Which companies can cope with pot commoditization?

Fund manager explains how that affects holdings and due diligence

Which companies can cope with pot commoditization?

The risks of commoditization in the marijuana industry highlights the importance of fund managers doing proper due diligence on companies.

The government’s bill to legalize recreational marijuana was sent back to the senate last week as political parties wrangled over the details. Approval is, however, inching closer.

Charles Taerk, of Faircourt Asset Management, is the sub-advisor of the Ninepoint-UIT Alternative Health Fund, the first actively managed cannabis-focused mutual fund in Canada to have a full one-year track record.

He acknowledged the dangers of potential oversupply to recreational demand but said LPs still have significant room for build-out.

He said: “We see commoditization on the horizon. The question is when. What we do is look for efficient producers that are expanding their footprint and focusing on higher value-added product, whether that is in brands, IP, distribution capabilities, international opportunities or other key success factors.

“In terms of timing of commoditization, we must consider the difference between current capacity and funded capacity. To get to the volume where supply meets demand, there is still significant build-out to be completed among all licensed producers. This is where we undertake due diligence, touring facilities and meeting with management to get a sense of how development is progressing.

“Not all management teams are going to execute in the same fashion, and some companies may alter development plans and not complete previously planned projects. In addition, as the amount of supply diverted from sales of dried bud to extraction grows, the supply needed to meet that demand rises.”

One of the challenges for production companies as they attempt to establish a foothold in the market place is cost and whether operations can scale enough to enjoy high margins and survive the inevitable price war.

Taerk said: “We believe that to be a low cost-per-gram indoor grower the goal is $1-1.25. Indoor grow should be able to withstand commoditization, with selling price in the $7 range. We believe that greenhouse growers will see more price pressure, so being efficient at $0.50/gram or less will be important, with selling price at $5 or less.”

He explained that a vital consideration when analyzing companies to include in the fund is how attractive they will be when big alcohol, big tobacco and big pharma come knocking.

With Constellation Brands having already taken an equity stake in Canopy Growth and Southern Glazer working with Aphria in its Canadian distribution, Taerk believes this is simply a sign of things to come as the market becomes more mainstream.

He said: “We anticipate other sectors will get involved. We would be positioned both by owning those cannabis companies that we believe are best positioned to take advantage of the coming merging of industries.

“We also have a portfolio allocation that allows the fund to invest in companies that are not solely in cannabis. Our investment universe includes; pharmaceutical companies; nutritional vitamins and supplement companies, health and wellness service providers; businesses engaged in providing diet and weight loss programs; alternative healthcare service providers; Canadian licensed producers of marijuana and related service providers; as well as companies involved in the processing, marketing and distribution of organic food and beverage products.”