MSOS - MJ And MSOS: Likely No Immediate Reprieve

2023-07-26 13:36:33 ET

Summary

• The marijuana industry has not rewarded patient investors as expected, even five years after Canadian legalization and despite hopes for federal legalization in the U.S.
• History shows that new industries often see a surge of companies emerge, but only a few survive as the industry matures and marijuana investors may have to bear more pain.
• Popular marijuana ETFs have seen close to 90% drawdown from their all-time highs, with poor returns and high expense ratios, suggesting the industry lacks clear direction.
• The vast majority of the components of the ETF are unprofitable, face declining equity and are seeing major shareholder dilution.
• Investors hoping for federal legalization will likely have to wait a lot longer and the industry will have to re-tweak its strategy accordingly.

I think one of the best examples of how wrong investors can get sometimes is the marijuana industry. The understanding was that the industry was going to reward patient investors but that has not happened even five years after the Canadian legalization. The wave of legalization with other countries following suit was likely expected by many to reward patient investors. That hasn't happened either. I think a lot of hope was pinned on federal legalization in the U.S. But even with a democratic president, there hasn't been much progress on that front. What does the future hold? Is there any hope for the handful of patient investors still believing in the marijuana story?

Nascent industry, same problems

Investors get all too excited whenever a new industry shows up. The promise and potential of a new industry is all too alluring and the narrative picks up accordingly. Too often, it is forgotten that history has not been kind to any new industry. During the initial adoption phase, numerous companies emerge buoyed by the excitement and capital flowing into the industry. However, as the industry matures, only a handful of these companies manage to survive.

A notable example is the automotive industry in America, where around 2,000 car companies existed between 1900 and 1920. Yet, by the 1930s, this number significantly decreased to only a few dozen, and over time, it further declined.

A more recent example was the fad during the internet era. Almost 50% of the companies went bust post-this era and many never reclaimed the highs they established during that time.

I believe we repeated a similar cycle for the Marijuana industry and we are still quite some time away from the bottom . Does that mean individual companies are a bad bet and ETFs are the way to go?

ETFs are safer, they say

This is not entirely accurate in my view. The drawdown for some of the most popular marijuana ETFs has been brutal. The two ETFs with sizeable Assets under Management would be ETFMG Alternative Harvest ETF ( MJ ) and AdvisorShares Pure US Cannabis ETF ( MSOS ). Both have seen close to 90% drop from their all-time highs and also have a big negative return since their inception. Without proper risk management, this would have been disastrous for a portfolio. These ETFs also have around 0.8% expense ratios and it is hard to justify paying this kind of management fee and getting such returns.

Let us dig into the ETFs and understand the components that has resulted in their poor returns.

AdvisorShares Pure US Cannabis ETF ( MSOS )

Actively managed and non-diversified ETF that aims to have a minimum of 80% of its net assets in securities of companies deriving at least 50% of their net revenue from the marijuana and hemp industry within the United States (or in derivatives that share similar economic characteristics). It also focuses on concentrating at least 25% of its investments in the pharmaceuticals, biotechnology, and life sciences industry group within the health care sector.

MSOS is the top marijuana ETF in the U.S., with over $330 million in assets. Instead of holding stocks directly, it uses total return swaps, which are contracts exchanging cash collateral to gain the returns of an asset. This is necessary because federal and custodial banks limit direct investments in U.S. cannabis companies by ETFs. The idea behind the ETF is that the companies based in the United States are engaged in the largest marijuana market globally, and they stand to gain the most from banking reform or any favorable changes at the federal level regarding cannabis.

ETFMG Alternative Harvest ETF ( MJ )

The investment aims to achieve results similar to the overall returns of the Prime Alternative Harvest Index and is non-diversified (This index monitors the performance of common stock from companies worldwide). The fund will allocate at least 80% of its total assets to the securities listed in the index, including ADRs and GDRs related to those securities.

The idea behind this ETF is that International cannabis sales are expected to increase, with Germany emerging as a hot spot for growth as it moves forward with recreational legalization. The fund with over $200 million in assets under management, is the second-largest cannabis ETF after MSOS.

I went ahead and analyzed the components of the ETF and wasn't too pleased with the results. I could not find a profitable company that had improved shareholders' equity or did not have shareholder dilution. The few ones that have positive operational cashflows were quite influenced by Stock-based compensation

This means the whole industry is suffering and lacks any clear direction. One may argue at least ETFs are safe in the sense that they may not go bankrupt. But you may be forced to liquidate based on the Assets under management. Continued bad performance on the components means investors might start to lose confidence in the industry, AUM could start to drop and you could potentially have a fund that decides the best course of action is to liquidate and return the money to shareholders. In fact, this is exactly what happened to Evolve's two cannabis ETFs. The ETFs lost more than 50% in less than two years and they decided to liquidate.

No immediate reprieve

If there are any investors waiting for U.S. legalization to save the ETF, then the wait may be a little longer than originally thought.

The cannabis industry's hopes for federal legalization have been dampened by various political and regulatory challenges. Florida Governor Ron DeSantis, if elected president in 2024, has expressed no intention to decriminalize cannabis. Neither President Joe Biden nor other major candidates are supportive of cannabis legalization in my view. In any situation, legalization could be at least 5 years away. Despite widespread public support, federal cannabis reform seems to face obstacles due to politicians' lack of prioritization. The review of marijuana's Schedule I classification still remains complex, with approval from the FDA being a crucial benchmark. Overall, while there have been significant advancements in cannabis legalization at the state level, the path to federal legalization remains challenging and dependent on various political factors.

For the companies in the ETF to turn a corner, they will have to re-tweak business strategies to focus on state-level reforms. This could be a unique situation for any industry. Many industries count on scale and transportation on a country level to benefit their economics. Therefore, it is a difficult path but I believe it remains the only path for the immediate future.

For further details see: