Institutional Investors and Cannabis

Why Haven't Institutions Joined the Cannabis Rally?

Cannabis stocks have staged an impressive rally off the lows. Retail investors, especially Reddit and social media, have been in a tizzy on the news that cannabis is likely to be Federally rescheduled to Schedule 3. And now it looks like SAFE, or should I say SAFER Banking, which shields Federal Banks and other Federally chartered financial institutions from any risk of working with state legal cannabis businesses, is going to move in the Senate as well.

After years of anticipating change, these movements on Federal reform are what cannabis investors have been waiting for. But a funny thing has happened or rather has not happened since the news hit.

Not much money has entered the space, and specifically not much institutional or professional capital has entered the space. Consider that MSOS, the main cannabis ETF, has seen inflows of just $70 million (Thank you Jungle Java for helping me with this number!). This is simply nothing compared to the sheer size of the global financial system.

A $100 billion revenue industry going to possibly more than $200 billion and finally the financial world might be able to participate and a paltry $70 million enters?!

Why haven’t institutions entered the space in any meaningful size?

There are lots of good reasons. The first and most powerful one is the worry that all this movement on the Federal front is a head fake, or better yet this:

It could also be that most investors have watched or even participated in what happened in Canada and aren’t in a rush to potentially light more money on fire.

Another powerful reason may be that institutions just really don’t understand cannabis, the plant, the industry, the customer base or really anything to do with cannabis culture.

But instead of focusing on why they haven’t entered, I think it is much more valuable to focus on what will matter to institutional and professional investors when they do enter.

Here are some of my thoughts:

1.     When institutions start researching the space and doing due diligence, they are going to want to understand not only the competitive positioning of each company, but the unit level economics. What does it cost for a company to cultivate, manufacture, distribute and retail its cannabis products? What do those products sell for? What are the drivers of COGS (Cost of Goods Sold)? Are they going up or going down? Which states drives profitability? And this leads into my next point.

2.     Institutions are going to want much better disclosure from most cannabis companies. Most of the large publicly traded companies disclose none of the above. You can guess where the profitability comes from or which states drive the most cash flow, but due to the inherent complexity of how many different business lines large cannabis companies are in and the number of states they operate in, it is confusing to say the least. For example, how much of a large MSO’s revenue or cash flow comes from wholesale in a particular limited license state and what happens if prices go down, is a very important question. Institutional investors should and will demand better disclosures and if they don’t get them, they just won’t invest.

3.     Growth is going to be another big issue for institutional investors. Investors love growth because obviously this is what drives future value creation. When I first started my cannabis fund, many cannabis companies were growing at 30-40% a year and it appeared as if they had massive runways. However, a lot of that future growth ended up being a mirage due to crashing cannabis pricing and poor operational performance. In the upcoming third quarter earnings reports, many large MSOs will be lucky to grow their top line at 5%, much less 30%.

4.     And in addition to growth concerns, institutional investors are also going to probe and analyze each company’s balance sheet risk, because if the unit level economics don’t kill you, dilution and debt may instead. A lot of cannabis companies have less than stellar balance sheets and clearly need to clean up their debt loads. But even beyond their debt loads, there is also the issue of incredibly toxic sale/leasebacks. Many of the large cannabis companies are stuck in long-term, very expensive sale/leasebacks with escalating rent clauses that tie them into facilities for years. In my humble opinion, these are essentially debt bombs and institutions will be wary.

5.     The biggest kahuna though is interstate commerce risk. Right now, cannabis cannot cross state lines. This leads to all kinds of distortions in the market. The biggest ones being that cannabis pricing varies greatly from state to state and states that have natural advantages environmentally to be growing cannabis outside and in greenhouses such as California and Oregon cannot send weed to places like Illinois or New Jersey. If I’m an institution and a long-term investor, I know $2000 to $3000 a pound cannabis will not last. And frankly, I would be frightened that profitability at many of the limited license companies might go down more than 50% upon interstate commerce.

For an institution, if you are going to invest in the large cannabis companies playing in the limited license markets, I think you must hedge out interstate commerce risk by investing in a company that would benefit from interstate commerce like a Glass House Brands (OTC: GLASF) or a Grown Rogue (OTC: GRUSF). For what it is worth, I think the main cannabis ETF, MSOS, understands this risk and has done a good job of accumulating Glass House as a hedge.

This isn’t 2021 and too much money has been lost in cannabis to date. Interest rates are soaring, and the cost of capital is simply much higher than it was during the last cannabis bubble. Once you step back and look at the material issues weighing on publicly traded cannabis companies, you begin to understand the hesitancy and why institutions have yet to pour into the space.

But this doesn’t mean there isn’t opportunity or material upside. I believe that we are hearing the national anthem play before the first pitch of the first game of the season. The players haven’t yet taken the field. I believe there is more opportunity than ever before in cannabis, especially for small companies that are not hindered by legacy operations, expensive sale/leasebacks and are focused on operational excellence.

Institutions have yet to enter the cannabis industry and they will, it just may be slowly. And that is why I believe the real game has yet to begin.