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The Swinging Pendulum

April 13, 2018

Greetings,
 
In Howard Marks’s brilliant book on investing, “The Most Important Thing,” he writes:
 
Investment markets follow a pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced.
 
We think this pendulum metaphor is particularly apt when thinking about the global cannabis market today. Let us consider the comparison between the U.S. and our friends to the north – Canada. While dutiful readers of this newsletter know the U.S. regulatory situation all too well, Canada is quite another story.
 
Canada first dove into legalization with the introduction of medical cannabis in 2001. Then, more importantly, the country passed congressional legislation in November 2017 to legalize recreational use nationally. With the final congressional vote expected in the summer of 2018, Canada is poised to become the largest country in the world to legalize cannabis.
 
With 36 million people and high consumption rates, Canada is undoubtedly a promising market. For example, Wall Street analysts are forecasting a total addressable market of up to $9 billion within just a few years. To meet this demand, cannabis producers are rapidly raising funds to build new growing capacity and distribution infrastructure.
 
However, as companies began tapping the public equity markets for funds, it looked to us like the investment pendulum swung solidly to “euphoria”. As noted in a recent Barron’s article, the market capitalization of Canadian cannabis producers is collectively $30 billion – approximately 50% of that of Canada’s gold mining industry. Furthermore, company valuations are aggressive by any traditional measure, with the three largest companies trading at an average of 100x last year’s revenue. Lastly, in a typical sign of market froth, companies are pursuing acquisitions using their highly-valued stock as currency.
 
The crux of the valuation debate seems to hinge on two factors: pricing and export potential. Bears (or realists?) point to the examples of Colorado, Washington, and Oregon, where recreational legalization led to oversupply and corresponding price crashes. For example, New Leaf Data Services (which publishes a cannabis pricing index) estimates that average prices in these states fell by 20% in 2016 and a further 13% in 2017. Can Canadian producers buck this trend? With cheap equity capital, new market entrants, and aggressive expansion amongst incumbents, signs point toward “no.” While export markets could emerge to soak up excess supply, we think it is difficult to have conviction in this view given the uncertain global regulatory outlook for cannabis (not to mention potential tariffs and trade war wars).  
 
Contrast the Canada investment story with that of the U.S, where we think the investment pendulum is closer to “depression”. As we have discussed in past newsletters, we believe the U.S. cannabis industry has strong, long-term fundamentals, but is hampered by the contradictory legal framework, banking restrictions, legacy cultural stigmas, and rampant misinformation. However, these perceptions have resulted in more attractive valuations, and more importantly, we expect these perceptions to change over time. And as this transformation happens, we expect the pendulum to rapidly swing in the other direction.  
 
Until then, we look forward to providing you with more industry and business updates in the coming months. Stay tuned!
 
Cheers,
Mike and Kip
Co-Managers, Presidio View Capital

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