MJ - MJ: I Have No Conviction In Cannabis Penny Stocks

2023-06-19 06:21:52 ET

Summary

• The ETFMG Alternative Harvest ETF is the first cannabis-focused ETF to trade in the US, investing in companies engaged with legal cultivation, production, marketing, and distribution of cannabis and tobacco products.
• Despite its diversification, MJ's performance has been disappointingly low, with a total return rate of -88%.
• The future of the cannabis sector looks uncertain due to volatile small-cap cannabis stocks and slowing growth.

Strategy

Launched and managed by ETF Managers Group LLC in 2015, ETFMG Alternative Harvest ETF (MJ) is the first cannabis-focused ETF to trade in the United States. MJ invests in the stocks of companies engaged in the legal cultivation, production, marketing, and distribution of cannabis and tobacco products. It invests in growth and value stocks of companies across diverse market capitalizations and seeks to track and replicate the performance of the Prime Alternative Harvest Index. The portfolio is market-cap weighted and does not invest in swaps but holds ETFs using swaps to gain exposure to similar indexes. Moreover, MJ invests in a variety of countries globally but focuses mainly on the US. The index is reconstituted and rebalanced on a quarterly basis.

Holding Analysis

MJ invests in myriad industries that engage with cannabis, including health care, pharmaceuticals, biotechnology, and life sciences, to name a few. The fund allocates nearly 80% to securities in the US, but also invests in Canada, the United Kingdom, Australia, Israel, and Denmark. Most notably, MJ invests in two other ETFs, ETFMG U.S. Alternative Harvest ETF (MJUS) and ETFMG Sit Ultra Short ETF (VALT), with 54% and 10% weight, respectively. Overall, the fund invests in a total of 35 holdings and allocates over 92% weight to its top 10 holdings, leaving less than 8% for the rest of the 25 holdings. A comprehensive distribution of the fund's sectors and top 10 holdings can be seen in the charts below.

Performance Analysis

MJ's historical performance has been surprisingly underwhelming. Despite various peaks over the last 5 years, the fund has demonstrated high volatility and has been on a consistent downtrend since the beginning of 2021. MJ seems to have an inverse relationship with the S&P 500, having a total return rate of -88% while the S&P 500 has a rate of 73%. The fund has continued on its downtrend even after the S&P 500 started showing signs of recovery nearing the end of 2022 and throughout 2023.

Moreover, Seeking Alpha gives MJ a momentum grade of F, with Fs across the board for every metric. MJ's performance has consistently been in the negative for both the short term and long term. The fund has also been given a rating of Strong Sell by quants every day for the past two years.

Strengths

Amid a sea of weaknesses, MJ stands to benefit from a portfolio diversified across various sectors. As shown above, the fund allocates a substantial portion of its portfolio to sectors like health care, real estate, and consumer defensive. Among cannabis ETFs, MJ allocates more holdings to non-cannabis holdings than others. This strategy could potentially provide a level of stability that is not seen in the volatile small-cap cannabis industry. The health care sector is projected to grow at a CAGR of 12.9% each year from 2023-2027, reaching a market volume of nearly $28 billion by 2027. Moreover, Chicago Atlantic Real Estate Finance ( REFI ), a cannabis REIT with over 3% weight in the portfolio, demonstrated steady growth in 2023, being up 6%. Also, Innovative Industrial Properties ( IIPR ) showed strong growth in the past month, being up nearly 6%. If MJ begins to shift more weight to holdings like these, I believe the fund can somewhat balance out the poor performance of most individual cannabis stocks with larger-cap stocks in industries destined for higher growth.

Weaknesses

MJ has been down nearly 90% in the past 5 years, a trend that can be attributed to the poor performance of volatile small-cap cannabis stocks. Alongside this, I do not foresee a highly profitable future for the cannabis sector. While the sector has experienced slight revenue growth each year from 2017 to 2021, revenue growth is forecasted to decline from 2021 to 2027, dropping by nearly 25% in that time period.

Although cannabis sales in the United States are forecasted to grow from 2022-2028, the growth is undoubtedly slowing down throughout the years, as shown in the chart below. Combine this slow growth with increased competition in the market, and small-cap cannabis companies will continue to struggle to gain traction. While there is an increase in volume as the number of dispensaries and clinics increase, profits for individual companies will decrease, ultimately causing prices to crash .

Merging of e-cigarette and cannabis industries

On the bright side, we can anticipate some developments in the cannabis sector that do not relate to its federal legalization. Most notably, the merging of e-cigarettes and cannabis can provide significant opportunities for the cannabis sector. While e-cigarettes were originally developed for the vaping of nicotine, this method has been increasingly embraced by the cannabis industry to discreetly inhale THC, the active cannabinoids found in cannabis. This development can significantly reduce the prominence of gray and black markets that have facilitated the rise of these THC vaping products. With more regulation and oversight over these markets, legal cannabis companies can stand to benefit from their increased market share, ultimately driving growth in the industry. The National Institute of Justice is planning to hold a presentation addressing the merging of the e-cigarettes and cannabis industries on June 29, 2023.

Conclusion

MJ is the first cannabis-focused ETF to trade in the United States, but its performance since its inception has been overwhelmingly disappointing. Over the last 5 years, its performance seems to have had almost an inverse relationship with that of the S&P 500. Its historical returns demonstrate high volatility, with a significant downtrend since the beginning of 2021. The fund's primary weakness is the inherently volatile nature of micro-cap and small-cap cannabis stocks. Combine this with a stalling federal legalization environment and increased competition in the market, and small caps will continue to struggle. Overall, I do not have faith in the US cannabis industry, and I rate MJ a Sell.

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