MJ - MJ: A Bet On Cannabis Legalization

2023-05-31 05:46:24 ET

Summary

• The fund is an ultra-aggressive bet on the legalization of marijuana. The market for this plant actually exists in a legal "gray area."
• The market is potentially very voluminous, but the whole issue is expanding the area of approval of the plant.
• There's no point in looking at the low valuation - the scale of the issuers is small, and some don't even have the revenue.
• Investors have been waiting 5 years for progress on federal approvals. In 2021, after Biden was elected, it might have looked like federal legalization was waiting for the market, but no.

Introduction

Essentially, by buying the foundation you are betting on the ultra-aggressive legalization of marijuana. The market for this plant actually exists in a legal "gray area" where federal, state and local laws often contradict each other. Medical use is legal in 38 states, and recreational use is legal in 21 states after a wave of successful ballot measures in recent years. Only four states in the U.S. now have total prohibition, but even these states have gradually decriminalized cannabis possession and production over the past decade . More than two-thirds of the U.S. population now supports the legalization of marijuana, up from about 15 percent in the 1970s and 35 percent in the early 2000s, while about one in eight Americans regularly uses cannabis. The market is potentially very large, but it's all a matter of expanding the area of approval of the plant. While medical cannabis use is becoming more common, growth in recreational use will depend on increased tolerance and official legalization around the world. It is these expectations that are built into the projected 15% growth rate of the market. But legalization is slow, and the FDA has only approved 1 cannabis-derived drug and 3 cannabis-related drugs so far.

General Info

Launched December 03, 2015, ETFMG Alternative Harvest ETF (MJ) follows the Prime Alternative Harvest Index (provided by the Chinese investment research firm Prime Indexes), which tracks a portfolio of 32 companies benefiting from global initiatives to legalize cannabis for medical and recreational purposes.

The fund contains exposure to the healthcare sector (cannabinoid producers), real estate (lending to cannabis companies, providing them with real estate) and consumer protection (tobacco companies). The bet is on the industries:

• Health care, pharmaceutical manufacturers (cannabis-based). The size of the global pharmaceutical cannabis market is estimated at $51.3 b$ in 2023 and is expected to reach $92 b$ in 2027 (CAGR 15.77%). The main growth trigger is the legalization of cannabis for medical purposes, the high risk of chronic diseases after age 50 for which cannabis-based medicines are applicable.

• Real estate, mortgage and specialized REITs (the share of 7.52% from the financial sector listed in the ETF prospectus can also be included here, since it is REITs in the fund that invest in and lend to companies growing plants and making drugs from them). There is no profitability forecast for these funds, but given that the trigger for their growth is similar (legalization of the product), the growth rate of the industry is comparable to that of drug manufacturers. Owning the physical real estate behind the cannabis industry has historically been more efficient than investing in producers. But after several small property tenant defaults in 2022 (due to a 60% decline in cannabis costs), rent collection problems, and loan yields, REITs have fallen 60-90% over the past year.

• Consumer protection sector (tobacco companies). The forecast for revenue growth for 2023 is 8.5%, and for profits - 5.1%. For 2024, the revenue growth forecast will fall back to 2017 levels (+4.6%), while the profit growth rate will continue to move toward the upper end of the 10-year range (+7.4%). Smokeless product growth and stable demand for tobacco products are key drivers of market growth.

Top 5 holdings

• Tilray Brands ( TLRY ) - Medical and cannabis products, including oils, vapes; alcoholic beverages, cannabis-based foods and other health products. The company is loss-making, P/S FWD 2023: 2.4 (-42% to the industry average);
• SNDL ( SNDL ) is a licensed Canadian cannabis producer and the largest liquor retailer. The company is loss-making, P/S FWD 2023: 0.5 (-87% to the industry average);
• Cronos Group ( CRON ) is a Canadian cannabinoid manufacturer. The company is loss-making, P/S FWD 2023: 6.7 (+66% to industry average);
• Canopy Growth ( CGC ) - Canadian cannabis producer. The company is unprofitable, P/S FWD 2023: 2 (-61% to industry average);
• Chicago Atlantic Real Estate Finance ( REFI ) - leading mortgage REIT investing in real estate and lending to state-licensed cannabis operators. P/E FWD 2023: 7 (-16% to industry average);

Disadvantages

In addition to the uncertainty in the market, there is another disadvantage: the cheapening of the product. Cannabis retailers are under pressure from a weak pricing environment. You have to understand that growing cannabis is a very simple process, it is very easy to enter the market, and companies have no technological moat at all. Many companies entered the market in 2018, the second wave came in 2021, after Biden was elected in hopes of legalization. As a result, for example, wholesale marijuana prices in Colorado fell to a record low of just $658/lb in 2022, down more than 50 percent from 2021. Production costs are estimated at $800 to $900/lb. The U.S. Cannabis Spot Index (Cannabis Benchmarks) also set a series of record lows in 2022, with the national average dropping to $956/lb. in December 2022 - about 35% below the average price from the previous five years and more than 50% below the 2015 average amid the first wave of state legalization.

The ongoing federal ban and resulting restriction of access to traditional banking services has forced companies to turn to alternative sources of capital. These have become REITs, effectively serving as "unbanked" lenders to state-licensed cannabis growers who are often denied access to traditional lending from banks. But the REITs themselves - both those who make loans and those who rent out properties - are under pressure because of periodic bankruptcies of growers. They get a higher rate from loans, but it doesn't pay off because of bankruptcies and defaults caused by lower product prices.

Of the top 10, there's not even anyone to note - 2 REITs that are not interesting because of pressure on "recreational" producers, the rest are solidly loss-making "junk" companies with a $0.4-$3 share price.

Bottom line

In general, there is no point in looking at the low grade - the scale of the issuers is small, some don't even have revenue. In connection from the pharmaceutical sector with a prohibitive P/S has no approved products. Its entire portfolio is 28 different R&D programs and 6 clinical trials of drugs. Investors have been waiting a long time for progress on federal approval. And it's not a case of companies just stagnating while waiting for federal legalization. The situation in their business is getting worse every day. That is, if you go into MJ's hoping for quick progress among U.S. lawmakers, you'll get 30-50% in a year.

What's worse is that after legalization, the big pharma companies will come into the market and squeeze the small manufacturers that make up the foundation. They have much more resources, and they will be able to lower production costs, and the ease of growing removes all market barriers. Therefore, MJ is a speculative tool that can be used either in the run-up to the elections or at the news of legalization.

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