CORZW - Investing In The New Cannabis World After A Terrible 2022

Summary

• A convergence of factors caused the poor performance of cannabis stocks in 2022.
• The investing environment has changed, and cannabis investors must change along with it.
• The potential for investor profits is as strong as ever, but investors must be strategically selective.
• Guidance and positioning for 2023 and beyond.

Could 2022 have been any worse for cannabis? Perhaps it wasn't a “perfect storm,” but it was a storm we won't forget. As the year progressed, the high beta cannabis sector followed all major market indices down. A growing risk-off attitude in the general market turned money away from all emerging growth. Quarterly reports were disappointing in the face of poor macro conditions for the industry. In December, tax selling has been exacerbated by failure of SAFE banking to make it through Congress.

The 2022 numbers

Legal sales in the US reached a record $25 billion, but shares went in the opposite direction. The table below shows the year-to-date prices of some widely held cannabis names: Ayr Wellness ( AYRWF ), Cresco Labs ( CRLBF ), Curaleaf ( CURLF ), Green Thumb Industries ( GTBIF ), ETF MSOS ( MSOS ),Trulieve Cannabis ( TCNNF ), and Verano Holdings ( VRNOF ). The best performer was Curaleaf, with a loss of 55%, and the worst was Ayr, with a loss of 92%. The average [mean] loss was 73%.

Cannabis stocks had lots of company. Most emerging growth sectors performed just as poorly, or worse. Wolf Richter's wolfstreet.com has a running commentary on what he calls “imploded stocks,” those down 70% or more. His list is very long. The table below shows year-to-date stock prices of five companies for which the investment world had great enthusiasm before 2022: AI lender Upstart ( UPST ), fintech Affirm ( AFRM ), real estate industry disruptor Opendoor ( OPEN ), ecommerce giant Shopify ( SHOP ), and bitcoin miner Core Scientific ( CORZ ). Four had losses greater than 90%, and there's growing doubt about the continued existence of a couple.

Even supposedly no-lose titans were down big. Amazon ( AMZN ) was down 51%, Google ( GOOG ) down 40%, and Meta down 65%. The cannabis sector has its own issues, of course, but an informed perspective is important. There's nothing inherently deficient about cannabis as a business or investment; the industry is following an inevitable emerging growth path full of challenges to be met.

Where are we now?

The current state of cannabis is a golden opportunity for every investor to decide on its future in our portfolios. Some people will want to get out completely and forget the experience – that's a legitimate choice. I have had experiences that turned me away from entire investing sectors (mortgage REITs, ugh!). But if you have read this far you probably want to continue with cannabis. So, acknowledging lessons learned, looking at the present landscape, and pondering future direction, we move forward.

A recent article by Leo Nelissen contained the following quote, which is a great place to begin.

I have realized that the past and future are real illusions, that they exist in the present, which is what there is and all there is. - Alan Watts

Money invested in cannabis at the height of the boom is not likely to be fully recovered. The past is done and gone. We must remember the lessons from the boom, but not let it distort our perception of cannabis present and future. There is big money to be made in the years to come from money invested now. It will require patience and the ability to ride out periods of high volatility.

No one knows when the current stressful conditions in cannabis will end. There are exogenous factors, like inflation, tight money, a shaky economy, and the failure of SAFE Banking, that come from outside. Other factors, like margin compression, competition, and high leverage, are centered inside the industry. The silver lining for investors is that conditions may have led to a capitulation phase, defined in Investopedia thusly:

Capitulation in finance describes the dramatic surge of selling pressure in a declining market or security that marks a mass surrender by investors. The resulting dramatic drop in market prices can mark the end of a decline, since those who didn't sell during a panic are unlikely to do so soon after.

Capitulation or not, the adverse conditions will eventually resolve, but until they do, investors have to tread carefully and prepare for an industry that may look quite different. In good times all companies do well, but in times of stress weak companies are culled out. Now is the time to emphasize the stronger, safer companies and avoid the weak ones.

Report from the heartland

A recent article in Politico, titled “A national weed glut is causing prices to plummet and imperiling businesses” highlighted this nationwide situation as it plays out in Michigan. After three years of adult use there, the legal market has reached $2 billion in sales. The number of outlets has grown 50% just this year, to about 600 stores. But the price of cannabis has dropped 75%, from about $400/oz to $100. There are too many people trying to cultivate and sell legally, not to mention the estimated 70% of sales that are illegal, and many businesses are heading towards existential crisis. “We are starting to see a lot of people who are wanting to sell,” according to the president of C3CRE, a Michigan real estate company specializing in commercial cannabis properties. “For well-funded, good operators, there will be plenty of opportunity to scoop up people for cheap.” Consolidation is receiving a lot of attention within the industry. A recent article in MJBizDaily, titled , “How to navigate consolidation in the cannabis industry,” is very informative from the business point of view.

This is the situation playing out across the country, and it will be an important theme over the next few years. I have been educating readers about important changes in industry dynamics like this with articles like A reassessment of the cannabis ETFs and Trulieve: Why you must own this future dominant cannabis company . Investors must manage their portfolio to account for the transition from an environment where growth trumps all to one where strength, skill, and execution are the focus. The sections below give some guidance about how to manage the transition.

