The Green Rush – Exploring Canada’s Cannabis Industry

Executive summary

Since the legalization of recreational cannabis in Canada, two of the most common questions GLC’s investment professionals received were, “do you own cannabis stocks?” and “why?”. In this report, we dig deeper into the risks and opportunities of this emerging industry. We weigh in on the longer-term bear and bull case arguments for the Canadian cannabis industry. Ultimately, as institutional asset managers, we must build portfolios and allocate capital where we see the best risk-adjusted returns – and for now, that’s not in weed stocks. 

Introduction

Canada became the first G7 country to legalize recreational cannabis with the passing of the Cannabis Act in October 2018. With legalization, windows into unknown social ramifications (good and bad) and doors to opportunities and risks were opened wide. In spite of the uncertain path forward, many entrepreneurs and investors quickly dove in with visions of sizable payoffs for taking on the risks inherent within an emerging industry. The extreme shifts in sentiment toward cannabis stocks have sent the S&P/TSX Composite Health Care sector both soaring and diving. Who’s right? The bears or the bulls? Time will tell, but today, here’s where both stand. 

The Bear Case

  • Cannabis stocks have shown extreme volatility. A large retail investor base, significant short positions in many of the stocks, and heightened headline risk have each added to the volatility of these stocks. The large drawdowns (i.e. price drops) already witnessed make these stocks risky investments.
  • Most traditional valuation metrics suggest Canadian cannabis stocks, particularly the large-cap ones, are very expensive. More complex valuation methods require a longer-time horizon which, given their minimal track record, requires many assumptions and therefore present a higher risk of forecasting error.
  • Cannabis cultivation is a commodity business with very few production barriers to entry. Planned capacity coming online suggests the Canadian market will be significantly oversupplied in the coming years. Coupled with a still large illicit market, excess supply will pressure prices and margins lower.
  • International expansion requires legal reforms in other countries. In a global market, cannabis grown in foreign markets with cheaper cost bases (e.g., South America) will also pressure prices and margins lower.

The Bull Case

  • The growth opportunity for Canadian cannabis producers is massive. Loosening regulations and shifting attitudes have the potential to provide a strong industry tailwind. Total addressable market (TAM) is estimated to be in the hundreds of billions of dollars.
  • A domino effect of global legalization is opening up many new markets for producers. The U.S. market, where the conversation over federal legalization is gathering pace, would be the ultimate prize for Canadian producers.
  • Canadian cannabis producers have a first-mover advantage. Producers will look to differentiate themselves and develop IP (intellectual property), notably creating value-added products (which also come with the added benefit of higher margins).
  • Medical cannabis is believed to have many remedial benefits and many view it as a viable alternative treatment to some opioid drugs. Increasing legalization allows for a whole new level of scientific research that could validate many of these claims.
  • The option of marketing cannabis as a wellness alternative could be a massive opportunity. Many consumers are exploring the potential benefits of CBD.
  • Product innovation, such as beverages and edibles, has the potential to disrupt categories such as alcohol and tobacco. Pet care, sports drinks and beauty products are examples of categories that may see disruption.

What to make of it all

We believe the cannabis industry has the potential to be an interesting growth story over the coming years as the legal market matures. Given the volatility and the uncertain outlook at present, we believe buying cannabis stocks lies closer to the speculation end of the investment spectrum. Stock selection will be important given a dichotomy between the larger, more expensive names and the smaller names more at risk of being left behind. As the industry matures and the outlook becomes clearer, the risk-return equation will evolve. However, to date we believe cannabis stocks are still overly expensive relative to their visible growth outlook and the tangible reward opportunities are not adequately compensating for the risk profile and uncertainty. For these reasons we remain out of the weed stock frenzy for now. 

The Green Rush – Exploring Canada’s Cannabis Industry

Background

With the passing of the Cannabis Act in 2018, Canada became the first G7 country to legalize recreational cannabis and only the second country globally (Uruguay being the first). While the legal cannabis industry remains in its infancy, development is moving at a rapid pace, both within Canada and around the world.

