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Waiting on the USA – U.S. Investors Drive Marijuana Stocks

Retail investors continue to be a driving force behind the valuations of marijuana stocks. It was a volatile quarter for marijuana stocks in particular within the sector benchmark, represented by the Horizons Marijuana Life Sciences Index ETF (HMMJ), which had a -13.71 percent return at the end of the second quarter but is still up 34.62 percent on a year-to-date basis as at June 30, 2021.

If expectations of U.S. growth potential continue to not meet the lofty expectations investors have set, the next quarter could be characterized by further consolidation and more of a holding pattern. Investors are likely waiting for guidance on potential regulatory changes that could lead to U.S. federal legalization or at least the potential for U.S. listed stocks to have federally legal U.S. cultivation and distribution businesses.

Much of the slowdown in marijuana stocks can be attributed, in part, to the torrid pace of growth experienced in Q1 of 2021 even as it appeared that many U.S. investors were purchasing U.S. listed marijuana stocks in advance of anticipated legalization.

There are two important dimensions to this:

  1. Most major state-based markets now have some form of legalization, so a lot of the pricing on U.S. market growth was likely priced in.
  2. The stocks that investors have been putting money into in 2021 are largely American- listed Canadian Licensed Producers (Canadian LP) which only have cursory exposure to the U.S. since their listings – the very thing that allows them to attract U.S. retail investors – prevents them from directly owning American cultivation and distribution operations.

Do Marijuana Stocks Need U.S. Federal Legalization?

This is a loaded question. The Canadian LPs that currently dominate most of the investor inflows so far in 2021, and make up the bulk of the holdings of HMMJ, we feel need legalization to move their businesses forward. Canadian LPs are still for all intents and purposes “trapped in Canada” until they can transition to U.S. cultivation businesses.

Without federal legalization most of the Canadian LPs have little to no access to U.S. market expansion, which in 2020 surpassed US$17.5 billion in annual sales, according to BDSA Research. With U.S. federal legalization, the Canadian LPs could see rapid revenue growth by engaging in aggressive U.S. expansion, through mergers and/or acquisitions, financed by their ability to tap into capital markets.

This is not to say Canada is an unattractive market. Firms in Canada are starting to move closer to profitability based on increasing sales continuing to drive forward record levels.

The quarterly rate of marijuana sales has nearly doubled from Q1 2020 to Q1 2021. Nearly C$850 million in sales was generated in Q1 2021. Due to this, Canada is on pace to generate over three billion dollars in annual sales for 2021.

Canadian Cannabis Sales (In Thousands)

retail-sales-(2).png
Source: Statscan as at March 31, 2021 (Most recent data).

Compare this impressive sales growth to the U.S. and it is not all that comparable. The states with legalized distribution are generating about US$1.6 billion in sales a month, which puts the U.S. on pace to potentially close in on US$20 billion in sales for 2021. States like California easily generate more in sales than all of Canada combined.

statecannabissales.png

Source: MJBiz as at May 31, 2021.

This underscores the crucial fact that the lack of federal legalization hasn’t inhibited these corporations from building viable and successful businesses in the U.S. The American domiciled multi-state operators (MSOs) are generating very strong sales with 18 states now offering legal recreational and medical cannabis usage and a further 20 states that have legalized medical marijuana usage. 38 of the 50 U.S. states have some form of marijuana legalization with Texas now being the only major populous state that has not passed any form of legalization measures.

california-sales-(1).png
Source: MJBiz Daily, as at June, 2021.

The only ancillary benefit of federal legalization for the MSOs would be they could finally get U.S. stock-market listings and tap into U.S. retail investor demand. This federal legislation doesn’t necessarily have to be complete legalization of marijuana. In April, The US House of Representatives approved the Secure and Fair Enforcement (SAFE) Banking Act of 2021, also known as the SAFE Banking Act. 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.

Most of these MSOs can be accessed through the Horizons US Marijuana Index ETF (HMUS), which is the first index ETF in the world to provide direct exposure to U.S. marijuana stocks almost exclusively listed in Canada. Through most of the year, these stocks have traded at a lower valuation than the Canadian LPs even though they are directly involved in the higher potential growth market in the United States. Their challenge is they cannot access the same level of capital funding through equities that the Canadian LPs enjoy.

There has been some interesting consolidation in the MSO space – the biggest being Trulieve’s acquisition of Harvest Health in May of 2021 for US$2.1 billion, to date the biggest MSO merger. The new combined entity is expected to easily surpass US$1 billion in sales in the next 12 months. The new entity will have operations in 11 states with 22 cultivations and 126 dispensaries. This kind of seed-to-sale scale simply does not exist in the Canadian marketplace, so it could be viewed that at least at the industry level, players believe the valuations on the MSOs are compelling for consolidation relative to the future potential.

Below is the breakdown of the relative valuations of HMMJ and HMUS and their top 10 holdings.  The metrics for HMMJ and HMUS reflect the simple weighted average of these metrics from the underlying holdings in each ETF portfolio. You can see that HMUS has a higher price-to-book ratio than HMMJ but nearly 4x times the sales growth of HMMJ.

HMUS

Slide1.JPG

HMMJ

Getting Paid to Wait:
If stock performance on HMMJ and HMUS remain range-bound, there is the added benefit that both HMMJ and HMUS currently pay a monthly distribution.

An often overlooked benefit of HMMJ and HMUS is that both ETFs are expected to pay a distribution. Typically, companies in early-stage industries aren’t expected to generate any significant yield for their investors. That’s certainly true of marijuana-focused companies, which are not typically expected to pay out any dividends.

Securities lending is a common practice for many mutual funds and ETFs.  Mutual funds and ETFs have the ability to lend out up to half of their underlying securities and earn additional income.

Due to several factors that include, but are not limited to, volatility, the amount of free-market float and available lenders, many of the stocks in HMMJ and HMUS can at times be lent out at higher-than-average lending rates compared to what is available for traditional large-cap equities.

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. 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.

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