The Seeds We Plant
The Mindset Value Fund Q3 2023 Investor Letter
Disclaimer: The below post is my Q3 2023 Investor Letter that I sent last week 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.
The Mindset Value Fund Q3 2023 Investor Letter
The Mindset Value Fund increased by approximately 11% in the third quarter on a net basis and is now up 47.4% for the year.
Seeds to Our Cannabis Surge Planted Last Year
Cannabis has driven almost all our positive performance not only this quarter, but also this year. It’s strange because this is the exact opposite of what happened last year, when cannabis was a heavy anchor pulling us down.
Part of the surge in cannabis is due to the news that cannabis might be rescheduled. I sent the following note to investors on August 30th:
Today, the HHS (Department of Health and Human Services) sent a recommendation to the DEA (Drug Enforcement Administration) that cannabis should be rescheduled to Schedule 3 from a Schedule 1 illegal drug.
The main takeaway from this news is the following: the Federal government is signaling to the entire world that the US government considers cannabis to be significantly less dangerous than it has in the past and is downgrading its view of its negative impact to society.
This is the biggest potential reform in cannabis history. Rescheduling to Schedule 3 is a big first step for the Federal government in righting a wrong put in place when cannabis was placed on the Controlled Substances Act by the Nixon administration, purely for political reasons.
When this rescheduling process is completed, 280e taxation (the excessive taxation plaguing this industry) will go away. But this is much bigger than just taxation. I believe this is a giant bat signal to the world and most importantly the financial industry that it will soon be safe to enter the cannabis waters.
I think that this is akin to the national anthem playing before the first pitch of the first baseball game of the season. The warmup pitches haven’t even happened, and the players have not taken the field.
And while this caused a big jump in cannabis stocks in September, a lot of the initial excitement has fizzled out. I wrote about how little institutional capital has entered the market since the news and speculated why: https://mindsetvalue.substack.com/p/institutional-investors-and-cannabis.
Our gains have been holding up for a few reasons. One, starting last summer, we moved up the capital structure and are invested not just in cannabis common stocks, but also preferred equity and convertible debt. Every quarter, we get inflows into the fund from these investments.
One example is the Glass House preferred investment we participated in last year. We get paid over 20% a year in interest (we also received warrants as well). I continue to think that the Glass House investment was the best risk/reward opportunity I have come across since I stood on the courthouse steps in Atlanta, GA in 2011.
But beyond interest payments, the real driver of performance is the results our cannabis companies are reporting and there is no better example than Grown Rogue (Canada: GRIN, OTC: GRUSF).
Grown Rogue Might Yet Be the Most Undervalued Cannabis Stock
Grown Rogue is an investor’s dream. It is a company with demonstrated operational and cost advantages that has a long reinvestment runway with extremely high returns on invested capital. In fact, in a Schedule 3 world with some financial protections from SAFER Banking, this is a lender or a private equity firm’s dream investment.
And the company is starting to go on the offensive with its cost advantages including entering the state of New Jersey. What happens when a company that is free cash flow positive at $800 to $900 flower prices enters a market with $2500-$3000 pricing and competition is low and so is quality? I wrote about the potential of that market.
Even in its existing markets, Grown Rogue is seeing sales and profits continue to soar, with revenue soaring by 48% last quarter and cash flow by 79%.
So, how does a company with some of the fastest growth in the industry that is now accelerating possibly trade at one of the lowest valuations on next year’s estimates?
First, not one analyst covers the company. Second, it is a microcap cannabis company and can be extremely illiquid. Third, even in cannabis, in which stocks are notoriously illiquid, buying Grown Rogue can be even harder than your average cannabis stock. For example, investors cannot buy the stock on Interactive Brokers, a major financial platform for small to medium sized money managers and investors. We have had to open two different Canadian brokerage accounts and work with sellers to buy shares. Though, we have done so happily.
Due to our early conversion of our December convertible, we crossed the 5% ownership threshold in Grown Rogue between our two funds and now own over 8% of the company. Here is our 13G filing. I expect our ownership to only increase.
Why? Because it’s not often you get the chance to invest in the following:
1. One of the best operationally run companies in a sector.
2. The fastest growth rate that is now poised to accelerate.
3. A clear and long reinvestment runway (almost too many opportunities right now)
4. Focused attention when competitors are struggling financially and distracted.
5. And then trading at 2 times my end of year 2024 unlevered cash flow estimate
The problem in cannabis is not limited licenses, but a shortage of operational excellence. The governor or limiting factor for Grown Rogue is talent and making sure they don’t bite off more than they can chew at any one time. Even though Grown Rogue is up more than 150% since the beginning of the year, I believe the upside is even greater now.
Glass House’s Operationally Excellent Quarter
Glass House (OTC: GLASF) announced yet another excellent quarter, which beat every forecast. But the most remarkable thing was the company announcing that production was much higher than expected.
Glass House announced a production increase that was at least 30% greater than my estimate and announced that they expect ongoing annual production to be approximately 30% higher than they previously thought. Instead of 270,000 pounds of annual biomass production, they now expect at least 350,000 pounds and there may be further opportunities to improve from even that number.
I don’t think it is any coincidence that the two companies with the highest growth rates in cannabis (Grown Rogue and Glass House) are also the best performing cannabis stocks for the year.
HireQuest Disappoints and the Market Overreacts
On the other end of the spectrum, one of our long-time winners HireQuest (NASDAQ: HQI) fell 40% in the quarter. The company announced a disappointing quarter that surprised investors including myself.
I believe several one-time items hit the quarter including a weakening in job placement demand, some abnormally high worker comp claims and a slower than expected integration with the company’s latest acquisition. Many of these should start to reverse in the soon to be announced quarter and I believe the company is working on multiple new acquisition opportunities to continue to grow.
The company’s superior franchise staffing model, high returns on invested capital, great management and a model that takes advantage of economic slowdowns puts them in a great position to continue to create value for shareholders.
Despite the steep decline, HireQuest is flat for the year. HireQuest’s decline highlights the overall struggles small and microcap stocks are experiencing. The Russell 2000 is down 3% for the year and flat for the last twelve months. And the index is up a paltry 14% for the last five years!
There is plenty of opportunity in small and microcap stocks, especially those that are growing and generating free cash flow. I believe the future remains bright for HireQuest.
Summary
Despite high interest rates, an uncertain economic outlook and continued geopolitical turmoil, I remain optimistic that our portfolio is primed for solid growth while being buoyed by dividends and interest flowing quarterly into the fund. With major changes coming in Federal cannabis reform as a tailwind, our quirky, asymmetric portfolio should be primed to continue its outperformance over the next twelve months.
Sincerely,
Aaron M. Edelheit