Highs and lows: why cannabis remains an unfulfilled investment promise

WP marks 4/20 day by reflecting on the nascent industry's stop-start progress since legalization in Canada

Highs and lows: why cannabis remains an unfulfilled investment promise

In 2018, Canadian investors were abuzz: with the legalization of cannabis in the country, they had a rare opportunity to get in on the ground floor of a new, budding industry. But after four years of false starts, pandemic struggles, and brief rays of hope, the promise investors saw during those high times has yet to be truly fulfilled.

“A lot of euphoria was built in when the Democrats won the U.S. elections in 2020, and that filtered through to the start of the year in 2021,” says Nawan Butt, portfolio manager at Purpose Investments. “That was when we got positive statements from U.S. legislators surrounding the pushing forward of new bills and laws to potentially decriminalize cannabis in the U.S.”

That messaging came from Chuck Schumer, Democrat and Senate Majority Leader, who promised that he’d make decriminalizing cannabis a top legislative priority. At the time, it was a great tailwind for many Canadian stocks – including Canopy Growth and Tilray – with direct and conditional exposure to the U.S. market through various production and distribution agreements.

With the promise of legal and regulatory catalysts to open up a new legal market for marijuana, Canadian and U.S. pot stocks took off in January and February of 2021. Canadian stocks had a leg up over their U.S. counterparts, Butt says, as they remain the only stocks available for most U.S. investors to invest in without the risk of attracting scrutiny under U.S. securities law.

“Even on the NYSE and the NASDAQ, you’ll mostly see Canadian [cannabis] stocks listed. And most U.S. stocks are listed on the Canadian Securities Exchange,” he says. “Even on the TSX, we don’t have any U.S.-listed pot stocks. So any positive news around the cannabis industry tends to favour Canadian stocks.”

The early 2021 bump in pot stock prices, Butt says, priced in market expectations that the incremental U.S. pro-cannabis reforms would happen very, very quickly following Schumer’s announcement. But by August, there was still no solid follow-through on the pledge for incremental reform, and the marijuana legalization agenda was put on the back burner in favour of other legislative priorities. Supply-chain issues precipitated by the pandemic didn’t help.

“We’ve seen a weakness in Canadian and U.S. company valuations throughout the year. And because the broader stock market performed really well in 2021, a lot of investors used pot companies to conduct their end-of-year tax-loss selling, which pulled them down even further,” Butt says.

That weakness and lack of faith in the pot sector is carrying over until today. In its most recent Advisor and Investor Sentiment Surveys, Horizons ETFs noted that the North American Marijuana Index posted a -11.33% return in Q1 2022. Both advisors and investors polled were overall bearish on the sector, registering just 34% and 37% bullishness on the space, respectively.

The gears of reform are slowly grinding forward in the U.S. In March, Congress passed the MORE Act for the second time; under that proposed legislation, marijuana would be removed from the list of scheduled substances under the Controlled Substances Act, and criminal penalties linked to manufacturing, distributing, or possessing marijuana would be eliminated. Another piece of legislation passed by the House of Representatives, the SAFE act, could potentially open up more access to capital for marijuana businesses in the U.S.

Still, those and other Democrat-led proposals that have passed through Congress haven’t generated headline-catching excitement, as they have continually been blocked in the Senate amid a continued impasse between the two ruling political parties. However, Butt emphasizes that they represent important positive developments that could tilt in favour of Canadian or U.S. companies, depending on the time horizon being considered.

“In the near-to-medium term, those types of developments will lift Canadian stocks because they’re the only names U.S. investors can access now, and they’ll improve the prospects of Canadian companies conducting business in the U.S. or participating in cross-border transactions,” he says. “But in the longer term, as the markets get more relaxed, the direct positive impact should be even more significant for U.S. cannabis stocks, which will become available on more senior exchanges for a broader base of investors.”

More recently, Canada released its federal budget for 2022, which included a commitment to support Canada’s cannabis industry. While he doesn’t believe the incremental positives in the package would make the industry hugely profitable in the short term, he acknowledges that it could result in more efficiency along the cannabis supply chain.

Canada’s federal budget also effectively reduces the working capital requirements for smaller producers as it requires them to remit their excise taxes on a quarterly basis rather than a monthly basis. That measure, Butt says, effectively lowers the working capital requirements for smaller players, and potentially allows them to operate more smoothly. Still, he argues that other steps are necessary to help the still-budding industry.

“It would really help if taxes were actually lowered rather than the payment requirements being adjusted,” he says. “That would make the products more affordable for consumers and really help the legal industry compete against the black market, which still commands about a third of the market share here in Canada.”

From a product perspective, Butt says introducing more form factors and raising the thresholds for the amount of active ingredient that can be included in each product. Looser product formulation guidelines, he says, would bring a lot of market share back from the black market and into legal channels.

The prospective demand tailwind for cannabis continues to grow, he adds. As a case in point, he says an adult-use cannabis program is expected to be in place in Germany around 2024, which would open up another new market population of 80 million people.

“As Canadians, we have the global first-mover advantage in our ability to invest in an industry that’s been around for thousands of years, but is just now making its way into modern financial markets,” Butt says. “It seems inevitable that pot will be legal in more jurisdictions as we move forward, and we Canadian investors should be leading the world on this charge.”