Listen above or on the go via Apple Podcasts or Spotify.
Why Chris DeMuth likes the opportunity in cannabis (1:20) Julian Lin on M&A, debt and disappointment (10:05) Alan Brochstein: waiting for catalysts while working through tough times (12:20) Jesse Redmond discusses the best way to invest in this space (13:35) Emily Paxhia on SG&A containment, gross margins and using the right metrics (17:20).
Smart investors and thinkers know not to make assumptions, but it’s safe to assume that cannabis investors are tired – of waiting, of losing money, of being told that life-changing legislation is always just around the corner. That said, long-term, myriad reasons remain to be optimistic about the cannabis space.
Some good news to start the new year. Here’s to a lot more of that. As we transition from one year to the next, here’s a rundown of reasons to be hopeful – and some compelling advice – from some our favorite conversations in 2023.
Chris DeMuth: I’ve never used cannabis. I’m interested in it. I think the war on drugs, which was in theory a terrible idea, but in practice much worse, kind of delayed for decades sound study of what a lot of things could do from cannabis to mushrooms and other things. We just don’t know.
And so I’m kind of humble about health and safety, but don’t like rules about what other people put in their body. In any event, big throat clearing there.
I like the opportunity to get in ahead of other people. And I like people telling me that they’re going to jump in later. And I have one, two or three year runway to get in and build up operationally private businesses to invest in public securities.
My personal individual account has one stock in it and it’s a cannabis stock. And so it’s an opportunity to wait and have a head start with businesses that are already profitable but could be a bonanza a few years from now once capital is able to kind of flood into this space.
Rena Sherbill: And why did you decide to get into it now? I mean, the case could be made to get into it earlier. Obviously, you mentioned some reasons to get into it later. Why now?
CD: Some is just specific to life circumstances, people who’ve left the finance and hedge fund industry to go into operations on the private side.
On the public side, there was kind of an opportunity that I would say was related to the SPAC destruction where many, many of the, virtually all of the post de-SPACed equities have kind of fallen out of favor, some dramatically so.
And so in at least one case, price, in at least one case just early adopters not getting the tempo quite right, that there have been plenty of delays on all of the puzzle pieces that I think are really important.
But politics is downstream from culture and the culture I think is moving to a point where it’s almost impossible to come back to where you have younger people who are more supportive than older people. And then you also have just a big breadth of reasons for why legalization is supported.
You have people like me, who, once you say, let people be free to, I don’t need you to end the sentence. I’m on team liberty for this. I’m in it for the liberty part. And then there’s other people who just really like pot and they’re willing to get along with libertarians. And there are people who are very concerned about the civil liberty history of the war on drugs, which is extremely ugly. I mean, extremely pointed racist and has just strange things about it that need to come to an end at some point, now is pretty good.
And anybody can add to kind of the civil liberty concerns, the people who just like smoking pot, the people who are libertarian, the people who — you have kind of there’s all sorts of left wing and right wing versions of why this current status is terrible.
And I think it’s also just something I get very stuck on. When you look at the scheduling of cannabis, it’s just not true. It’s just not, it’s just not — forget about politics and forget about philosophy and liberty and all that stuff, which I think is the fun stuff to think about. At some point, somebody has to just notice that the scheduling makes no sense chemically for this chemical.
And somebody at some point is just going to not have a care about anything but say let’s just do this properly and cannabis will be rescheduled. Also, it is dangerous to have American citizens forced into a cash, literally currency business that’s not part of our financial system. Our country, America, the U.S. is broke. And so at some point, the government’s going to have to start doing stuff to – that is good for revenue and brings huge number of Americans into 21st century finance.
So those confluence of interests really make the culture one that I think is inexorable and that’s going to go in a certain direction. There’ll be hiccups along the way. There has been a decade of delays already. There’ll be delays further. We’re heading this next year into an election year with the House, the Senate, and the White House pretty close to parity in terms of kind of the jump balls, in terms of partisan politics.
The cleanest, most obvious route to success here would go through the Democrats and would go through Biden winning. I think that would be the lightest lift, but I can see all sorts of ways the Republicans could win and be in the forefront of this reform. A higher percentage of Republicans and Democrats voted for the Civil Rights Acts in the mid-1960s. I think a higher percentage of Republicans and Democrats could vote for a lot of good things that relates to winding down the failed war on drugs, especially as it relates to pot and cannabis.
So yeah, I think we have a great, clear legislative route. It’ll be messy and complicated, but we have dates on the calendar for Senate markup. And this is something they could really make progress on. If you look at the younger members of Congress from both parties, that’s where you can see a lot of agreement.