Size matters: In general, the larger cannabis companies have an advantage over smaller ones. There are economies of scale in sales, marketing, manufacturing, and administration. A larger financial base means it's easier to expand in a new area or state, and a failure is less impactful. It's easier to attract attention from investors, and easier to raise money on favorable terms. It's not a coincidence that the two companies that have borrowed at the lowest rate to date, 7%, are Trulieve and Green Thumb, among the largest.

Geography matters : The geographic areas in which a company operates can make a big difference. On the positive side, the favorable environment in Florida has allowed Trulieve to become one of the dominant players there, and the financial strength they accumulated has facilitated major expansion into other states. The likely addition of Florida adult use in 2024 will be another huge tailwind for them. New Jersey is another example of a beneficial environment. Although a liberal state, progressives have not yet wrested control from the old boy network in state government. Cannabis is regulated and taxed with a relatively light hand, and the social equity component is not a hindrance. Companies like Ayr and Green Thumb are reporting excellent results there.

On the negative side, companies with a large or exclusive presence in areas with difficult regulatory regimes are suffering. They will continue to suffer, because those states have shown no ability or inclination to change. Success for companies with important operations in Canada, California, New York, and certain other states will continue to be elusive.

Financials matter : Investors are advised to take a close look at the financial performance of each cannabis holding. Cash flow, cash on hand, gross profit, net profit, debt, etc. take on extra importance in times of stress -- that's when the weakest players are in the greatest danger. It is beyond the scope of this article to examine individual companies, but more detailed analysis is planned. As readers may have surmised, a good place to start is with cannabis heavyweights like Trulieve, Green Thumb, Curaleaf, and Verano. Some analytical comparisons have appeared recently on Seeking Alpha, including my Green Thumb: Undisputed Cash Flow Champion In Cannabis and articles by financial veteran James V. Baker.

An illustration of how these comparisons can be useful is the debt to equity ratio for a sample of companies shown below.

Look sideways : As noted above, the projected growth of cannabis is very strong for years to come However, regulations, state fees and taxes, impediments to banking, confiscatory federal taxes, and illegal sales make it difficult for cannabis sellers in the US and Canada to turn a profit. A way to get past these impediments is to invest in companies where they are not a factor. These companies will benefit from the growth of the industry, some even from growth in illegal sales, without being tied to success in specific companies or states. There are several types:

• Ancillary businesses: These are companies that do not cultivate or sell but provide goods or services to those that do. WM Technology ( MAPS ), formerly Weedmaps, provides ecommerce and other software to cannabis companies worldwide. GrowGeneration ( GRWG ) and Scotts Miracle-Gro ( SMG ) both provide supplies and equipment to cannabis growers. They are not cannabis pure plays, but will benefit from industry growth.

• REITS: Innovative Industrial Properties ( IIPR ) and New Lake Capital Partners ( NLCP ) are REITs that provide capital to cannabis companies through sale-leaseback transactions, making money through lease costs.

• International: Cannabis outside the US and Canada is growing faster and will be larger than the North American market . The Global Cannabis Report projects the $44 billion global market in 2022 could rise to $100 billion by 2026. Europe is where North America was 4-5 years ago. Some NA companies, like Tilray ( TLRY ) and Aurora ( ACB ), are targeting Europe, but it is a small part of their business and it's not clear that they will be viable competitors. The European market is new, and finding a worthy company accessible to US investors is difficult. One that shows promise is InterCure ( INCR ), which is presently the largest pharma-grade cannabis company in the world.

Special note on the SAFE Banking saga

An end-of-year cannabis article is not complete without a discussion of the failure to pass a SAFE Banking act. There was strong support for it in the Senate, but in the end it fell victim to byzantine and messy Senate politics. The importance of legislation like SAFE for investors was clear. Many stocks rose as much as 50% in the lead up period, only to fall back even more when it failed. Given the still improving progress of cannabis on the federal, state, and popular levels, it's only a matter of time before SAFE or similarly important legal developments are reintroduced and passed. The process will likely take years, which is little consolation in the short term, but important context for long term investors. Also, social progress of this sort "lumpy," and there's the possibility that it could arrive suddenly and unexpectedly. Certainly everyone was surprised by Pres. Biden's announcement that Federal convictions for possession would be expunged.

Cannabis is growing but changing

Cannabis is following the path of every emerging growth industry: introduction, growth, maturity, adaptation or decline. It's still in the growth phase, but according to the Global Cannabis Report by Prohibition Partners capital raises were down 60% and M&A volume down 80% through October 2022 compared to 2021. It is starting to touch the maturity zone, at a spot where there are an unsustainable number of new businesses and consolidation is the future. This is a multi-year process, although in our high-tempo society it will be more compressed than in decades past.

This is not the time to be an investment “hero,” putting money into small, unprofitable companies that haven't demonstrated the ability to succeed in the past under comparatively better conditions. If we do so, there should be a compelling reason why such a company stands out. As a more general rule we need to be positioning ourselves to own the companies with the best chance to survive and thrive. Developing a cannabis portfolio for the future means committing to an honest assessment of each company and doing the work to make that assessment meaningful. It requires time and energy, but these are necessary ingredients in any successful endeavor. Some general guidelines are given here: size matters, geography matters, financials matter, look sideways. More specific assessments will follow throughout the year.

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