Why You're Investing in Cannabis the Wrong Way
Active portfolio management in the space may not be the best idea
While this first post might relate to some and not to others, just hear me out.
Cannabis has had one hell of a rollercoaster over the last 4 years. With Democrats entering the presidency again in 2021, many thought it would finally be a boom for industry with cannabis-friendly legal changes.
Take a look at AdvisorShares Pure US Cannabis ETF MSOS 0.00%↑ below.
The short-lived optimism was only met with seemingly long-term pain ever since the “bubble” popped in February 2021.
But why am I making the connection between investing in cannabis and venture capital? Well, when you think about market dynamics and the current limitations in the public market of cannabis, it makes total sense.
Given that cannabis is not federally legal, the industry is limited by who can invest in the space. Large institutions, various funds, and even banks can’t do business with them (though this varies depending on exactly what is being done).
This means that a lot of the industry is reliant on smaller retail investors, OTC exchanges (if US-based), and smaller funds for financing and investing purposes. Because of this, the market gets punished since the level of liquidity is not even close to other publicly traded markets on the major US exchanges.
I wrote about the core limitations below in a separate post from 2021.
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With seemingly only sellers at this point, many have thrown in the towel as the pain train has taken its toll on investors. Without the proper market fundamentals of buyers and sellers, it’s no wonder why cannabis has only gone down since peaking.
At the time of writing this article, the top 50 biggest cannabis-related companies on the US public markets command just a $35 billion market cap on $21 billion in sales (31% CAGR over the last 2 years), and just over $2 billion of EBITDA.
Not saying all companies are created equal either but it just proves a point about how small of a public market this is even though total revenues are expected to hit $40 billion in 2024 and $67 billion in 2028.
So why are you investing wrong? Well, you’re investing in a sector that would greatly benefit from efficient markets. However, sadly, they’re not in efficient markets.
In essence, current investors are betting on a race where the runner has his shoes untied and is expected to run a 100-meter dash on the same playing field as the rest of his competitors.
The fact of the matter is that it’s not going to change any time soon (most likely). Every cannabis bull is hopeful for SAFE Banking, federal legalization, 280E going away, etc. I am too, but we have to be realistic. Every 20 / 30 / 40% pop in cannabis names on a given day is mainly brought on by the hope and prospect that policy will change will occur from a bill proposal.
Every. Single. One.
It’s great for those who have bought on the low end of the price but not for the long-term investors who are down >50% on positions without the underlying company not showing results.
This cannot be a sound investing strategy. Computers will always beat you to movements unless you’re already holding the name. You don’t know if something will happen tomorrow, next month, or even a year from now.
That’s why I believe, at this current point in time, you need to treat cannabis as if you’re in venture capital.
Pulling an excerpt from HBR,
Venture money is not long-term money. The idea is to invest in a company’s balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and then exits with the help of an investment banker.
While many of these names are already public (negating the need to be private to provide liquidity), the point is that investors in VC invest early in order to get outsized returns later on.
This will come from schedule changes, uplistings, more state legalization, possible federal legalization, etc.
We don’t know when change will come. But we do know that change will come.
Because of this, cannabis investing needs to be treated like VC. You invest at a price you believe is a favorable one. You leave it alone, let it grow, track it, perhaps even increase your position, but you do so with the understanding that the liquidity event is not right around the corner.
The mindset of this is critical, otherwise you’re just going to get frustrated with what’s going on.
The goal here, like in VC, is to allow duration to work itself out but also hedge your bets through diversification. There are plenty of crap companies in the public cannabis space (mainly in Canada → personal opinion) and plenty of stronger, tier 1 MSOs (multi-state operators) that I believe will be the winners coming out of all this.
Though you might be tempted to load up on a name or two, that might not be the best strategy.
When diversifying your cannabis “portfolio” as you would in VC, you need to assume that more than half the companies will at best return only the original investment and at worst be total losses. This could be because of heavy equity dilution in these names or even their going under.
Given the portfolio approach and the deal structure VCs use, however, only 10% to 20% of the companies funded need to be real winners to achieve the targeted return rate of 25% to 30%. In fact, VC reputations are often built on one or two good investments.
A typical breakout of portfolio performance per $1,000 invested is shown below:
With this approach, we can ascertain that we will eventually get some big winners in the space if we don’t micro-manage every price move that comes across the tape or every rumor of legislation through Congress.
If you want to invest in this space
Do your homework
Understand what you’re investing in
Understand who you’re investing in (management)
Be comfortable with timelines
Diversify your risk → even though most of these names rise and fall with the tides
Unlike VC, at least you technically have market liquidity to call it quits whenever you want. If people still give Cathie Wood money to invest in “next-generational” companies despite her piss-poor performance with high fees, you’re approach to betting on the next thing shouldn’t be a problem.
Time is on your side as long as you let it be.
This is my first post on Side of Weed and there will be more to come. Just like I had in the past, I’ll share more fundamental charts that I’m looking at (not trading charts), companies I’m eyeing and why along with material changes that I think are worth sharing.
Just like my other notebooks, I never share something if it’s not something that I feel is important to me. You won’t get spammed with tons of emails nor will you be getting posts on a regular cadence.
This is truly a shared notebook for when things pop up or materialize as I’m sure you only care about the important things just as I do.
Until next time,
Paul Cerro
Personal Twitter: @paulcerro
Cannabis Twitter: @SOWresearch
Fund Twitter: @cedargrovecm