RS: Let me ask you, because typically we talk to real industry insiders, people that are really focused on the cannabis sector. In addition to the investment world, they’re typically more focused on the cannabis side of things.
But as somebody who’s really entrenched in the traditional world of investing, what would you say is kind of the discourse around cannabis at this point? Are people biting at the bit to get in? Are they waiting? Are they waiting patiently? What’s kind of the sense that you get?
CD: The more kind of vanilla, long-only mutual fund type people seem to be ignoring it almost completely. Their individual incentives are basically, I don’t know what it is, get paid a salary, don’t get fired. And if your whole life revolves around get paid a salary, don’t get fired, you want to recoil from superficial hairiness.
I love superficial hairiness. I want to massively underpay and get a wildly unfair amount of reward for the risks I’m taking. And I can’t imagine how the world would ever hand that to you without some kind of subjective hairiness. Like you have to take something if you want to pay some small fraction of what you get and then get the thing back, which is what I want to do.
So, there’s usually something that’s gone horribly wrong with anything that interests me, but on the kind of long only mutual fund, don’t get fired side, I think there’s no interest as far as I can tell.
There’s kind of niche cannabis investors. I think they’ve had a lot of pain on and off last few years. I think that there is an awkward transition from the gray to the white market. And I think the good thing for this industry as an industry is you’re going to have those same kind of white shoe, long only people just flood with capital, but you’re also going to flood with competition.
I mean, these huge companies that have great distribution and marketing and branding, cannabis isn’t that hard to make. A lot of the skills have been the pluck and daringness to wade into this area historically. And pluck and daring doesn’t kind of define middle management in corporate America. Altria (MO) comes out with Altria Red Marlboros, and Altria Green cannabis, and they’ll be able to sell things very inexpensively and they’ll be able to deal with regulators as well.
Julian Lin: General thoughts on investing in cannabis. I think for sure, especially for myself who joined this investing in cannabis starting around the 2020, 2021 time, just right around the peak. I think there’s definitely a set of errors, some from myself, and some on the behalf of management.
The personal investing errors would definitely be underestimating how quickly growth will decelerate following the pandemic. And this wasn’t necessarily just related to cannabis. This happened also in e-commerce, or any of the other businesses that saw a big boom following the pandemic.
And I also definitely overestimated how much synergies could be extracted from M&A. In hindsight, it turned out that M&A just did not really lead to a lot of reduced operating expenses. And, of course, as I think every investor did, we definitely underestimated the level of price compressions and just how vicious that price compression has been.
But I think, those factors did not have to lead to where cannabis stocks are trading today. I think that arguably, a bigger, well, and also a very significant driver of the underperformance has been self-inflicted from the management teams, very specifically related to how much debt they have taken on over the last couple of years to fund M&A.
I think I have previously mentioned on a podcast with Rena that I was of the view that these names should be using stock. They should be issuing stock to be funding the M&A just because it did not quite make sense to be issuing debt at the high interest rates with 280E taxes and so forth, but, I mean, obviously, no one was listening to me then.
So all of these names have issued a ton of debt. And so they’re left in the uncomfortable position where they haven’t realized the growth or the margins they expected, but they’re left with all this debt. And a lot of these names, their debt is maybe multiples of their market cap.
Of course, the better names, the names that have done better are the names to have less debt. But, yeah, so debt remains a very important driver of risk even today.
Alan Brochstein: Yeah. Good points, Julian. And I would say for me, I think I’ve been a little bit on top of this. Rena, our last two interviews have been kind of a bummer, right, and my outlook has been muted. And a year ago, I was so optimistic because I looked at how much cannabis prices have fallen. And as the rest of 2022 played out, I kind of learned a lesson.
The problem there, as Julian pointed out to, there are some problems with the cannabis industry, and they should have been doing equity instead of debt. But the real problem is we have the same investors. It’s a pool of investors that’s mainly retail and all entirely tired of cannabis looking for new buyers. Where are they?
And I’ve been under the assumption that they’re just around the corner, but I don’t know where the corner is, or when it will happen. And what they’re waiting for is either Nasdaq listing for American cannabis operators, or more importantly I think, the end of 280E. And I think until then, we’re kind of stuck in a rough spot.
Jesse Redmond: The nature of a catalyst is that they are unknown things and they are unexpected. So really, the idea of being able to time a catalyst, if you could time it, it probably actually isn’t a catalyst if that makes sense. By nature, they’re unexpected.
