This week was a rough week for cannabis stocks, but especially the Canadian licensed producers (LPs), of which there are currently 28 publicly-traded companies, with at least six more likely joining the group within the next three months. Health Canada has issued 89 licenses so far, and the publicly-traded companies own 39 by my count. The Canadian stocks have been a tremendous momentum play for traders and investors over the past two years or so, and, in my view, the sector was overdone and ripe for a correction. By my calculation, the sector lost over C$10 billion in market cap over the past week.
New ETF Throws Gasoline on the Fire
Canadian LPs have had a very favorable investment thesis for several years: Medical cannabis is federally legal, and soon the country will become the first Group of Seven (G7) country to legalize for adult-use. While Canada is a bit smaller than California, with 36 million residents, it is still a large market, but the companies there have global opportunities that broadly expand their ability to scale into multinational corporations over time. For example, Germany, with a population of 83 million, has legalized medical cannabis and is providing insurance coverage and distributing it through pharmacies, all of which bode well for a very large market. The country is in the process of awarding a limited number of initial licenses, and several Canadian LPs, some of which are already exporting to Germany, will likely win licenses. The entire European Union is opening to the Canadian LPs, and Latin America, Australia and even Africa offer opportunities to these companies as well. Finally, while many of the estimates for future revenue are based on displacing the existing black market, these fail to consider that cannabis products will likely replace some pharmaceutical products (like for sleep aid or pain) and also compete with the alcohol market.
In late December, a new ETF hit the market, the ETFMG Alternative Harvest ETF. This ETF, which trades on the NYSE ARCA with the symbol “MJX”, followed the first cannabis ETF, Horizons Marijuana Life Sciences Index ETF, which trades on the Toronto Stock Exchange and has assets of approximately C$626 million. MJX, which now has assets of approximately $360 million, began with assets of just $6 million on December 26th, with the increase almost entirely related to inflows rather than price appreciation. MJX, which was a failed Latin American Real Estate ETF, changed its focus, something that may leave it with no trustee and potentially force liquidation.
The irony of MJX is that its success was likely due to California legalizing, a catalyst for drawing a lot of new money into the market. As a U.S. ETF for cannabis, in fact the only one, it was ripe for momentum traders to pile in. The only problem: MJX has no exposure to California! In fact, it is a very odd fund, with about half of its assets devoted to Canadian LPs and the balance to tobacco companies and biotech companies with little or no exposure to legal cannabis. So, money flowed into the ETF, which resulted in demand for Canadian LPs. Near the peak of the market last month, I wrote about how both MJX and the Horizons ETF were distorting the market.
While I think this was a key driver of the action, along with continued inflows into the Horizons ETF, another important factor was that Jeff Sessions changed U.S. federal policy in early January, and this made Canadian LPs a safer place for investors. While the stocks had fallen initially after the policy change, which was the rescission of the Cole Memo guidance from 2013 that allowed states to proceed with legalization without concern about federal enforcement of the Controlled Substances Act as long as they followed 8 principles, they went on to make new highs days later. A final potential driver was mergers and acquisitions, with Aurora Cannabis successfully negotiating a deal with CanniMed Therapeutics after a hostile bid wasn’t successful and Aphria acquiring privately-held Broken Coast.
A Flood of Supply Hits the Market
In response to rising prices and strong demand, Canadian LPs announced deals in excess of C$1.2 billion in January alone. This figure includes only public company offerings and also excludes warrant and option exercises that also would boost the supply of shares. The deals were spread out among 14 different companies, or half of the entire sector. For perspective, the amount priced in January represented over 1/3 of all public company offerings by LPs since October 2015.
The Damage is Big
The flood of supply hit a crescendo Monday morning, with two smaller LPs, ABcann and Maricann, pricing very large offerings of C$70 million each. At the same time, Aphria announced the acquisition of a company that had just begun trading publicly, Nuuvera, with the goal of boosting its international presence. I believe investors saw this as a sign that the sector was overheated, with LPs seeing their stock as great currency rather than using cash and using their stock to try to justify their valuations. The Canadian Cannabis LP Index, which peaked on January 9th near 1439, closed on February 2nd at 955.07, representing a decline of about 1/3. So far in 2018, it is now down about 5% after having reached a closing high gain of 43%. The index declined almost 29% over the past week:
A closer look at the market reveals that the strong performance in a few smaller LPs has boosted the overall returns of the index, which is weighted equally at the beginning of each month when it is rebalanced. At New Cannabis Ventures, we have segmented the index into three different tiers, and Canadian Cannabis LP Tier 1 Index, which is the six largest LPs in terms of revenue, has declined by over 12%. At the same time, the Tier 2 and Tier 3 returns, which are skewed by a small number of big winners, are actually slightly positive.