Cannabis has a long and complex history. The cannabis plant has been used by people for thousands of years for various reasons, but never in the commercial realms we’re now starting to witness. The regulatory complexity in many regions, particularly the U.S., puts the industry in a unique position and has only added to the divergent views on cannabis. Scientific research has been limited and many of the claims (for and against) and potential use-cases for cannabis remain largely anecdotal at this point. Cannabis advocates point to a plant offering a wide range of medical and wellness applications, while recreational legalization has the potential to disrupt a whole host of industries, such as alcohol, tobacco and others. Naysayers view cannabis as “just another vice” that will have a negative effect on society and believe medical claims are being greatly exaggerated.

Along with unknown social ramifications, legalization offers opportunities for profit. Many entrepreneurs and investors have dived in hoping to jump on this “once in a generation” opportunity. An uncertain path forward adds to the risk for participants, but also offers the potential for a sizable payoff. Canadian licensed producers (LPs) have their sights set on capitalizing on their “first-mover advantage” by cracking the Canadian market while also planting the seeds to become global leaders.

Hype around the potential for this burgeoning industry has seen retail investors jump onboard – spurred by widespread media coverage and bullish outlooks from a growing list of public companies. Institutional investors have been more cautious, partly due to the legal complexities and, initially, from the stigma around cannabis. More recently, institutional investors like GLC have shied away due to high valuations and outsized levels of share price volatility. The extreme shifts in sentiment toward cannabis stocks have resulted in a wild ride for the S&P/TSX Composite Health Care sector. Reflecting on the past two years of market activity at the one-year anniversary of cannabis legalization (Oct. 17, 2018), the storyline has been a classic case of ‘buying the rumour and selling the news’. ‘Cannabis-mania’ drove the S&P/TSX Health Care sector up over 100% in the year prior to legalization, only to see the sector fall almost 50% in the year since. The result has been a wild two-year ride with a very modest 6% return.

Line chart shows the value of a $100 investment in the S&P/TSX Health Care sector since October 16, 2017. The value climbed to a high of $209 in October 17, 2018 before falling back down to $106 by the two-year anniversary.

The first post-legalization year has undoubtedly been a rocky one for the Canadian cannabis space. Sales are well below expectations and most companies are losing money, while a wave of negative headlines has spooked many investors. Some of the issues are not overly surprising given the complexities of starting a new industry essentially from scratch, but they’ve added to the volatility for the space. While some investors see the recent share price declines as proof of a bubble that still has some way to go on the downside, other investors view it as short-term setback for a rapidly growing industry still in its very early days. Stock prices are forward-looking, and valuations will shift around depending on investors outlook for future company prospects. A deep dive into the bull and bear sides to the story (i.e., why people are buying or selling these stocks) provides a useful framework to analyze possible scenarios for this fascinating industry. Time will tell who will be proven right.

The Bear Case

1.   Stocks are expensive and the long-term outlook is uncertain.

“The price you pay is the most important determinant of future returns.” So goes one of the most widely used and enduring principals in investing. Good companies or exciting industries don’t necessarily equate to good investments if all the positive news (and more) has already been priced in. The hype surrounding the cannabis space has driven company valuations to extreme levels – even after sharp share price declines in recent months. Most Canadian LPs are still in the pre-earnings stage and are expected to remain so for a few more years – on its own, this is a factor that can deter some investors.

Based on consensus analyst estimates of earnings for calendar year 2021 (when the Canadian market ramp up should be largely complete – and companies are actually generating earnings), the large Canadian cannabis stocks trade at lofty valuations. Bottom-line earnings per share (EPS) will require a few more years before it becomes meaningful, so looking further up the income statement to EBITDA1, and comparing this to EV (enterprise value), EV/EBITDA multiples are generally over 25 times for the large-cap names, and much higher than that in some cases. This means it would take the company at least 25 years (with earnings at that level) to equate to the current combined equity and net debt value of the company. The path to these 2021 EBITDA numbers is by no means a sure thing and are baking in a more than tripling of revenues from 2019 levels. Looking at revenue multiples also tells of a similar ‘expensive stocks’ story and point to a cannabis sector that’s being awarded a significant valuation premium. For comparison, these valuation levels are at, or above,  levels seen by the current high-flying darlings of the stock market – the U.S. FAANG2 stocks, which are comprised of dominant global companies with proven track records of stunning growth. 

