Cannabis Investors Have Reasons for Optimism in 2016 by Alan Brochstein

By Alan Brochstein

www.420Investor.com

2015 proved to be a huge disappointment for the publicly-traded cannabis stocks.  As I conveyed in the Summer/Fall Edition, the big decline from the peak in early 2014 extended into this year as fundamentals for the stocks didn't justify prices.  While the price action, which saw stocks lose, on average, well over 50% of their value, was of great concern,  the most troubling development was the lack of new legitimate companies entering the space.  I track about 350 companies now that purport to be in the industry, almost all of which trade on the treacherous OTC.  The overall market has declined over 95% from its peak value in early 2014 as measured by the 420 Investor Marijuana Index.

We saw a handful of interesting companies begin to trade publicly this year, and, encouragingly, some of these have begun trading after going through the S-1 process of filing with the SEC rather than the more typical but risky reverse merger.  Still, the universe of cannabis stocks is largely uninvestable.  The liquidity in the sector continues to dissipate and is concentrated, for the most part, in companies with catchy names with tickers to match like "ERBB", "HEMP" or "MJNA", all of which appear to be massive insider enrichment schemes.  Events like the recent elections in November, which included an initiative that failed to legalize cannabis in Ohio, seem to draw investors in briefly, but, absent temporary improvements in sentiment, the sector is weighed down by negative cash flows and the dilution that covers it.

While the overall cannabis market is unlikely to perform well due to the plethora of undercapitalized and ineffective companies that have crowded into it, the industry is poised to continue to advance.  I expect to see a few winners among the publicly-traded stocks, and we could also see improving sentiment.  An interesting development in 2015 was the crossing of the "green line", with several public companies beginning to actually grow, process or dispense cannabis.  Until this year, that hadn't been the case, as the companies were involved in the ancillary part of the industry but not directly touching the plant. These early movers represent just a small fraction of the overall industry and serve as canaries in the proverbial coal mine.  For now, there have been no government interventions into any of these companies, which do file with the SEC.

One of the foundational flaws of the entire cannabis industry is that the federal government considers the legalization efforts solely an "experiment."  The "Cole Memorandum" in the summer of 2013 laid out rules for the industry that would allow businesses to operate without the fear of facing enforcement of federal laws, but these were not new laws.  The 2016 Presidential race, then, is very important to the future of legal cannabis, as it is possible that our next President could reverse the position of Obama's administration.  At this point, it appears that the Democrats would be neutral to positive, while a Republican White House is likely to be neutral with respect to the continued expansion of legalization on a state-by-state basis.

58% of Americans favor legalization according to a recent Gallup poll, with surveys suggesting that over 80% believe that medical marijuana should be permitted. It seems unlikely that our nation will reverse the trends towards legalization.  In fact, it is possible that some of the huge barriers to the cannabis industry could be addressed at the federal level without legalization on a federal level necessarily taking place.  One huge issue has been banking.  The Obama Administration made an effort to permit banks to take on the industry as customers, but this was never codified into law.  Consequently, banks haven't been comfortable that they aren't subjecting themselves to issues with the regulators and have, for the most part, refused to accept deposits.  Another big challenge has been the DEA scheduling of cannabis as "1", meaning that it has no inherent health benefits and is highly addictive.  This characterization has stifled academic research.  The good news is that Congress, which is contemplating several pieces of legislation that address these and other concerns, could move to provide clarity.

The most promising development has been in Canada, which has a federally legal medical marijuana program, MMPR.  Initially restricted to just dried cannabis flower, Health Canada opened up the market to extracts following a Supreme Court ruling this summer.  This could expand the market and also improve profit margins as the producers can now use more of the cannabis plant.  More importantly, the landslide by the Liberal Party in October could lead to outright legalization, though this could take some time to play out.  In the near-term, though, the medical marijuana program is likely to be dramatically improved going forward, with substantial support from the government as opposed to the reluctant oversight role forced upon Health Canada previously.  The Canadian market exploded in price following the elections, and the outlook is strong.  This is a market that appeals not only to retail investors but also institutions.

One big change in 2015 was the entry of institutional investors into the cannabis industry. There have been several highly publicized investments, including the participation of Founders Fund in a $75mm capital raise by Privateer Holdings, but even more encouraging has been the proliferation of what I call "marijuana money managers".  The Green Rush following the legalization in Colorado was so quick to develop that professional investors hadn't yet really focused on the industry.  I now count over a dozen institutional advisors that are running accelerators, private equity funds or other investment vehicles that are helping to raise the industry by holding companies to high standards.  This should lead to smarter capital allocation and also allow high net worth investors to participate more easily.  It will also pave the way for better companies to ultimately trade publicly.

Public investing in the early days of the cannabis industry has been a complete disaster.  Since the flood of demand in early 2014, we have seen the proliferation of publicly-traded companies that will never be serious contenders.  Fortunately, the industry is strong.  With some of the recent changes that I have noted, I am optimistic that investors could find it worthwhile in 2016 to focus on the cannabis industry.

Editor's Note: Alan Brochstein, CFA, began his career as a bond trader in NYC in 1986 with Kidder, Peabody and worked with CS First Boston and Criterion investments until transitioning to equities as a analyst/portfolio manager in 2000.  In 2007, he began AB Analytical Services, where he provided research and consulting to several investment advisors while also becoming one of the most popular contributors at Seeking Alpha.  In 2013, Alan launched 420 Investor, an online community focused on publicly-traded companies in the cannabis sector, and, more recently, he began New Cannabis Ventures, a news & information platform that highlights the most promising companies and influential investors in the cannabis industry.

www.420investor.com