Small Ball
Disclaimer: The below post is my Q3 2022 Investor Letter that I sent to investors in the Mindset Value Wellness Fund about two weeks ago. 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.
Dear Mindset Value Wellness Investors,
The Mindset Value Wellness Fund lost 5.2% in Q3 and is now down 53% year to date.
But a lot can change in cannabis, and I’m happy to report that as of the writing of this letter, we are up more in October than we lost in Q3, and we are currently down 44% for the year. And it’s all thanks to President Biden.
Biden Moves on Cannabis
President Biden created a shockwave in early October by announcing pardons on cannabis. It was shocking because his administration has been almost stone cold silent for his entire Presidency on the issue of cannabis. Specifically, Biden granted a pardon to people Federally convicted of simple possession of cannabis. More importantly, Biden called on the Secretary of Health and Human Services, and the Attorney General to “expeditiously” review how marijuana is scheduled under federal law (it is currently classified as a Schedule 1 Drug with no medicinal benefit).
I think the Biden administration has started the process to end the prohibition on cannabis and that the administration will either reschedule cannabis to schedule 3 or lower, or de-schedule cannabis altogether and that it will happen by the end of 2023. I wrote a post about my thoughts that you can find here:
We now have state led ballot initiatives moving in multiple states, Congressional reform with SAFE Banking and the executive branch finally moving forward on cannabis reform. I’m expecting some real fireworks to start after the midterm elections on November 8th.
Our Cannabis Portfolio Now Yields 4.5%
In the meantime, we aren’t just holding our breath and praying for reform. Through our investment in the senior secured note of a leading private cannabis brand we mentioned last quarter and our investment in Glass House’s (OTC: GLASF) preferred equity offering, our portfolio now yields 4.5% on an annual basis, and we are not using any leverage. Along with that yield, we also received warrants with substantial upside in both the private cannabis brand and Glass House. We are on the hunt for more yield with equity upside deals and are in the final process of investing in a cannabis company with attractive retail dispensaries in multiple states.
While I think reform is finally on the way on the Federal front, I could be wrong about the timing. Clipping yield while we wait removes much of the risk of investing in cannabis, which is that it just might take a long time for Federal reform to happen.
We Are Playing Small Ball
There is an idea in cannabis investing circles that bigger means better in terms of quality of the company, management, capital allocation and thus bigger is better for shareholders. These larger companies, also called Tier 1 Multi-State Operators (MSOs), should have greater access to capital, better access to top talent and and that the longer that it takes for Federal Reform, the better it is for these Tier 1s as they can entrench their footprints, brands and have bigger scale than smaller companies and competitors.
Green Thumb (OTC: GTBIF) is supposed to be the best of the Tier 1 cannabis companies, but are you really Tier 1 material if half your board suddenly resigns along with your general counsel? This follows two other directors who resigned earlier this year. The company has seen five directors in total resign from its board this year. Green Thumb only has six directors!
Other Tier 1s have had accounting problems, a revolving door of auditors, and questionable capital allocation decisions. The largest Curaleaf (OTC: CURLF) hasn’t even transitioned yet to GAAP accounting, which normally causes a significant decrease in reported cash flow.
Layer on top of these problems the fact that many of these Tier 1s have very quickly levered themselves at a time when interest rates are soaring, and the cost of capital is soaring as well. Refinancing these debts will not be easy or cheap.
And many have signed long-term sale-leaseback arrangements that lock these companies into expensive leases with escalating costs for a decade or more at a time when cannabis pricing is under pressure. And this is not even to mention the threat of interstate commerce. Many of these Tier 1 MSOs depend on interstate commerce restrictions remaining in place thus restricting the supply of cannabis and allowing outsized returns from regulatory capture. What exactly happens when you are locked into expensive contracts you can’t get out of, while the price of your product falls? And what happens if interstate commerce restrictions no longer exist?
Another risk I did not fully appreciate is that state regulators in several key states really don’t seem to like the MSOs and have been actively throwing sand in their gears to slow them down. A great example is how regulators slow-walked the rollout of adult use in New Jersey, seemingly on purpose.
Further, with Congress and now the Biden Administration looking at significant changes in cannabis regulations, the regulatory environment seems in flux. Does cannabis get re-scheduled? Does it get de-scheduled? With this much change on the near-term horizon, does it make sense to be invested in lumbering giants that are heavily indebted and/or locked into expensive operations?
I admit I fell for this idea when I first started the fund. I was invested in Tier 1s like Green Thumb and Verano (OTC: VRNOF). But after a series of disappointments in the quality of management, governance and capital allocation decisions, I’ve decided to stop and invest elsewhere.
The definition of insanity is to do the same thing repeatedly and expect different results.
I’m still very bullish on the future of cannabis and think that it is a question of when, not if cannabis becomes legal. But I’ve changed my investment strategy and the focus is now on smaller, nimbler companies. I’m calling this strategy: Small Ball.
I want my companies and my portfolio to be more like the Golden State Warriors than the lumbering Los Angeles Lakers. I want speed and agility, and not to be stuck in the past with aging “stars.”
And I’ve come to believe that efficiency and cost structure will be the key, not size. With a weakening economic backdrop and soaring capital costs, efficiency and speed will be the key to not only surviving, but will enable these smaller, more efficient operators to thrive.
This means our portfolio is invested in companies like Glass House, which is a low-cost producer of high-quality cannabis and has structural cost advantages. We are also invested in MariMed (OTC: MRMD), which has one of the cleanest balance sheets in cannabis, and is a scrappy, nimble operator that also possess real brands like Betty’s Eddies.
We also now own a large position in Goodness Growth (OTC: GDNSF), which after the termination of the merger with Verano, went from being a prized asset to an afterthought by investors focused on the so-called “Tier 1” companies. At a market cap of approximately $55 million, we think it is very undervalued on an asset basis and wrote a post about it.
The idea that we can invest in a company with licenses in New York, Minnesota, Maryland and New Mexico, states that represent 10% of the US population, for less than $60 million with some interesting patents sprinkled on top seems like a steal to me.
Summary
Federal Reform has never been closer. And the end of the year could bring crazy fireworks in terms of reform. I’m expecting that after the midterms, we should see substantive movement on SAFE Banking, which should allow more investment dollars to flow into the industry. I also believe that the Biden administration will move in 2023 on re-scheduling or de-scheduling cannabis. And last, but not least I expect California to move independently of the Federal government on interstate commerce in 2023.
For the capital starved cannabis industry, this is an incredible time to invest. Valuations are low and we are investing in very attractive investments in companies with durable competitive advantages.
Thank you so much for your support and let me know if you have any questions.
Sincerely,
Aaron M. Edelheit