August was the toughest month of 2019 for the cannabis industry. Is this the final hour before dawn?
It isn't often that I refer to the broader markets when reviewing the cannabis stocks, but in this case, one cannot possibly consider August, without broadening our view. August has undoubtedly been one of the worst months for the markets in general. At a macro-level, this has been largely driven by two factors; Trump's trade war and the imminent threat of a recession.
While Trump's head-spinning changes in tack may accomplish the goal of a trade pact with China, they add to the uncertainty hanging over the financial markets and the real economy.Barron's August 2019
August kicked off with President Trump Tweeting that the US would be placing an additional 10% tariff on $300 billion of Chineses imports come September 1. This put massive pressure on the markets. He then backed that up on August 5th when he dropped the "manipulation bomb" on China, after the yuan fell to a new 10-year low against the US dollar. Markets shat themselves with the S&P down over 3% on the day – the worst performing day of 2019.
"I think Trump the Dow Jones Man is ultimately going to eat Trump the Tariff Man," said one former senior administration official intimately familiar with the president's stock market obsession"
And then came the recession warning
On the 14th of August, something happened that always happens just prior to a recession, the yield curve inverts (which occurs when the 10-year Treasury yield falls below its 2-year counterpart). Basically, at that point, short-term investors are gaining a higher return than long-term lenders, who normally earn a higher return, given the extra timeframe they are committing their capital for.
The recession flash warning sent investors into panic mode, with many dumping stocks in favour of other safer havens such as silver and gold. This time it was the Dow Jones Industrial that suffered the hardest blow.
And so to August
We often speak of Beta and the fact that pot stocks have a higher Beta, which means that when the market goes up, pot stocks normally go up much more. However the inverse is also true, and so when a market is falling, pot stocks normally fall harder, and this has certainly been the case in August.
The table below shows the monthly performance of four indices. Three of them are run by New Cannabis Ventures. The Global Cannabis Index covers the entire market, while the Canadian LP index covers the Licensed Producers and the American index tracks the Multi-State Operators (MSOs). And finally, we track the world's largest cannabis ETF – The HMMJ.
As can be seen, the US index performed the worst of the three, down 17.3% for the month. There are a couple of reasons for this, but one of the most vital relates to the early-year consolidation that took place.
MedMen bought PharmaCann for $650 million, Harvest Health bought Verano for $850 million, Cresco Labs bought Origin House for $1.1 billion, and finally, Curaleaf acquired Cura Partners, also for $1.1 billion.
The markets loved these deals, as not only did they give the MSOs scale, but they were also synergistic and complementary. However, to date, not one of these deals has actually gone through yet. The reason – the DOJ's AntiTrust division is considering them…slowly.
Nothing that we have read, or heard, suggests that the deals are not going to be approved. Rather this seems to be the DOJ getting their heads around the cannabis industry and gaining a better understanding of the MSOs. However, this delay has resulted in investors fleeing for the hills, concerned the deals may not happen at all.
In this scenario, the "Pro-forma" revenues that these MSOs have been reporting is not going to eventualise, and hence valuations should be considerably lower. Well, guess what? They are now considerably lower, especially given their performance in August.
In Canada, the cannabis industry was still reeling from the double blow of Canopy Growth's CEO being fired, and CannTrust growing illegal weed. Add to that the current numbers coming out of the retail market, and the resultant downward pressure on the Canadian Licensed Producers has been immense.
Recreational cannabis in Canada has been a shit-fest from day 1. First off they launched with flower and low potency oils only, when the majority of the recreational market is in edibles, extracts, vape pens etc. Secondly, they also launched with almost no brick-and-mortar retail stores. Toronto still only has 25 retail stores, in a city that has been forecast to be able to support over 1000 stores. Yeah, you read that right.
Cannabis stocks have been going down and down and down since late March, and the bloodbath has been incessant. Recently, Motley Fool wrote an article entitled "Why you shouldn't invest in pot stocks." Basic highlights: Pot will be a commodity, stocks are all overvalued, and the market is nowhere near as big as analysts expected.
In response to this, let's be clear on this. Our thesis has always been, that cannabis is going to be the greatest healthcare disrupter of our time. It will also be a massive recreational industry that could rival beer (USD$100b per annum) in size. This is our 5-10 year view of the industry and its potential.
However, in the short term, there are a couple of key catalysts that could mark the bottom, and trigger the next run…
In October, Canada is set for Legalisation 2.0 – the legalisation of edibles and extracts. To give you an idea of just how big this is, it is estimated that the black market for vape pens in Canada is over $1b per annum. This is the market that would be open for business, and it's going to be massive.
Expect the LP's to start posting bigger numbers as they roll out higher price (and margin) extract products, and the Canadian retailers to start to deliver very big revenue numbers, as the product range and number of retail outlets both rapidly expand.
In the US, there are a few events that could spark a cannabis run. First of all, there are the mega-mergers — all of which are all currently paused – being given the green light. This will bring massive investor confidence back into the market, and we expect to see the MSOs rally hard.
Then there are two Acts currently in play. The SAFE Banking Act, which would regulate banking for the industry, giving all cannabis companies access to the range of corporate banking facilities other US companies enjoy. And the STATES Act, which would protect the rights of any State that legalised for medicinal and/or recreational use, from any sort of Federal intervention. This would immediately de-risk cannabis investments in these states, as cannabis businesses would now be fully protected, and free, to operate.
And either of these would bring pot stock investors running back to the market, knowing the industry is definitely a step closer to Federal legalisation.
They say the darkest hour is just before dawn. Although we are not certain that this is the exact hour before dawn, it certainly feels very close to it. Stocks have been hammered, investor confidence is shot, and the global trading conditions continue to lean heavily on pot stock's Beta.
Warren Buffet famously said to be greedy when others are fearful. And right now, they're shitting themselves. Enough said?