Taking the Police Test
The Mindset Value Wellness Fund 2022 Year End Letter
Disclaimer: The below post is my Year End 2022 Investor Letter that I sent to investors in the Mindset Value Wellness Fund about over 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.
“Bro ..u have been wrong as rain. Take the police test.” - Random email I recently received in response to a newsletter post.
The Mindset Value Wellness Fund finished the fourth quarter down 13.7% and the year down 59.4%.
What police test is this person referring to, you ask? I’m not sure, but I’m assuming he means for me to examine myself, my thinking, and my strategy intensely. And when you were as wrong as I was last year and you don’t want to repeat the same mistakes, a deep dive investigation is in order.
Rubbing My Nose in It
I would like to share a different quote this time from Charlie Munger:
“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.”
I believe I made two big mistakes in cannabis. First, as I have discussed before, I did not realize how badly capital would flow out of the cannabis industry. And I also made a mistake believing in the long-term durability of the larger Multi-State Operators (MSOs).
Let’s start with capital flows.
I was completely wrong on capital flows. In the beginning of the year, I thought new investment capital was going to enter the industry and that it was unlikely for it to become harder to invest in the sector. I was wrong on both fronts.
The pain started in the second quarter when multiple brokerages and investment banks started to put more restrictions on trading and investing in cannabis. Then three different cannabis dedicated funds and portfolios were liquidated. With interest rates and inflation popping, the cost of capital surged as well.
Unfortunately, December was just as shocking to me as the second quarter. I was optimistic that there was a window to pass SAFE. But even I acknowledged that with politics, nothing was a sure thing. So, while I was not surprised that SAFE did not get included into lame duck session, I was quite surprised at the wholesale liquidations and massive December selloff in cannabis.
Further, I was wrong to think that individual company performance would matter or that low valuations would provide a buffer. With as illiquid as the sector had become, when investors gave up in December, all that mattered was the capital outflows.
The other big mistake I made was the belief that the longer it took for Federal reform to occur, the stronger the bigger companies, often referred to as Tier 1s, would become.
This theory came from the belief that the cash flows and larger companies’ access to capital would help weather any storm while smaller companies were washed away. There was also an expectation of a certain durability of the underlying cash flows. The flaws in this thinking were exposed as multiple cannabis markets such as Massachusetts and Michigan saw cannabis flower pricing plunge. Those markets followed what California and other Western markets were already experiencing. And with those declines came massive reductions in forward EBITDA estimates. Needham estimates that the top ten cannabis MSOs saw their EBITDA estimates fall by an average of 32% since the beginning of 2022 to the end of the year.
Add in a soaring cost of capital and the fact that many of these large companies used the good times to lever of their balance sheets and suddenly these companies don’t look as safe as they once did.
Further, many of the top companies have executed expensive sale/leasebacks as a form of financing, in which their lease costs go up every year. It’s not rocket science to see how dangerous a combination of falling prices, escalating operating costs, leverage and soaring cost of capitals do to the safety or valuation of your investment.
Finally, just the process of researching smaller companies such as Grown Rogue (Canada: GRIN) was an eye-opening experience. These smaller companies are wildly outperforming their larger peers, especially on the cost side. I’ve come to realize that it is cost control, efficiency and producing cannabis for the lowest price possible that is the most important thing, not size, and not limited licenses.
Course Correction Leads to a Portfolio Yield of Nearly 8%
And so, considering these two big mistakes, what have I done in response?
First, the simple recognition that I cannot predict capital flows, nor can I predict when Federal reform will come. I can guess, but that’s it. So, starting last summer and continuing through the end of the year, I started investing higher up the capital stack, to earn yield so that if cannabis reform takes longer than expected, I get paid while I wait.
Even though I believe the Biden administration will act in 2023 on cannabis reform, it’s still politics and as we all learned from 2022, it doesn’t pay to try and predict cannabis reform.
We have invested in the following high yield investments:
1. Glass House’s preferred equity offering that pays us a 20% yield and came with warrants as well.
2. We invested in a private cannabis company paying us an 18% yield that came with “penny” warrants.
3. We invested in a convertible note with Grown Rogue (Canada: GRIN) that pays us a 9% yield and allows us to convert into equity ownership of 6% of the company.
4. We ended the year investing a small amount into Body and Mind (Canada: BAMM) that pays an 8% yield that converts into the company at a very attractive valuation.
Now however, the cannabis fund possesses an 8%+ yield in addition to having substantial equity upside thanks to warrants and convertible debt.
Second, is that as I have written before I’m playing small ball, preferring to own smaller nimbler companies that have demonstrated operational performance that isn’t derived from limited license markets. My great awakening in 2022, is that it is operational excellence that is in short supply, not limited licenses. I believe that the advantages are tilted towards the nimbler and smaller and those who have shown an ability to control costs. This environment is perfectly set up for those companies to grow as others pare back.
Consider that MariMed (OTC: MRMD) just announced that it was going on the offensive with a new $65 million debt deal. With numerous assets turning on this year and with extra capital at a time when many companies are distress, MariMed is really poised to grow. I posted an interview and wrote about everything MariMed is turning on.
Grown Rogue is another company I expect to take advantage of the tough environment. I anticipate Grown Rogue entering new markets with its market leading flower and unbeatable prices. As a reminder, I wrote about the company and its amazing operational efficiency. I also recorded an interview with Obie Strickler, the CEO, that can be found on Spotify with this link.