The caveat to using valuation metrics (like those mentioned above) is they’re selecting a year for earnings or sales in the relatively near future, while not accounting for the potential of a significant step up in growth in later years. Looking out four or five years (not an unreasonable time horizon for long-term investors) is probably a more appropriate lens for the sector. Forecasting further out naturally requires making more and more assumptions and opens a wider range of scenarios – especially difficult given the uncertainty around market size, regulatory environment and competitive landscape. 

It is true that many early-stage companies forgo profitability in order to invest in the business with the understanding that eventually the profit taps will open. Likewise, many investors don’t mind paying up for fast-growing, high-quality companies that have distinct competitive advantages and can earn high margins – the previously mentioned FAANG stocks are prime examples of this. However, sceptics will argue that cannabis companies offer few of these attributes today.

2.  It’s a low margin business, with brand-building hurdles.

Growing cannabis is essentially a commodity business with little-to-no barriers to entry (outside of gaining the required government licenses). Farming is inherently a challenging industry where crop prices are driven by supply and demand, and equilibrium prices naturally adjust to eat away at excess profits. Planned capacity additions from Canadian producers point to an oversupplied Canadian market in the coming years. Even if domestic demand exceeds the most optimistic of forecasts, increasing sales in international markets will eventually be needed to fill the gap. The problem is that legalization within foreign jurisdictions is no guarantee. Even if legalization does transpire abroad, it seems reasonable to assume that countries will be eager to capture any available economic benefits themselves (i.e., locally grown cannabis). It’s also a reasonable conclusion to think that Canada has very few competitive advantages in growing cannabis, and supply costs in more suitable climates with cheaper labour (South America, for example) will drive global prices down. Even within Canada, margins are being pressured by the illicit market, which is able to avoid many of the regulatory costs and taxes that eat into the bottom line of legal producers. Recent Statistics Canada data (Q2 2019) showed that almost two-thirds of Canadian sales continue to be derived from the black market. This “race to the bottom” points to lower prices and lower margins for Canadian producers.

Many products that have commodity-like features can still capture outsized market share and earn decent margins by building a strong differentiated brand. Experts believe cultivation will become a smaller part of the story and producers will focus their efforts on the higher-margin parts of the value chain, similar to how most alcohol and cigarette companies don’t grow the hops and tobacco themselves. The story here isn’t great for Canadian LPs either, as heavy regulations in Canada are making it difficult for companies to build their unique brand. Most notably, current strict product labeling and advertising regulations (aimed at preventing underage use) limit the ability for product differentiation.

1 EV or enterprise value represents the total value of the company (equity and net debt), while EBITDA (earnings before interest, taxes and depreciation and amortization) represents the earnings available to these stakeholders – sometimes thought of as a proxy for cash earnings.

2 FAANG = Facebook, Apple, Amazon, Netflix and Google (now Alphabet).

A diagram from AltaCorp Capital shows the cannabis value chain from cultivation to processing/manufacturing to product development, to branding, sales and marketing to final distribution and retail.

3. Stock prices are volatile, and investors are experiencing large drawdowns.

Risk management is an important discipline for investment managers. Returns are only part of the story when looking at investment opportunities. Even if investors can get past the high valuations and fundamental challenges of the cannabis industry, share price volatility is another factor that keeps many investors on the sidelines. Retail investors have dominated early trading and momentum is the key factor driving share prices. Surging share prices begets a FOMO (fear of missing out) mentality, while any signs of weakness have demonstrated how quickly things can turn ugly. Volatility has only been made greater by outsized short positions in many cannabis stocks (i.e., investors actively betting on a share price decline). High levels of short interest add to both upside and downside volatility.

