Are We Early or Wrong on Cannabis?
Mindset Value Fund Q1 2022 Update
Disclaimer: The below post is my Q1 2022 Investor Letter that I sent to investors in the Mindset Value Fund. This post is NOT a solicitation. I talk about stocks that I own and my view of the future. It is imperative that you do your own due diligence and not rely on anything written below. I’m posting this in order to show how my writing translates to actual performance. With that, I hope you enjoy and gain insights.
Mindset Value Fund Q1 2022 Update
We finished the first quarter down approximately 4.6%. We had a bit of delay in finalizing these numbers because we switched our custodial account from Pershing which prohibits ownership of cannabis stocks to StoneX (Former INTL FC Stone). This was a one-time switch and there should be no more delays in receiving your monthly statements going forward.
Poor April Performance
Our April performance was terrible. I estimate we were down approximately 14% in the month of April alone, and that we are now down approximately 18% for the year as of the end of April. It’s important to understand what is driving this. For the 57% of our fund that is not in cannabis, the average return of our investments is down 3%. This includes HireQuest (NASDAQ: HQI), Consorcio Ara (Mexico: ARA), Nelnet (NYSE: NNI), Universal Technical Institute (NYSE: UTI) and Lincoln Education (NASDAQ: LINC).
So, what’s driving the fall in our portfolio? It’s our sizable bet on cannabis.
New Jersey Lines Around the Block for Legal Cannabis
Imagine you were an investor in a private company, and that company just opened a new store, and this was the picture of the demand, a line that wrapped around the block:
Then imagine if you realized that in the next twelve months that this same scene was going to be repeated in Connecticut, New York, Maryland, Pennsylvania, and Virginia. And due to capital scarcity and the lack of cultivation capacity that these markets were going to be undersupplied for years. You would be telling everyone how smart you were, how awesome this investment was and how rich you were going to be in the future.
Now consider this exact scenario is playing out, but your private company is publicly traded. And instead of your company’s stock price going up, the stock price went down instead. This is what just happened with Verano (OTC: VRNOF) and many others, and it is a marker for how stock prices are not tracking fundamentals.
New Jersey finally allowed adult use sales on April 21st and the scenes were quite something. It is the first step in the start of the entire Northeast turning on. I wrote about this in a post called the Cannabis Nor’Easter.
What is remarkable is that two weeks past this launch, demand has not only not slowed down in New Jersey, I’m hearing sales are stronger than launch day. It is my opinion that estimates going forward for the second quarter and third quarter are now too low for those that are in New Jersey, like Green Thumb (OTC: GTBIF) and Verano.
And here is the conundrum, due to structural barriers blocking investment capital from entering the space, the stock prices are trading with other more speculative stocks. Neither fundamentals, nor valuations seem to matter and so cannabis stocks continue to fall.
Are We Early on Cannabis or Wrong?
The cannabis sector has been decimated this year. The main ETF, MSOS, is down almost 45% for the year. It’s even worse looking out over the last year, as MSOS is down 67% in just one year.
So, what is driving this precipitous decline?
First, let’s remember that cannabis is Federally illegal, but states have been legalizing either medicinal cannabis or full adult use. But due to the Federal illegality, US cannabis companies that “touch the plant” don’t have access to the Federal banking system, credit cards can’t be used in dispensaries and the leading cannabis companies not only pay extremely high interest rates, but also pay exorbitant tax rates, and trade on secondary or tertiary Canadian exchanges since they cannot trade on US exchanges. Finally, if that is not enough, most US investment banks and prime brokers will not hold in custody, nor allow any clients or even their own employees to invest in US cannabis companies.
And this has limited institutional ownership to a minuscule amount in the cannabis sector and the stocks trade limited volumes every day. Even the leading companies only trade a few million dollars’ worth of stock a day.
The pool of cannabis stock buyers has narrowed even further. An institutional portfolio manager who held sizable positions in the cannabis space was apparently fired in April and his positions have been liquidated into the broader market sell-off.
And I got word from a few international investors invested and focused on the space that they were recently prohibited from investing in US cannabis names near the end of the year.
So, who is left to invest? One answer is individual investors and those that are bit more aggressive than your average investor. And those aggressive investors are being taken to the woodshed recently. Consider this recent chart of ARKK, an ETF that is the epitome of the extreme overvaluation and hype about the future. ARKK and the cannabis ETF, MSOS, are almost the same chart.
Even though I believe cannabis is value, very few others apparently agree or are willing or able to step in to buy cannabis shares. Only a few other value investors have invested and most continue to avoid the space. If there is one mistake I have made in the last year, it is not appreciating who my fellow investors were and how their pain would inflict suffering on our cannabis positions.
The Importance of SAFE Banking
What would change the situation for our cannabis positions would be if cannabis was Federally legalized or de-criminalized. Considering the bitterly divided Senate, this is not currently politically possible. Congress could however pass a bill that shields financial firms from prosecution and allow state-legal cannabis companies to participate in the banking system, allow credit cards and allow most institutions to invest without fear of reprisal while the Federal government figures out broader reform. In fact, one arm of the government has passed such a bill.
Enter the SAFE Banking Act, a bill that has remarkably passed the House of Representatives six times. But here is the rub, it hasn’t come up for vote in the Senate even once. First, it was blocked by Republican Mitch McConnell when he was Senate majority leader and recently it has been blocked by Democrat Chuck Schumer.