Cannabis is still a $100 billion market and, in my opinion, it’s on its way to $200 billion in the long term. Capital is even more scarce since the fund started, institutional participation is minuscule, and the publicly traded companies involved are not only not listed in any major index or traded on any major US exchange, but they are also quite illiquid.
I remain bullish on cannabis. Why am I willing to endure crazy volatility, illiquidity and the short-term pain experienced to date? The upside from identifying the winners isn’t a couple of hundred percentage points, in my opinion, but it’s in the thousands of percentage points. So, if we stay focused and patient, make sure we correct any mistakes and focus on the companies that are demonstrating clear competitive advantages, the upside could not be greater.
2023 Should Be the Year That Glass House Breaks Out
I remain very bullish on our largest cannabis investment: Glass House Brands (OTC: GLASF). The company reported in November soaring revenue and margins for their third quarter as they turned on their “Ferrari” of a greenhouse. Even though they reported losses, the fact that they reported soaring gross margins at a time of such deep distress in California when other companies were reporting negative gross margins, proved our thesis that their unicorn of a greenhouse gave the company significant competitive advantages. But even further, our thesis is also that cannabis prices in California were far below the marginal cost of production and that California cannabis was going through its “negative crude oil price” moment. The stock with this as a backdrop nearly doubled from its lows as of the end of November.
We have done a tremendous amount of due diligence on the California cannabis market and are very confident in our understanding of the supply and demand situation. I was surprised when Glass House fell 51% in December due to the broader SAFE Banking related news. Why was I surprised? Because California cannabis prices were rising in December when they should have been falling. December is normally a time when prices should be falling due to excess supply from outdoor harvests that have been cultivated in what is known as “Croptober.”
And here we are near the end of January, and prices are bouncing materially higher. Multiple private operators tell me that prices are up at least 30-40% from the lows in September. If you read most commentary from brokerage reports or other investors, there is a belief that prices are “firming” and that prices are increasing slightly.
Here are a few quotes I heard from various cultivators in California in the last week:
“I wish I had more inventory. I don’t have any.”
“I am selling flower faster than I’m growing it.”
“I think we see $800 greenhouse flower by June.” (Note, it was around $375 in September)
I wrote a post about the looming inventory shortage of cannabis in California on January 12th. and wrote that we should be seasonally awash in cannabis flower inventory right now. We are not and there will not be any material supply response until at least November or the next major outdoor crop harvest.
But because prices are still not where they need to be for most farmers to make money and there is still no capital available (especially after SAFE failed to pass), farms are still going out of business, cutting back and not renewing licenses. Since I wrote my post two weeks ago, another 700,000 square feet of cultivation has not renewed their licenses and I estimate another 6 million square feet will leave the market by September, though it could be as much as 18 million square feet! In summary, the supply situation continues to worsen, as prices bounce higher.
On the other side is Glass House which should produce 300,000 pounds of cannabis biomass this year and is only utilizing 20% of its available capacity. Every $100 per pound increase in biomass pricing goes straight to Glass House’s bottom line in the form of an additional $30 million in cash flow. In September, Glass House was selling biomass for around $200 a pound. I estimate that they are now selling it for approximately $275 a pound. I expect since most cultivators are still not making money, that prices will have to keep rising or much more supply will come out of the market. At some point, something must give, and you could have soaring prices.
And Glass House will doubly benefit from flower prices rebounding because there has been tremendous competition on the CPG side of their business, which has struggled mightily. Smaller startup CPG companies have popped up and profited from the extremely low-priced flower thus enabling them to offer inexpensive CPG products made with that flower. Since those newer CPG companies don’t control supply, these competitors will be squeezed as prices go higher, which should finally provide relief to Glass House’s struggling CPG business.
Finally, Glass House completely re-engineered and reformulated its PLUS line of gummies, introducing a nano technology fast acting gummy, a solventless gummy, strain specific gummies and substantially improved packaging and branding. Remember that PLUS was a distressed asset when Glass House took the company over, and they have finally finished its overhaul. The PLUS re-launch was completed late in December, and we should start to see real benefits of the new improved PLUS line as the year progresses. Early consumer feedback has been positive especially from their strain specific line of gummies.
But then on top of this, right before I was to send out this report, news broke that California was moving on interstate commerce. Specifically, California’s Department of Cannabis Control that reports directly to Governor Newsom asked the California Attorney General Rob Bonta to issue a decision to allow cannabis interstate commerce sales. The summary is that I think this news spells the beginning of the end of interstate commerce restrictions. This of course has enormous implications for Glass House, which cannot sell cannabis across state lines. There are interstate commerce scenarios, in which Glass House could earn more than $5 per share in annual cash flow. That’s twice the current price of the stock.
For all those reasons and despite being frustrated at the panicked selloff in Glass House, I remain resolute in not only that things are getting better for the company, but the upside remains enormous despite how the stock performed in December. We not only own Glass House common shares, we own warrants (which increase our volatility up and down but give us significant upside) and preferred equity which is paying us 20% a year.
Let me leave you with one final quote from Charlie Munger: “Don’t go where the big boys have to be. You don’t want to look at the drug pipelines of Merck and Pfizer. Go where there are inefficiencies in which you can get an advantage and where there are fewer people looking at the stocks. Go where the competition is low.”
I believe there is very little competition in researching or investing in this space. I also believe that this fund has the potential to earn outsized returns in a capital starved industry with a very bright future. We are already having a much better January, so stay tuned as this should be a very different year.