The Bear Case(s) on Cannabis

by | Nov 5, 2021 | Company Analysis, Macro | 0 comments

As the publicly-traded cannabis stocks are currently about 50% off their February highs, and with a relatively simple long term bull case to understand, many people have been asking us:

“what are the bear arguments for legal cannabis”?

When investing, someone is always the other side of your trade, so the best investors know the reasons behind their counterparty’s actions – why are they selling when I’m buying?

We commonly call this a contrarian view when investing in public stocks, but it works on private companies too.

Some are good reasons to be on the other side, others are not.

This is why declines driven by non-fundamentals are great reasons to buy (e.g. “an index fund has to blow out of a stock that was delisted” as happened with RIV Capital, or “the owner is getting a divorce and needs money right now”)  vs. “the seller is an insider who knows competition is increasing and the revenue will decline while consensus expects an increase”.

Reasons need not be this stark; “the market is looking out 6 months, but I’m looking out 5 years”, and indeed this time arbitrage on macro trends is where the most money can be made as the public markets often underestimate the earnings power of long-term trends (otherwise Amazon would have been $395/share in 1999, which is $3,200 discounted at 10% for 22 years, and not $108).

The article below describes our first effort in illustrating all the arguments against investing in legal US cannabis; some are better than others, and we give the counterargument and our take . To be clear, we do not believe all of these reasons, but to buy you must know why others are selling.

It covers regulatory risks, fundamental risks, and financial risks, with a detailed counter point for each of the 12 scenarios within this topic.

As an aside, the very fact we are writing this now makes it feel like we are closer to the bottom than the top. The fact that the US operators rallied 10-18% in the last 30 minutes today is hopefully mere coincidence.

The below topics are detailed in the body of this article:

Regulatory Risks

  1. The illicit market
  2. Regulatory waiting room
  3. Federal legalization will result in de-verticalization

Fundamental Risks

  1. Cannabis is a commodity business
  2. Unsustainable margins in limited license states
  3. Interstate commerce will force the shutdown of most cultivation facilities across the country
  4. International import/export will force all US cultivations to shut down
  5. Energy costs will limit the growth of indoor cultivations

Financial Risks

  1. The industry is dead money until uplisting, and what if institutional investors don’t buy post uplisting?
  2. Multiples will and should be range bound as investors wonder about margin sustainability
  3. Post legalization, multiples will compress to reflect a competitive CPG industry
  4. EV/S and EV/EBITDA valuations are higher than they appear after adjusting for 280E