This Dynamic is not New
For those who have been tracking this sector, there is a sense of déjà vu, as the introduction of the Horizons ETF in April brought a lot of new buyers into the market. The timing in early April was just ahead of the formal introduction of the legalization legislation, C-45. Prices in the sector spiked higher, rising 27% from April 3rd to April 10th before then losing 44% over the next three months.
Supply surged in April as well, with over C$185mm of deals from three LPs from April 10th through April 20th. Similarly, the sector heated up in late 2016 after the U.S. elections turned Congress and the White House over to the Republican Party, raising concerns that legalization progress might be stymied in this environment. In a two-week period ending November 18th, the index rallied by 77.6%. The rally stalled as 5 LPs priced over C$200 million in equity or convertible note deals from November 11th through the end of the month, one of which was a TSX-listed IPO for CanniMed Therapeutics that totaled C$69 million.
Buy the Dip?
I stepped up exposure significantly this past week, especially on Friday, to the Canadian cannabis producers in my model portfolios at 420 Investor. While I don’t believe the decline is necessarily over, I see this as a good opportunity to scale into the sector for longer-term investors and as a potential trading entry.
As we began the year, I was underweight Canadian LPs, which had experienced a huge run from October 27th through year-end on the tail of a game-changer announcement that Constellation Brands was taking a 10% stake in market leader Canopy Growth with warrants that could double the position. Prices had increased by 109% during that short period of time, and the overall market cap for just the publicly-traded stocks (disregarding all the private companies) was C$26 billion. With prices now down slightly after the rally and retreat, the valuations are still a big concern for me, but for those who want to be invested in the cannabis sector, the LPs are a safer bet than U.S.-focused companies following the rescission of the Cole Memo in early January, and I have adjusted my exposures subsequently. I think the U.S. market is riskier, though it offers much better valuations potentially, and I hope to feel confident enough in the near future to up my exposure to it.
I run several model portfolios (not real money), each with a different set of goals and guidelines. My swing-trading model portfolio, which I call “Flying High”, was about 81% cash going into Friday morning’s bloodbath, and I purchased positions in two LPs in the morning that now represent an investment of 45%, so I clearly see at least a bounce opportunity. My other two model portfolios are more longer-term focused, with both having the Global Cannabis Stock Index as their benchmark. 420 Opportunity, which is a bit more flexible than my other model portfolio, 420 Quality, is permitted to hold no more than 20% cash. During the week, I began with cash at 20% and ended the week with just 5%, with the majority of the cash deployed going into LPs, which now account for 29.5% of the model portfolio. 420 Quality, which is permitted a maximum of 30% cash, began the week with 29% cash and ended with about 12%. About half of the cash deployed went into the Canadian LPs, which now represent 25.7% of this more conservative portfolio. The index has about 23% exposure currently to the LPs.
While a few of the LPS look very appealing to me from at least a short-term perspective but also relative to other cannabis stocks, I believe there could be some more downside in the near-term. The consolidations after the the prior two parabolic spikes in April 2017 and November 2016 took months not weeks to play out. The pending legalization later this summer suggests to me that this correction will likely be short-lived. One concern I have is the very high trading volumes in the largest three stocks in the sector by market cap, Aphria, Aurora Cannabis and Canopy Growth, which, as a group, traded C$1.12 billion across all exchanges in Canada on Friday. The high dollar volume is nothing new, and it has been higher at points over the past few months, but it represents excessive speculation in my view. The spike Friday was hopefully a sign of capitulation and traders getting stopped out on their positions early in the morning. Looking ahead, I expect volumes to subside, and this may be a better time for investors to consider the market. I have shared with my subscribers for several of the LPs levels that I think will represent good entries, and some I believe are right here, while others have more downside.
The bottom-line: There is a very bullish long-term thesis for Canadian cannabis producers, and the bull market that began when Justin Trudeau and the Liberal Party gained control of the Canadian government in 2015 is in correction not decline following a massive spike that was met with an even more sizable boost to the supply of shares. While valuations are certainly a challenge even after the decline in prices, the bears seem to neglect global opportunities and may be underestimating even the Canadian opportunity.