I wrote about how in my opinion, SAFE Banking’s chances have increased because Senator Schumer no longer has to worry about a primary challenge from the left. I believe that the odds of SAFE Banking being passed either as a standalone bill or allowing it to be included as part of another bill like the America Competes bill is quite high and has increased substantially recently.
However, this past week, we learned that the timeline for the conference process for the America Competes bill, in which the House and Senate hash out the differences between their bills, is being blown out from May/June to possibly later in the summer. This may make it impossible for the bill to get through before bitterly fought midterm elections. This news added to the downward pressure in cannabis stocks, and you could feel investors giving up.
But there is an urgent reason why many Democrats and leading officials are starting to become more vocal about SAFE Banking: Crime. Treasury Secretary Yellen, Speaker of the House Nancy Pelosi, Senator Patty Murray (3rd ranking Democrat in the Senate) and more are all starting to speak up in favor of SAFE and are starting to get quite loud about it.
What happens when you allow businesses to flourish that mainly deal in cash and everyone, including the bad guys, knows these businesses only deal in cash? You get armored robberies and people getting killed. A recent article about Washington state’s woes highlights the problems.
In the state of Washington, Craft Cannabis Coalition showed that 80 cannabis-related robberies have occurred so far this year, surpassing all robberies combined from 2020 and 2021.
And just on Saturday, April 29th, in broad daylight in Tarzana (the San Fernando valley or greater Los Angeles), a dispensary was robbed and a customer was shot and killed. All this would come to a remarkable end if dispensaries were able to eliminate the need to deal exclusively in cash.
Democrats aren’t exactly known as the party for being tough on crime and the longer they hold back SAFE Banking the bigger this becomes a problem, especially in their home states. Guess which states just approved adult use sales: New Jersey and New York. And guess which dispensaries deal in cash and some of which are in higher crime areas. It’s a ticking time bomb in the northeast as states open and this is nothing to say for how social equity or any small business succeeds with a lack of investor capital.
I continue to believe that SAFE passes this year, it just may have to be later in the year and in the lame duck session of Congress. And this delay along with withering stock prices have caused many investors to give up and sell.
But outside of ongoing political delays, the future for our cannabis investments looks brighter than before, now that New Jersey is finally open for adult use cannabis sales. Third quarter earnings and beyond for our companies, especially for Verano and Green Thumb (OTC: GTBIF) are going to be spectacular, especially if Connecticut allows adult use sales this summer. Verano has 40% market share in Connecticut.
But even more than the fundamentals are the jaw dropping valuations that these companies now trade at. And none are as exceptionally undervalued as MariMed (OTC: MRMD).
Our Portfolio is Exceptionally Undervalued: The Example of MariMed
Why are we so focused and concentrated in cannabis? MariMed is a great example. This is a company without leverage, with 30% EBITDA margins, that is cash flow positive from operations and free cash flow positive, that raised guidance last year and then beat that guidance. And it trades at a remarkable 4.7 times TRAILING EBITDA.
I wrote up a detailed report on MariMed because the company’s forward estimates are too low. The company will be a prime beneficiary when Maryland allows full adult use sales and it is possible it trades at less than 3 times 2023 EBITDA. This for a company that has doubled revenue in two years, has deep management experience and has real brands that others have offered to acquire. There is simply no other industry that offers such extreme undervaluation.
Upcoming Fundamental Catalysts: A Lot to Look Forward To
Lest you think we are doomed to an ever downward spiral and that nothing matters consider that we own companies in which management own significant stakes sometimes of 50% or more like Nelnet and HireQuest.
Nelnet has recently been buying close to 0.4% of the company back every month and this year will have approximately $10 per share in cash roll off its student loan portfolio on to its books. The company also trades near book value.
HireQuest trades at 11.6 times my estimate of this year’s earnings and 8.9 times next year, despite having a near 60% operating margin and one of the best CEOs I’ve ever invested with. I’m expecting the company to report strong earnings on May 10th and continue its string of accretive acquisitions in which it converts mom and pop vertically integrated staffing companies into HireQuest franchises.
Consorcio Ara, which has been flat as molasses is poised to pay us a 6% dividend in one payment this summer and is opening 10 new home communities in Mexico in the back half of the year. Remember that Mexico has a shortage of homes and Consorcio Ara is sitting on a massive land bank and trades at less than 40% of book value.
And I personally cannot wait for Q3 earnings from our cannabis companies. I believe it will be eye-popping what is announced. Frankly, it will be hard to ignore even if there is no SAFE Baking or reform legislation.
This is what gets me excited, all our companies have strong fundamentals and sell at distressed valuations. Cash flows and fundamentals always win out in the end.
New Part-Time Analyst
I’m excited to announce that we have a new part-time research analyst. Fateh Mann has been an amazing asset. After 8 years operating in tech, he has followed his passion into the investment world. He's an insatiably curious individual who reads everything he can get his hand on, from annual reports to history books to fiction. And his level of diligence has been excellent. He is helping research new ideas, helping with new write-ups, and following existing positions so we can make sure we are casting a wide net and not missing anything.
It is really hard to watch stock prices go down, especially when fundamentals are strong, and the valuations seem so undervalued. One of the reasons that the private equity industry has grown so large in the past two decades is that many investors are so deeply uncomfortable watching short-term stock movements. Just hiding that volatility and pretending businesses and business valuations are smooth has simply been a great way to gather assets.
However, if you can weather volatility, keep your calm, and focus on fundamentals, in the end you will do just fine. At least this is what twenty-five years experience has taught me.
Thank you so much for your support and if you have any questions or want to discuss any part of the portfolio with me, please let me know.
Aaron M. Edelheit