Starting as a peculiarity in the 1970s in the Netherlands, the use of cannabis for medicinal or recreational purposes has gained immense momentum across the globe in recent times. Thus far, 4 countries and 11 U.S. states have officially legalised cannabis for recreational use and more than 40 countries and some 30 U.S. states for medical use. Furthermore, the recent legalisation of cannabis in Canada (in 2018) and in the U.S. State of Colorado (in 2014) for recreational purposes has been widely publicised and commented upon. Effectively, this opens up a large market and puts North America at the forefront of this new industry. These countries and states are accompanied by a large number of countries in which, while not fully legal, the use of cannabis is either decriminalised or allowed under specific circumstances.
According to BusinessWire (2019), the cannabis market is estimated to grow from around USD 11 billion in 2018 into a USD 154 billion behemoth by 2027. Corporations have also started to gain interest in this industry, as observed in the USD 1.8 billion investment of Altria Group (a tobacco company) into Cronos Group or the USD 4 billion investment of Constellation Brands (an alcohol producer) into Canopy Growth Corporation (Market Watch, 2018).
How can investors participate in this trend?
Contrary to popular wisdom, today’s cannabis market is neither constituted of potheads who consume this soft drug for recreational purposes in some dark, hidden corners of the city, nor is the production or distribution in the hands of shady dealers.
The market has professionalised and financialised to become a multi-faceted business with investment opportunities in production (cannabis growers), distribution (development, production and distribution of medical or recreational products) or ancillary services (providers of products and services to the cannabis industry).
Investing in cannabis-related companies has become popular over the past couple of years and the market has started to cater for investors who want to get a share of the pie. Today, investors wishing to take part in the upswing of this industry face a multitude of legal and financial possibilities. One can not only buy shares directly on Canadian (TSX) and U.S. (NYSE, Nasdaq) stock exchanges, but also face a small but growing choice of Exchange-Traded Funds (e.g. Horizons Marijuana Life Sciences; ETFMG Alternative Harvest) and mutual funds (e.g. Purpose Marijuana Opportunities Fund or Evolve Marijuana). It is also possible to participate in private companies through venture capital funds (e.g. Benchmark; Base Ventures) or crowdfunding campaigns for more risk-seeking investors.
In the non-equity domain, several cannabis companies have issued bonds (e.g. Aurora Cannabis), while others provide cannabis-related properties through Real Estate Investment Trusts (e.g. Canna Real Estate Advisors; Innovative Industrial Properties). The legalisation of cannabis in Canada and multiple U.S. States has further spurred on investors and corporations from other industries (e.g. Constellation Brands or Altria) to get interested in this new business and to pour money into it. This constitutes a more indirect, yet diversified manner for retail investors to participate in this industry.
Is investing in cannabis profitable?
Financial news provides anecdotal evidence that cannabis stocks constitute a good, if not outstanding investment. For example, a list of the best performing stocks on the Toronto Stock Exchange over the past three years reports two cannabis stocks in the top 10 (Canopy Growth with a 1’823% and Aphria with a 479% return over the period July 2016 to June 2019). While these numbers look very appealing they may only provide a biased view of this market as witnessed by two counter-examples of flailing former star companies. CannTrust Holdings was a big player on the market with a market capitalisation of close to USD 1 billion. Over the course of a few months, the stock price declined from USD 9.85 (in September 2018) to a penny stock worth USD 0.83 (in November 2019). Tilray constitutes another example. With quarterly revenues of just USD 9.7 million, it boasted a market capitalisation larger than American Airlines before the boom faded. The overall picture is consequently not as rosy or green as believed but is, as always on financial markets, more nuanced.
Weisskopf (2019) in a recent study (performed at Ecole Hôtelière de Lausanne) has analysed the performance of 33 North American Cannabis companies over the period 2014 to 2018. Overall, it finds that performance is far from being attractive once risk is taken into account.
Over the period 2014 to 2018 these cannabis stocks have, on average, offered a superior return compared to their respective U.S. or Canadian market benchmarks and also compared to industry benchmarks related to other sin stocks such as alcohol, defense or tobacco. This is true for both an equally-weighted and value-weighted portfolio containing these stocks. A large range and volatility three to four times higher for cannabis stocks, however, indicates that this strong performance is accompanied by a huge risk relative to the other industries and the overall stock market.
