EDITOR: | July 29th, 2014 | 3 Comments

Separating the Weed from the Buds

| July 29, 2014 | 3 Comments
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There have been hundreds of articles in the financial press and investment blogs about Medical Marijuana, “MMJ” stocks, including many about how to analyze them. I read with great interest yesterday’s article in InvestorIntel about the NY Times coming out in favor of legalization in the state. This is indeed big news. However, in this piece I focus on some basic attributes of the companies that are in the MMJ space. That said, full disclosure: I don’t own or trade any outright MMJ stocks. I used the qualifier, “outright” because unlike Bill Clinton, I did inhale recently….I own shares in a company that was an Oil & Gas play until about five months ago — that company is now 100% pot-committed (poker pun intended).

One key takeaway in my due diligence is that there’s no urgent reason to own any of the MMJ stocks I’ve looked at. There are plenty to choose from and they have a tendency to go on sale from time to time. It’s been well documented that a number of junior mining stocks have changed course, rather abruptly, looking for short-term fixes to troubled projects that require serial capital raises. The problem with many junior mining stocks is time. Timelines that stretch multiple years. Switching to the MMJ space offers the possibility that a company can earn some quick profits to redeploy into a troubled mining project.

Junior Miners Switching to the Green Side Coming to an End

More recently, the idea of earning some spare change to advance under-funded projects is pretty much out the window. The mining projects are put on hold and even listed as non-core assets to be monetized. There was a few months where a few dozen mining ventures switched gears and headed off to greener pastures. It was interesting how they did it. Typically, they announced the hiring of a consultant to help the company identify opportunities in the MMJ space. However, as they say, hope is not a strategy. So, with the mining companies pretty much done announcing surprise! changes in operating plans, I will turn to companies that actually get into the MMJ on purpose.

These companies are frequently not much better off than the mining aspirants to the green gold lottery. Why? Simply because this is an ever evolving and difficult space to enter and conquer. Will there be winners in the MMJ space? Sure. Will most companies fail? Yes. Think about, so far we’ve been told that the, “smart money” has been entering the space. I’ve been hearing that for about a year now. Yet, I don’t see any stand out companies, especially at reasonable valuations. As far as I can tell, the winners are the illegal, black market operators who don’t suffer from the costs and time consuming legal, compliance and quality control burdens of newly legitimate players. It seems both illegal and legitimate MMJ businesses are highly speculative ventures. Since there’s no consistently proven model for success, especially among publicly traded companies, MMJ companies tend to throw ideas against the wall to see what sticks. To reiterate, hope is not a strategy.

How to Compare Companies? 

As investors evaluate companies in this wild west of tumble weed, they tend to do what investors typically do, compare and contrast peer companies. However, as mentioned above, there are more black market operations than publicly traded ones. And, to be clear, I’m not just talking about the cultivation of marijuana, I’m talking about all aspects of the business that come under regulatory scrutiny. For example, “edibles” are foods that have marijuana in them. Think of Willy Wonka bars that do things that the famous candy man may never have been capable of.

Barriers to entry for growing pot or creating edibles are not very high. Therefore, the black market thrives and comparing the relatively few companies that are public and have balance sheets and income statements gives an investor little information about the overall industry. Even worse, it might give investors a false sense of security that he has picked the best bud in the jar.

Many pundits point to a strong management team as a prerequisite for investing in a MMJ stock. I agree. Strong management teams are key to any successful operation. But, how can any investor be sure the leaders of a company are strong and competent? How many have direct experience in MMJ? I will go on record right here and right now in saying that very few have direct MMJ experience! Still, there certainly are executives in the sector that have relevant experience in distribution, marketing and logistics.  Will there be winners in the MMJ space? Sure. But how hard will it be to find them?

I’ve written several paragraphs without even mentioning the fact that in the past year upwards of 10 MMJ stocks have been halted by the SEC or FINRA (both U.S. agencies). Clearly, it goes without saying that the sector is a dangerous one to play in. One of the top 3 industry bellwether stocks at the time, Growlife, Inc. was trading at roughly 100x trailing revenues, with at a market cap of $500 million. It was halted for two weeks and is now down 80% from the day it was halted. The SEC found no smoking guns, two weeks passed and the stock began trading again, but on the grey market where many investors fear to tread.