And if you think about this one, who expected this kind of announcement, the last week of August when a lot of traders were out of town, the space could not have been more dead. I remember that week, I put out a tweet that said to the 37 of you that are still paying attention, here’s some information on valuations for the top five companies. And you’ve probably seen it Rena, engagement just got super low.
Volume was super low and then out of nowhere when nobody expected it, we get this huge announcement that the HHS was recommending Schedule III. And so I think that’s just further evidence that the space is really hard to time.
Maybe there’s a perspective which I had last year that you could increase exposure during these more politically active periods. So we don’t know if the DEA is going to respond within 30 days, or if it’s over 90 days, or if it’s going to be some time closer to the primaries early next year, it could be the conventions over the summer. It could be waiting until the actual election in the fall of next year.
So I would say these things are pretty hard to time, but maybe there’s a strategy where you could increase exposure around these events. But for someone like myself, that doesn’t have an edge in market timing, and I think that’s true of most people, I think most people are better off being long-term investors and not market timing unless you do have a demonstrative edge in that space. And so my thoughts for most of this year have been to focus on quality.
I often reference this conversation I had with Abner Kurtin, who’s the Executive Chairman of Ascend (OTCQX:AAWH). And he said in this type of environment, it’s not about finding the things that will go up 200% rather than 150%. It’s about avoiding the ones that will go to zero. And that’s changing a little bit, as we do get into what could be a new bull run here. If people want to invest in more speculative names, we can talk about the kind of stuff that has been going up the most.
But I think there’s enough opportunity in cannabis that I would tend to focus on quality and have a longer term time horizon. My thought has been give this 3 years to 5 years, give this 4 years to 6 years, maybe even longer to play out because we do have this series of political catalysts.
We have SAFE Banking. We have the potential for rescheduling. We have ultimately decriminalization, or legalization and somewhere along that path, we’re likely to pick up uplisting as well. So that’s three or four big events along the way. And I think you need to give yourself time as an investor to let those things play out.
And I think you have to be invested not to miss those. It would have been super easy not to have that invested in late August and missed this first 80% of the move. And at the same time, thinking about that timeframe, you need to give yourself time for new states to open. We have 23 adult-use states. So that’s about half of the U.S. and we have some big ones on the horizon.
Maryland just opened. We have the potential for Ohio and Pennsylvania, which are both big states, 10, 11 million people. And then we also have Florida, which is a huge state, 22 million people and 120 million tourists a year. And so again, going back to that core thesis about a state-led growth story with a series of hard to time political catalyst, I think the best way to harvest that opportunity is to own quality, be a longer term investor, give yourself three, five years plus to let that state led growth story play out and catch those series of political catalysts.
Emily Paxhia: We’re always looking at the operating companies, we’re always looking at SG&A containment. We like looking at gross margins. We like looking at and we break it down, too. I mean, I really look at the mix of the revenue of the businesses, like, how much of it is driven by the retail, how much of it is vertical, how much of it is wholesale.
And, yeah. So we look at, I would say when we’re looking at these public companies, we do look at the financial fundamentals of the business and it used to be that we looked at EBITDA. Now everything’s adjusted EBITDA. So you have to really dig in on what the a, adjusted is, like, what are they adjusting.
But I think if you can also just kind of trend track like, how they’re doing on their gross margins, how they’re doing on their path to free cash flow or cash flow from operations. And all of that backstopped by understanding the asset base and the mix of the revenue profile.
So, like, I would prefer to know that people are being very careful with their wholesaling and that they have a really solid retail footprint. And then there’s the brand mix, but I like to look at that too and understand how they’re doing in terms of their reach through on their vertical to the shelf space.
RS: Do you have an opinion on companies deferring taxes?
EP: I have a point of view on that that I think people are doing this as a strategy with a very specific objective in mind. I think as long as they’re accounting for it and they’re not spending money that they “don’t have”, it is the rate that they’re paying on the plans around deferring taxes, is like pretty appealing compared to the rate of lending in the industry.
And you can think about it, but what I would be nervous about is the people who, or if groups aren’t thinking about how they’re going to pay that tax bill ultimately. I mean I’ve seen when I’m looking at assets in California, I’ve seen far too many companies that you can’t even touch because they’re so – their tax situation is so up there, it’s pear shaped. And so you’ll never get out from underneath that. And guess who, I mean, the tax man always comes to collect. So you’ve got to be really careful.
But I think if it’s managed prudently and without hubris, I think, or with some humility, I think you can use that as a lever in building a business carefully. But I wouldn’t want to get on the wrong side of that.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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