric highs of mid-September? Not much to be honest, except sentiment on the sector. As we highlighted back in September, valuations in these stocks seemed extremely high by any type of investment metric, and in order to maintain those valuations there would have to be a spate of continuous positive news to drive things forward.
Instead, the opposite has happened. For starters, many of the big names in the sector, most notably Aprhia and Canopy, had poor earnings results in their Q3 earnings reports. While these earnings do not incorporate profits from recreational marijuana sales, they do highlight that without a significant bump in recreational sales these producers have very stretched balance sheets.
At this point, the market will need a big shot of good news to spark a significant recovery – either in terms of more large-scale consolidation news, like we witnessed recently with Altria, the parent company of Marlboro Cigarettes, committing to purchase 45% of Cronos Group – or significant earnings growth from Canadian recreational sales being reported in Q4 earnings.
Where are the earnings? Q4 earnings reports are going to be vitally important for this sector. Investors and analysts want to see what companies are actually delivering on the lofty expectations of recreational marijuana sales in Canada. So far, earnings have been disappointing from the third quarter, with a lot of profits coming from ancillary sources of revenue – such as asset sales or revisions to the estimated prices on marijuana crops.
The issue at hand is not everyone is going to be a winner in recreational marijuana sales. It’s a consumer product and intangible factors such as branding, distribution, and even luck could be big factors as to which producers see a bigger share of shelf space with Canadian consumers.
Another big factor has been supply issues, where getting product to market has been just as important as growing it. Some of the larger providers, such as Canopy in their recent earnings call discussion, have highlighted that supply remains a key hurdle to profitability. We could see a scenario where larger producers have trouble getting their product into market in the same proportion as smaller producers. Again, this is another a big unknown until we start to see Q4 earnings.
A lot of this means dispersion amongst sales performance is a strong possibility, meaning dispersion amongst stock performance is also a potential likelihood. Until October, most Marijuana stocks moved in one direction (up mainly) in anticipation of the Canadian recreational legalization, but now with a greater focus on revenue and accounting, there will be some potential winners, and almost certainly losers.
Already, we see that Aphria has been besieged by a potential scandal involving ownership of some of its Latin American assets. We won’t belabor the details, which have been well-documented in the press, but the lingering questions over the legitimacy of Aphria’s holdings in Latin America – questions over whether they are actually legitimate businesses – has resulted in a wave of short-selling pressure that has pushed the stock down more than 60% over the last three months.
Consider that Aphria was one of the ‘Big 5’ Canadian Marijuana companies, and anyone with large or concentrated weights has been punished much more than the broader sector. This underscores why we have advocated the diversified approach of HMMJ and HMJR. For example, HMMJ had nearly 50 holdings in its portfolio in Q4, and while it held Aphria, it also held stocks that have had positive returns over the last three months, including Cronos and Innovative Industrial Properties, which have helped offset losses.
We believe that over the long-term, if there is positive price movement in the sector, it will be reflected in the performance of HMMJ and HMJR, similar to how the performance of the NASDAQ-100 Index has generally benefitted from the ascension of technology leaders, even as other names in that index fail. This is the lynchpin of diversification in an emerging sector.
There are still some very compelling reasons to consider investing in this sector. The first and most important one is the global medical opportunity. A report from BMO in November suggested the global opportunity for legalized Cannabis could be approximately $194 billion in seven years, assuming the U.S. and 28 other countries in the EU legalize marijuana at either the medical or recreational level.
For example, Germany’s medical marijuana opportunity is projected to be bigger than the entire recreational opportunity in Canada (Financial Post, November 1, 2018). Already, key players in HMMJ’s portfolio, including Aurora, Canopy and Tilray have made significant inroads in this market. In general, the price-per-gram earned on medical marijuana tends to provide higher profit margins to the producers.
Then there is the U.S. opportunity. While performance has been poor for many of Canada’s licensed producers (“LPs”) over the last quarter, there’s been a number of new listings of U.S.-focused producers, primarily on the Canadian Stock Exchange (CSE). In fact, a much larger proportion of capital markets investment is going into these stocks relative to their Canadian counterparts, according to Bloomberg.
According to a December 18, 2018, article from Bloomberg:
“In the first 10 months of the year, U.S.-based cannabis issuers raised C$1.5 billion ($1.1 billion) on the CSE, or about 60 percent of the total raised by all pot firms, according to data provided by the exchange. By comparison, there was one U.S. cannabis listing on the CSE in all of 2017 which raised C$145,000.”
There is a significant opportunity for these U.S.-focused producers if the U.S. continues to liberalize its market. Many signs point to this including the fact that 47 of the 50 U.S. States have undertaken some sort of liberalization of their state marijuana laws, with 10 states fully-legalizing all forms of marijuana distribution and consumption.
The biggest challenge to allowing producers to realize the U.S. opportunity has been the illegality of marijuana at the federal level. Even that seems to be liberalizing with the recent Senate approval of a Farm Bill that would legalize the cultivation and sale of industrial hemp (defined as Cannabis crop with less than 0.3% of active THC). This development has a significant potential for Marijuana producers, since it could open the door for national distribution of non-psychoactive cannabis products such as CBD oil.
For investors in Canadian-listed Marijuana stocks, this could be a dual-edged sword, since it’s clearly U.S.-focused stocks that benefit the most from this and might provide better return potentials in 2019 as opposed to any large Canadian LPs with TSX-listings which cannot have significant exposure to U.S. cultivation businesses.
The big Canadian LPs have the ability to enter this market through joint-ventures in a big way if/when any movement on federal legalization at either the medical or recreational level occurs.
Investors looking at investing at the Marijuana sector from a long-term perspective currently have a more attractive entry point than possibly any other point in the last 12 months. In September, the price-to-book ratios on many of these stocks were extremely high.
|AURORA CANNABIS INC.||ACB CN EQUITY||1.61|
|CANOPY GROWTH CORP.||WEED CN EQUITY||5.3|
|CRONOS GROUP INC.||CRON CN EQUITY||12.06|
|TILRAY INC.||TLRY US EQUITY||35.51|
|APHRIA INC.||APHA CN EQUITY||1.23|
While still high relative to historical perspectives, the valuations on many of the sector-leading names have dropped considerably. This could mean the sector is providing a reasonably attractive entry point, but again, investors should view any investment at these valuations with a longer-time horizon. There could be more problems in the sector before it recovers.
*As at November 30, 2018.
Note: Investment fund regulations restrict the presentation of performance figures of HMJR until the ETF reaches its one-year anniversary.
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