Sardines & Sentiment

by | Dec 9, 2021 | Comp Table & Market Commentary

Cannabis stocks, like most stocks, are behaving like trading sardines. I’ll let page 18 of Seth Klarman’s Margin of Safety explain the parable:

There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up, and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.” Like sardine traders, many financial market participants are attracted to speculation, never bothering to taste the sardines they are trading.

A decade of easy money has pushed the value of most assets up, more so by change in sentiment than change in underlying economics – basically selling the same asset to someone else at a higher multiple. Lower interest rates will do this overall on the cost of capital, but increasingly, momentum is driving returns – what goes up keeps going up on the greater fool theory.

The cannabis stocks are acting like trading sardines, whipping around on the prospect of federal legalization, and we wonder what will force the return to the fundamentals – which for many, are pretty good.

November began with rapid decline on Curaleaf missing and guiding to the low end of their annual forecast, but then news of a pending Republican bill by Representative Mace sent the stocks up 28% in 6 trading days between November 5 and November 15. Just before Mace’s press conference, the stocks turned down on “sell the news,” ending November down 18% from the press conference on November 12 and -5% for the month overall.

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But what’s fundamentally changed?

On legalization, the proposed Republican bill is a net positive, making the issue more bipartisan.

On 3Q earnings, the results were soft due to tough comps and pricing pressure, but unlike past years, price softness was not offset by the opening of new markets with high demand.

Did some companies miss and deserve to drop? Yes, as shown in our analyses of Weedmaps and Hydrofarm’s guide downs.

Did most outperform or at least support the long-term narrative? Yes.

Is cannabis just a trade on the quarter, or 2022, or uplisting, or legalization? We don’t think so.

At this point, cannabis stocks are trading in-step with regulatory sentiment, but some of these sardines are worth opening and eating.

Are all of them fundamentally sound? Hardly. We recently outlined the bear case arguments (and counter arguments), and many of the bear cases are company specific. This means management teams can rectify these issues, but the issues will exist regardless of legislative changes.

 

But isn’t Value Investing Dead?

Well, value investing has been in a bear market during a decade of easy Fed money and an expanding economy, off a depressed 2010 base. So yes, it has been for a while.

But will it always be dead? No. Buying good businesses that generate cash and can grow their operations at an attractive price is a good investment regardless of the overall market.

And there are some US cannabis operators that fit this bill.

Unlike many other parts of the market, well run cannabis operations can generate free cash flow if they choose to do so. As we noted last month, we think that the sentiment can be divorced from whipsaw congressional tweets by the operators themselves proving they can generate free cash and deploying some of that cash to either dividends or buying their own shares in the open markets.

Given that it will take much more capital to fully build out the entire cannabis agro-industrial-consumer complex over the next decade or so, cash should generally be used for growth. But if the market will sell down the assets you already own to highly accretive valuations, some of that free cash should be used to buy the existing assets.

Cannabis seems to be the odd industry that has a multi-decade long secular growth theme trading like mature cyclical value type multiples, that only 9 months ago was trading at growth consumer multiples.

Secular Growth Trend Doesn’t Need the Fed

And there always remains the option value of the improving sentiment returning. The 47% return in 6 days for Green Thumb in early November indicates the potential. If the operators keep executing and return some free cash to shareholders, we think they will find their valuations increase regardless of market backdrop. Those that generate their own cash won’t be at the mercy of new investors.

We view cannabis as multi-decade secular growth theme of a proven consumer/wellness good driven by changing societal views (62%68% of the US now in favor of legalization), which manifests itself in a legal shift away from regulatory prohibition. Growth is first driven by share gains from the illicit market, then share gain amongst the non-consuming population driven by easier access, social acceptance, and product innovation and new applications.

The US operators increasingly look more attractive into year end and 2022 despite the continued terrible performance of the stocks:

1. Low valuations of 2.5X sales and 8X EBITDA on 2022 estimates are more akin to mature cyclical industrials like plastics than secular growth sectors, even after adjusting for the excessive 280E taxes compared to other consumer business and multiples 

2. Estimates for 2022 for the US operators have declined by 2% for sales, 7% for EBITDA, and 220bps on margin to 33.1%, but still show sales growth and margin expansion.

At the end of the day, we would rather invest in sardines we can eat than those we can’t, because you never know when market liquidity and pricing will drop and force you to crack those cans open.

As of December 9, 2021, the authors have positions in Green Thumb Industries, Hydrofarm, and Schwazze, among others not specifically mentioned. They make no commitment to update holdings in these positions.