Heightened headline risk adds to the risk of sharp drawdowns3. The news flow for Canadian cannabis stocks is unlike most other industries – especially given the fact that many companies are not yet generating earnings. Speculation over corporate deals and partnerships, or shifts in the regulatory outlook within international markets, can cause big shifts in sentiment toward the space. Within this inaugural year, a few notable corporate governance lapses have already spooked investors. The most high-profile example was Canntrust, which had their licenses suspended for growing cannabis in unlicensed facilities. The company saw their share price decline by almost 90% in the space of six months! Recent health concerns surrounding vaping has also added  to the negative sentiment toward the industry. Judging by the drawdowns experienced by many of the large cannabis companies, investors will need to have a high degree of risk tolerance, patience and conviction if they wade into this space.

3 A drawdown is a peak-to-trough decline in the price of a security. A drawdown period will continue until the security returns to its previous high. While this is not the typical experience for most investors, it represents the worst-case scenario of buying at high price levels.

A line chart compares the stock performance of the four major cannabis companies to the TSX index between October 2016 and August 2019. All four stocks have drawdowns of approximately 70% from their original starting value, while the TSX held steady.

The Bull Case

1.  A big growth opportunity within a large total addressable market (TAM)

Corporations don’t necessarily have to be dominant players in their industry to be successful. Taking a piece of a rapidly growing pie can be a rewarding path for companies. Cannabis has been popular for a long time despite all the legal barriers that have existed. It’s worth remembering that alcohol, a category that cannabis gets frequently compared to, was prohibited in many countries up until the early 1900s. A global shift in the form of loosening regulations and  more accepting attitudes toward cannabis has the potential to provide a strong tailwind for the industry. Factoring in the medical angle, cannabis has the potential to impact a multitude of market segments and demographics – the growth potential could be massive! The bull case for Canadian LPs assumes these companies will become truly global players supplying cannabis to the world, likely on a medical basis first, whilst also shaking up adjacent consumer product industries ripe for disruption.

The concept of TAM, or total addressable market, is common for early-stage growth companies. Adding up all the regions and industries that cannabis may impact, estimates of TAM for cannabis companies are significant (and wide-ranging). Canada’s two largest producers, Aurora Cannabis and Canopy Growth, both peg the global market opportunity at over $200 billion when factoring in the various targeted consumer product categories. Many third-party estimates are also generally over $100 billion. TAM numbers tend to be ambitious or aggressive, particularly coming from company executives, but these numbers speak to a huge growth opportunity ahead for the cannabis sector, nonetheless.

A bar chart shows the total potential number of markets for Aurora Cannabis. The first bar shows 3 medical markets in Canada and 70 around the world, and the second shows 9 consumer markets in Canada and 115 across the globe.

2. Canadian companies have first mover advantage and new product opportunities.

Given their potentially massive growth opportunity combined with the present legal restrictions in most other regions, Canadian producers have a first-mover advantage they will look to pounce on. High share prices are a big benefit to producers as they provide access to “cheap” capital (i.e., issuing shares) to fund growth initiatives. The Canadian producers will aim to build up some key early learnings by growing cannabis at significant scale, building out supply chains and creating value-added products. While some companies will aim to be low-cost producers, many Canadian producers are acutely aware of the limited opportunity that cultivation presents. A clear objective for many companies will be to differentiate themselves and develop IP (intellectual property) – products or processes that will be hard for competitors to replicate.

The second phase of Canada’s staggered recreational market rollout began in October 2019 when a whole host of new products, such as beverages and edibles, became permitted (expected to hit the shelves in late 2019/early 2020). In this “Cannabis 2.0” world, many believe cannabis will be viewed more as an ingredient with the potential for significant product innovation. These value-add products also offer higher margins relative to selling the dried flower of the cannabis plant. Cannabis executives are quick to paint a picture where cannabis beverages replace a significant portion of the alcohol market, a scenario not being ignored by big alcohol companies. A clear sign of recognition was Constellation Brands (owners of Corona and other popular wine and spirits brands) investing CAD$5 billion in Canopy Growth Corp, Canada’s largest cannabis producer. Tobacco companies are also acutely aware of the disruptive potential of cannabis, as evidenced by Altria’s CAD$2.4 billion investment in Cronos (one of the large Canadian producers) earlier this year.