Valuation

Clearly in this market one should have a high risk / high return mentality and a short-term horizon. One should diversify across a few different stocks. But, for me, deploying more than just a small amount on one’s capital in the sector is more gambling than investing. Many of the companies are now, for the first time, reporting revenues, but most of those companies are still losing money. Needless to say, it’s risky to pay a multiple of revenues (a common metric in the industry) on a company with negative earnings.

Speaking of valuation, which truly takes on a new meaning in this sector, there’s a segment of the market that’s quite telling. In Canada, there’s a reported 50,000 card carrying MMJ patients and I believe 13 companies with licenses to serve those 50,000 patients. Of the 13 only a handful are public companies. In fact of that handful, some don’t even have a license to sell yet. They’ve merely applied for a license. But recall what I mentioned above, one should not simply compare the public companies in this segment, there are about 10 (and more getting approved by Health Canada) that are still private but have licenses and can directly compete with the publics. Doing some simple math suggests that fewer than 10, (I would argue perhaps just 5) with substantial growing facilities could, over time, service 50,000 Canadian patients. Even if the number of patients were to increase, there’s still a black market that the legitimate companies have to compete with.

Will a few of the licensed producers in Canada be winners? Perhaps. But some of the public ones are already trading with large market caps. Picking the ones that will prevail will be difficult, albeit first mover advantage could be very important.

Conclusion

It’s easy to poke holes in the MMJ sector, there have been numerous self-inflicted wounds. It’s easy to point out that there will only be a few winners compared to a large number of losers. However, like any emerging industry, the winners could offer investors huge rewards for taking on very substantial risk. Perhaps the space is not so crazy after all. Compared to the junior miners that have been in a slump for three years, the MMJ express train offers investors/gamblers large return potential in months, not death by a thousand cuts over years.


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Comments

  • Urban Girl

    There are many battles a head when it comes to MMJ and not just the investment but from an acceptance. More and more physicians are recognizing the benefits of marijuana and signing the forms. At the end of January 2012 there were 13,781 Canadians authorized to possess dried marijuana. By the end of December 2012, that number had grown to 28,115.

    July 29, 2014 - 5:30 PM

  • hackenzac

    I think the real money will be in the recreational market with big alcohol and companies like Starbucks being the dominant forces. Medicinal marijuana will be about as large as medicinal alcohol but in a cafe concept, Starbucks could be a big winner if they choose to go that route. The margins on coffee are better and there’s no under cutting black market to contend with. In Washington State, home to Starbucks and everybody else’s coffee, a pervasive coffee culture and with first mover medical/recreational marijuana businesses legal and flourishing, it’s the best laboratory going to see how things are going to play out. With the set official price of 15 per gram for bud, the black market can and does undercut that substantially so why would a casual user pay 15 when they can get it for 8? You’re better off putting your money in big coffee imo.

    July 30, 2014 - 11:00 AM

  • Peter Epstein

    I received several emails in defense of the MMJ (or cannabis) market. The gist of the emails was that my article didn’t take a strong stand for or against the opportunity to invest in the space. To be more clear, I think the space is investable, I just haven’t found the right stocks yet! I welcome suggestions of stocks that readers find attractive. I for one am a believer in the picks and shovels model, real revenues and (hopefully profits) selling products and services to the hundreds of Canadian and U.S. companies in the sector.

    One sponsor of InvetorIntel I noticed, Nex Gen, is organizing large investment conferences focused on MMJ and related companies. This is a good example of a picks and shovels model as Nex Gen can leverage its exposure to the hundreds of participating companies into potentially profitable partnerships. Nex Gen can also learn a great deal from the thousands of attendees of these conferences as to their respective wants and needs in the MMJ space.

    July 30, 2014 - 11:22 AM

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