It has been shown that sin industries are interesting for diversification purposes due to their medium correlations in the range of 0.5 to 0.6 with overall markets. Cannabis stocks exhibit an even lower correlation of around 0.15 with regard to both the U.S. and Canadian stock markets. Overall, this suggests that cannabis stocks may lead to diversification benefits when added into a financial portfolio.
Additional results expand on the initial evidence on diversification. To better understand the features of an investment in the cannabis industry, the study runs a market model and different Fama-French factor models. Evidence suggests that the alpha (a measure of risk-adjusted performance) is not different from zero (i.e. no outperformance) for the cannabis companies. The beta coefficient (a measure of market risk) is significantly positive, between 0.5 and 0.9, hinting at the rather defensive nature of the cannabis industry.
Overall, this study shows that both risk and returns of cannabis stocks are large. This is, however, compensated by low correlations and market risk measures.
Should an investor go for the cannabis industry?
While in the long run there is a definite potential for the overall cannabis market to establish itself as a mainstream business and industry, in the short-to-mid-term prospects are more questionable. This is due to four major reasons.
Most companies active in this industry are small caps with little information and research performed on them. This is accompanied by low market liquidity, especially on the U.S. market on which most cannabis stocks remain OTC-traded. Additionally, as for most new business segments, the risk of a price bubble is all but non-existent. The high multiples and stock price appreciation observable over the last two years suggest that a price correction may occur (as witnessed for cryptocurrencies in 2018 or internet companies in 2000). However, once the market has sorted itself and stabilises, this issue should be diminished.
Risk remains high both in terms of how the market will consolidate in the future and how quickly the legalisation process will evolve in the United States and in other countries. In order for the market to stabilise, it needs clear rules. In Canada this has been achieved, but much less so in the United States where regulatory risk remains an issue, (cannabis remains illegal at the Federal level which creates a legal grey area). Also, the speed at which other markets develop will have an impact on the emergence of new entrants, cannabis prices and the market in general.
The industry is not uniform, displaying two distinctive businesses: medical and recreational. The first appears more acceptable and successful, but comes with a variety of problems, especially political and regulatory. This sub-industry is more focused on R&D, clinical trials and distribution like traditional pharmaceutical companies. The second is more open to interpretation, but should revolve around brands, marketing, and consumer segmentation similar to the tobacco or alcohol industries.
The price evolution for cannabis is unclear. The legalisation process should lead to more demand and higher prices in the short-term. However, the low entry barriers for companies wanting to enter this industry may lead to an over-supply in the long run. This may have an inverse effect on prices and consequently on corporate revenues. As with many other industries, only the fittest may survive the ensuing and inevitable consolidation process.
What about the hospitality industry?
Lastly, one wonders how actors in the hospitality industry may profit from the growth and development of the cannabis industry. The two most promising venues are related to the hotel and, more importantly, the F&B-side of the industry.
Cannabis and the hotel industry could offer a unique selling proposition to hoteliers and could take on many different forms. For example, some U.S. properties already allow guests to smoke or consume cannabis on-site, generally providing guidelines as to what is acceptable. According to Ellen Myer (2019) hotelier Roger Bloss goes a step further and is currently constructing a resort which will offer an immersive experience with a variety of cannabis products and physical spaces for education and discovery. The on-site dispensary will include wellness goods, such as cannabis-infused lotions and shampoos, as well as a full range of cannabis products.
In addition to spa applications and products, cannabis may transform the F&B arena. Chefs in the United States, including those in hotels, are experimenting with cannabis-infused cuisine and cocktails. So far, the experimenting has been mainly focused on the East and West coasts, and is done using CBD. For example, some hotels offer in-room dining menus dedicated to CBD-infused items. Some restaurants propose dinners with marijuana pairings which is sourced from local shops.
Overall, the cannabis industry and its offspring in related industries displays the typical features of emerging markets or products, along with their lot of accompanying infancy issues. Once the market has separated the wheat from the chaff in terms of companies and business fields, and the regulation become clearer, there is no reason why it should not turn into a respectable and investable industry like any other.