The cannabis sector is slowly emerging from its long period of prohibition, and the investment opportunities are turning heads. Retail investors believe in the industry’s future and want to participate before regulations change. The institutions covering the sector are keeping a close eye on it even if most have yet to dip their toes in.
The cannabis industry constitutes a new frontier in investing and is ripe with growth opportunities. The hype and speculative froth of 2018 and early 2021 has burned off, and the market is right sizing: Valuations are more reflective of actual profitability, as cannabis companies suffer from the same dearth of capital as other areas of the private markets even as more US states legalize cannabis use.
So, How Did We Get Here?
This is not the first time US consumers have had access to legal weed. In the colonial era, governments encouraged cannabis cultivation. The Virginia Assembly required farmers to grow hemp, a non-psychoactive cannabis variety used in the production of sails, ropes, and other textiles, and George Washington and Thomas Jefferson, among others, produced the crop. By the late 19th century, consumers could buy psychoactive cannabis at their local pharmacy.
The US government made its first foray into this otherwise free market in 1906 when it required that cannabis-infused products be labeled as such. But the real change in the perception and regulation of cannabis came with the Marihuana Tax Act of 1937, which ushered in the Reefer Madness era. Spearheaded by Harry Anslinger, commissioner of the Federal Bureau of Narcotics (FBN), a precursor to the Drug Enforcement Agency (DEA), the law sought to criminalize the sale and possession of cannabis. As the years progressed, cannabis became associated with the countercultural movements and anti-war protests of the 1950s, 1960s, and 1970s, and new laws imposed ever more severe penalties.
But in the last few decades, amid a slow change in sentiment, the pendulum has begun to swing back, and prohibition has given way to pre-Anslinger acquiescence if not acceptance. California became the first state to legalize medical cannabis in 1996, and Colorado and Washington became the first to legalize recreational use in 2012. Today, recreational cannabis is legal in 23 states and its medical use in many more. Still, psychoactive cannabis remains illegal at the federal level.
Today’s Fragmented Landscape
But as more states legalize cannabis, more Americans favor federal legalization. Young people are drinking less alcohol and consuming more marijuana. The stigma associated with cannabis use has dissipated. Among older cohorts, the market for cannabis wellness products shows great growth potential.
The federal government last year removed a big hurdle in this regard. It withdrew the prohibition of federal funding for medical cannabis research and allowed doctors to discuss cannabis with their patients. Still, as a drug, cannabis retains the highest risk classification, along with heroin, LSD, and ecstasy, and is considered to have no proven medical benefit. According to these ratings, cocaine, methamphetamine, and fentanyl have a lower risk of abuse than cannabis. With more research into its medical benefits and lower potential for abuse, the pressure to reclassify cannabis will increase.
Cannabis investing encompasses not only plant-touching companies — the growers, edible and joint manufacturers, and dispensaries — but also companies that provide services to cannabis firms, from technology to fertilizers. Plant-touching companies incur the federal government’s punitive cannabis tax structure. Because cannabis is still classified as an illicit substance, cannabis companies can deduct expenses only for cost of goods sold (COGS). This leaves a high effective tax rate that hits dispensaries, with their large staffing costs, especially hard.
That is why the prospect of federal legalization and relief from such tax treatment so excites investors. But their optimism is likely misplaced: They shouldn’t hold their breath. Much of the investment capital in the cannabis space continues to flow to non-plant-touching companies. This sell-shovels-to-gold-miners approach has obvious appeal. Businesses can avoid punitive taxation and potentially achieve greater profitability with less legal risk.
Where Is the Money?
Since it is illegal at the federal level, cannabis cannot be transported across state lines, nor can any capital associated with it be transmitted through the federal financial wire system. What this means in practice is that each state has its own microcosm of brands, products, plant types, and financial arrangements. The landscape for cannabis investors in Arkansas looks much different from what it does in California.
This ecosystem of small players in small markets exists parallel to that of so-called multi-state operators. Such organizations set up individual companies in different states under the same name and can thus claim a cohesive multi-state operation, even if they can only sell their wares in the state where they were grown and manufactured.
Multi-state operators have attracted most of the related investment capital. Their valuations shot to the moon amid the social isolation associated with the COVID-19 pandemic, the concomitant increase in recreational drug use, and expectations of potential federal legalization under a new Democratic administration.
Needless to say, the hype going into 2021 was just that — a Green Rush — and cannabis valuations soon fell back to earth. Historical prices of MSOS, the first US focused cannabis exchange-traded fund (ETF), reflect this trajectory.
AdvisorShares US Pure Cannabis ETF (MSOS) Performance
2 September 2020 to 18 October 2023
Source: Bloomberg
Multi-state operators are now focused on consolidation and cost cutting. Smaller operators are either finding their competitive niches or shutting down. And a host of burned investors are vowing never to put money into cannabis. In other words, there is lots of blood on the cannabis sector’s streets. Many cannabis-focused investment shops opened during the bubble, when investors were throwing money at anything that smelled like marijuana. Several have lost more than 60% of their initial value and have conjured cannabis-market benchmarks to rationalize this massive wealth destruction.
While raising money for cannabis investments is much harder today, investors are still interested in the opportunities this nascent industry offers. Without reliable benchmarks or historical averages on which to base future performance expectations, these investors will inevitably come to different and disparate conclusions.
Nevertheless, notwithstanding the twin risks of unfavorable tax treatment and overly optimistic expectations of federal legalization, the cannabis sector is what nostalgic investors who recall the 1980s bond markets pine for: an inefficient market where deep analysis of fair values can pay off.
The industry can produce so much more than giggles and munchies. Research into the plant’s non-psychoactive components remains in its infancy but is progressing rapidly. Indeed, cannabis products could have potential applications in promoting gut health and treating cancer, chronic pain, and mental illness, among other uses, and the pharmaceutical industry has taken note.
Moreover, the investment opportunities extend well beyond the United States. Many overseas governments are either encouraging their cannabis industries or at least not impeding them. While the US market may have the highest upside, its international counterparts, for both medical and recreational use, are growing, and many developing countries have lower production costs and more favorable growing climates.
The popular perception of cannabis has undergone a dramatic evolution, from a crop cultivated by the Founding Fathers to the era of Marijuana Madness, criminalization, and cannabis as symbol of countercultural rebellion to gradual 21st century legalization. Investors interested in an up-and-coming sector with an uncertain but potentially lucrative future should pay attention.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / underworld111
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