3. The opportunity for international expansion is real.

Industry valuations have gone way beyond just pricing in the opportunity within the Canadian market. Many Canadian LPs are taking advantage of their head start by attempting to build a global footprint. The number of countries that have legalized cannabis (mainly on a medical basis) is changing rapidly, with a near domino effect pushing others to join. Momentum has been gathering recently for recreational legalization in Mexico, a country of 128 million people. The larger Canadian companies are already building out infrastructure and teams in a host of foreign countries. Various European medical markets, most notably the sizable German market, have shown strong growth. The U.S. market, being over 10 times the size of Canada, would be the ultimate prize for the Canadian LPs. While the current U.S. regulatory system is complex (cannabis is classified as a schedule 1 drug and illegal at the federal level, though legal in many states on a medical and/or recreational level), many bullish investors are hanging their hats on the assumption it will be legal on a federal level in the near future. Indeed, with the 2020 U.S. presidential election on the horizon, it seems likely legalization will be a topic up for debate. Any changes to the current system could be a massive catalyst for the sector. As such, Canadian companies have been forging forward with creative ways to position themselves for this possibility – building out U.S. hemp businesses (more on this later) or even constructing creative takeovers of U.S. players that only trigger in the event of U.S. federal legalization.

A diagram shows a map of cannabis legalization around the globe. Only Canada and Uruguay are fully legalized for medical and adult use. South America and Europe are the most concentrated areas of legalized medical use and/or areas exploring legalization.

4. Medical cannabis and CBD products could be category disruptors.

Offering an alternative treatment to traditional opioid drugs is the big prize on the medical side for cannabis companies. Cannabis advocates will point to a whole host of medical benefits, such as treating pain, inflammation, sleep issues and anxiety. Given its complex history, most of the remedial benefits of cannabis are anecdotal at this point. Gaining status as a pharmaceutical drug requires clinical trials that can take many years. Only one cannabis-based drug is currently on the market – Epidiolex (produced by a U.S. company), which is used to treat seizures for some forms of epilepsy. Many Canadian LPs have numerous clinical trials ongoing and patents in application. Big pharma is watching developments in the cannabis space closely. Canadian producer Tilray’s partnership with Sandoz AG (a division of Novartis) is the biggest deal in this space so far, but we suspect more developments will happen as cannabis research progresses.

While gaining status as a pharmaceutical drug has big benefits for cannabis companies, the ability to market cannabis as a wellness alternative (without waiting for patented status) is a massive opportunity that many companies will choose as a quicker way to market. Wellness and/or ‘well-being’ investing in one’s own physical and mental health is a priority for many people and a huge trend around the world. People suffering from sleep issues or anxiety are seeking relief but don’t necessary want prescription drugs. This leads them to consider cannabidiol (or CBD), the most well-known, non-psychoactive compound in cannabis. Already hugely popular in many parts of Europe, many consumers are exploring the potential health benefits of CBD, perhaps feeling more comfortable with its use without the high associated with cannabis containing higher levels of THC (tetrahydrocannabinol – the psychoactive component). CBD hype went into overdrive with the passing of the U.S. Farm Bill in late 2018, which legalized hemp, a low-THC, potentially high-CBD variety of cannabis. The bill's introduction meant CBD is legal on a nationwide level in the U.S. – although the FDA continues to conduct research before allowing it to be legally used as a food ingredient. 

