Chasing Liquidity in Cannabis
US cannabis companies are growing triple digits while Canadian ones grow double, but you wouldn’t know that by looking at their market cap.
Multiples are 2x higher for Canadian cannabis stocks because they have cheaper access to capital. This valuation gap will close as the US legalizes marijuana and US stocks uplist to major exchanges. Once that happens, investors will pour capital onto the sector and multiples will expand.
I’m chasing liquidity in cannabis. I’ll tell you why.
Canada vs. the US
Though highly regulated, marijuana is legal in Canada. Licensed Producers (LPs) can grow, process, package, and sell cannabis products across the country, as long as they abide by regulations1. LPs can also list in the major Canadian and US stock exchanges, giving them easy access to capital2.
Things are different south of the border. Cannabis isn’t federally legal (yet), so US companies have to operate inside states which have legalized cannabis for medical or recreational purposes. That’s why these companies are called multi-state operators (MSOs).
Importantly, MSOs have a hard time accessing capital. They face banking restrictions and can’t list in the major US stock exchanges, such as the Nasdaq or the NYSE. Instead, they have to go public through minor exchanges in Canada (such as the NEO and the CSE) and the US OTC market. Also, large companies from legacy industries— think Altria, Constellation Brands, Inbev, L’oreal—can’t invest in them.
The Valuation Gap
Fundamentals don’t drive the higher valuation of LPs. The US market is larger and much more profitable than the Canadian market. MSOs are growing sales at double digits quarter over quarter, and many are already EBITDA positive. LPs are growing more slowly, with significant losses.
The Canadian market is competitive, fragmented, and oversupplied. This environment is unsustainable but many companies are kept afloat due to the endless capital offered to them. LPs are the only investment option for many retail and institutional investors, hence their multiples and market cap.
When new legislation comes online in the US, the capital that’s abounding for LPs will be redirected to MSOs.
Fundamentals + Liquidity
There are two reasons to own US cannabis stocks.
Fundamentals
The US market is currently worth US$15bn and is forecasted to grow to US$100bn by 20303, a +20% CAGR over ten years. There’s a secular growth tailwind driven by increased marijuana consumption and development of new product formats (think beverages, candies, supplements, creams, shampoos, pharmaceuticals, etc.).
In addition to a long runway for growth, the environment is catalyst-rich with the perspective of new banking regulation, the legalization of cannabis at the federal level, and investments from legacy players from the CPG, pharma, and retail sectors. There’s also potential for US companies to explore international markets as global jurisdictions legalize cannabis. In ten years, who knows how the cannabis market will look like in Europe?
Liquidity Flows
Here’s the first stage of what will happen once regulation changes and the barriers to invest in US cannabis fall:
Stocks will uplist to the Nasdaq and NYSE;
Retail and institutional investors will pour capital into the sector;
Canadian LPs will deploy part of their capital to buy MSOs;
CPG and pharma companies will buy, invest, or partner with MSOs for the production of cannabis food, cosmetics, health, wellness, and pharmaceutical products;
Cost of capital will decline and multiples will expand;
The sector will get overvalued.
Later on, in a second stage, the US will follow the same trend as what’s happening in the Canadian market today. There will be too many players and competition will be fierce. Slowly, the sector will consolidate. A lot of capital will be wasted and there’ll be few winners.
It’s the well-known boom and bust cycle. I want to invest in the sector today, before the boom, and get out before it goes bust.
One Way to Play US Cannabis
The US market is growing fast but it’s hard to pick a winner. Companies have to operate separately in each state, posing a complex regulatory and competitive environment.
A large portion of my thesis relies on capital flowing into the sector. As an alternative to stock picking, an ETF allows me to play this liquidity game. I expect that US cannabis stocks will appreciate to the point where they will get overvalued due to large liquidity inflows and the hype around this catalyst-rich environment and the promise of future growth. The same happened with Canadian cannabis stocks.
I like the MSOS ETF (AdvisorShares Pure US Cannabis). MSOS doesn’t invest in Canadian LPs or international players and ~50% of the ETF is concentrated at the top 5 largest US MSOs.
The market cap of those top MSOs together amount to ~US$30bn.
While I’m not sure if they are undervalued, they certainly aren’t overvalued. Consider that MSOs are growing triple digits despite their state-fragmented operations. The addressable market is large and the sector has clear catalysts ahead. As these catalysts play out and access to capital becomes cheaper, I’m betting on a strong run up.
I’m long MSOS.
You need licenses for cultivation, manufacturing, testing, sales, etc. You also have limitations on packaging, branding, and marketing.
If you follow the space, you know that LPs have raised (and wasted) billions of dollars—and they continue to do so. Dilution is a constant.
Compare that to the current size of the Canadian market, which is only worth ~US$3bn.