The option to offer cannabis products as beverages, edibles or other forms is important when thinking of more health-conscious consumers who may be averse to smoking. While only time will tell how much disruption the alcohol market will face, CDB-focused products offer a wide range of alternative opportunities. Canadian LPs are planning on launching energy and sports recovery drinks in the market very soon. Some professional sports athletes, keen to manage the pain imposed from a physically demanding career, have jumped on the CBD bandwagon. Nothing sells a product quicker than a celebrity endorsement. Martha Stewart partnering with Canopy to work on a line of products containing CBD is a prime example of a high-profile endorsement that has received a lot of media attention, while more recently, Drake formed a partnership with the same company. Pet care is another huge market where CBD can flourish (e.g., dogs suffering from anxiety). Other categories such as beauty are jumping in (notably Sephora is launching its own line of CBD products) and consumers can expect to hear more about a wide range of cosmetic products such as CBD-infused moisturizers and shampoos. While these examples sound exciting and give a good sense of the wide-ranging potential disruption, validating these claims and/or showing more widespread efficacy will ultimately be the deciding factor of how far cannabis can go.

What to make of it all?

Exciting industry, but valuations are rich, and volatility is likely to continue

Like most things, the conclusions aren’t clear and simple; the answer likely lies somewhere in the middle. Right now, we see an industry with the potential for large returns, but with many risks that need to be factored in. This dynamic will change as time progresses. We believe the cannabis industry has the potential to be an interesting growth story over the coming years as the legal market matures. Secular growth of this nature, not necessarily tied to the ebbs and flows of the economic cycle, is a particularly sought-after characteristic in today’s markets and investors have shown they are willing to pay a premium for this trait. We must then pose the question of what a reasonable premium is to pay today for this potential growth. We generally believe that most of the Canadian cannabis companies are still overly-expensive relative to their visible growth profile and it requires a “leap of faith” and some difficult-to-predict assumptions to get comfortable with investing in this space. It could be two to three years at least before the full extent of the opportunity becomes clearer. In the meantime, sentiment and factors outside these companies’ control (more so than other industries), such as government policy, will likely continue to lead to heightened volatility. This year has been evidence of this, where you could argue the longer-term outlook for the industry hasn’t changed all that much, yet we have seen massive share price declines.

Stock selection will be important

We believe that there is likely too much money, and too many public companies, chasing this opportunity. History suggests there will be winners and losers and significant industry consolidation will inevitably occur at some point. From a stock selection perspective, we see a dichotomy where the larger names with scale advantages (and whom have a higher probability of dominating the space) are the ones with the biggest valuation premiums, while smaller names (that may be able to carve out a niche for themselves) are generally most at risk from industry consolidation and getting left behind. This presents a challenge for investment managers, requiring a high level of due diligence and analysis to seek out the potential winners.

Speculative investments not suitable for all investors

When committing money to an investment opportunity, it’s important to distinguish between investing and speculating. Given the volatility and the uncertain outlook at present, we believe buying cannabis stocks currently lies closer to the speculation end of the investment spectrum. Large drawdowns combined with concentrated positions in riskier names like this can throw an investors well-constructed financial plan off course very quickly – and take many years to recover from.

Is GLC investing in cannabis stocks today?

No. Despite all the media attention, cannabis stocks currently represent less than 1.0% of the S&P/TSX Composite Index and the big share price swings have had very little impact on the returns for a diversified Canadian equity investor. The equity portfolio management teams at GLC have avoided cannabis stocks to-date, believing valuation levels aren’t adequately compensating for the uncertain industry outlook, particularly when considering risk management parameters and the prioritization of downside protection. To that end, GLC’s portfolio managers continue to find better risk-adjusted return opportunities in other parts of the market.

Will GLC ever own a cannabis stock?

With the exception of GLC’s exclusionary SRI funds (where recreational cannabis companies are currently explicitly excluded from investment), GLC’s portfolio managers will continue to follow their disciplined investment processes, choosing whether to invest in cannabis stocks depending on their evolving views about the outlook for the sector and individual companies. At GLC, every sector and stock selection decision is done with the goal of building a portfolio that will deliver strong, long-term risk-adjusted returns for investors. 

Copyright 2019 GLC. You may not reproduce, distribute, or otherwise use any of this article without the prior written consent of GLC Asset Management Group Ltd. (GLC).

This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.