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BY: MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS

October 17, 2018

A lot of the momentum of investing in the Marijuana equity sector has been driven by pending legalization of the recreational use of marijuana in Canada. Now that we’ve actually reached that day where the cultivation and sale of recreational marijuana is legal, investors may get to learn about the sector’s winners and losers.

Which Recreational Marijuana Companies Will Come Out on Top?
The simple answer is: ‘No one knows’. That’s the big risk in taking concentrated bets on the leading Marijuana stocks. Certainly, the bigger cultivation stocks in the sector, such as Canopy Growth, Aurora Cannabis, Aphria and Tilray have significant production and distribution advantages over the smaller competitors. Investors buying now are paying a lofty premium to be in these stocks, which are trading at high valuations relative to the broader sector.

In other words, investors are paying a steep price for investing in the perceived “safety” of the bigger names. This means if any of these larger companies disappoint when it comes to recreational sales, there will be more of a reckoning on valuations that could result in steeper losses relative to the broader sector.

Another key consideration is that the overall size of the Canadian recreational marijuana opportunity could be much smaller than what is being forecast. Conservative estimates put this recreational market size at about $4.5 billion (Deloitte, 2016), where other estimates suggest Canadians could consume more than a million kilograms of marijuana in 2019, which would be the equivalent of one billion grams. In that case, the market would be closer to $8 billion. To give some context, that would suggest Canadians, on average, would be consuming 28 grams of marijuana per year. That’s possible, but that may be quite high.

Given the current valuations on the stocks, much of the lower-end range of the valuations has been factored-in to the price of the sector. Therefore, investors would need Canadian recreational demand to be much closer to the $8-9 billion range, which would put cannabis-related sales on par with beer sales (Statistics Canada, 2017.)

If Recreational Disappoints, Will Marijuana Stocks Fall?
This is where things get interesting. While Canadian recreational marijuana has been the big catalyst for valuations – it’s really only the first big milestone for the global Marijuana industry. Canada’s market is essentially a non-factor when held against the context of a broader global market for both medical and recreational marijuana.

One area that has potentially been overlooked is the global medical marijuana market. Most of Canada’s established licensed producers (LPs) currently have a core businesses selling medical marijuana. On average, the prices on these goods are expected to be higher than recreational prices.

This potentially makes overseas sales of medical marijuana very lucrative in new markets that have opened up, such as Australia and Germany. One report from Grand View Research suggests the aggregate global medical marijuana market could be worth USD $55 billion by 2025.

Major developed markets that have legalized medical marijuana include:

• Germany
• Australia
• Denmark
• Finland
• Netherlands
• Norway
• Mexico
• Switzerland

Many of the Canadian LPs have already invested substantially in these foreign markets. However, a challenge is that the regulatory and political environment in these regions is likely going to favour domestic providers. The world is not going to give the global Cannabis industry to Canada. Strategically, through local partnerships however, many of the Canadian LPs seem well-positioned to capitalize on global growth.

Of course, none of this factors in the USD $100 billion1 gorilla of the U.S. market. Some of the recent fervor in Marijuana equity valuations has surrounded the fact that both Tilray and Canopy Growth have been granted federal relief to export Marijuana to the U.S. for clinical research. While this is a small concession, it does highlight a potential turning point on the part of federal U.S. authorities on the export of marijuana between borders.

These opportunities are potentially massive. To some extent, Canadian producers have a key leadership advantage given the substantial capital funding and investment they have at their disposal to partner and acquire non-Canadian businesses in jurisdictions that begin to contemplate or institute marijuana legalization.

The Importance of Staying Diversified
We operate the Horizons Marijuana Life Sciences Index ETF (HMMJ), which seeks to replicate the performance of the North American Marijuana Index (the “Index”), net of expenses. The Index is designed to provide exposure to the performance of a basket of North American publicly listed life sciences companies with significant business activities in the marijuana industry. HMMJ is the world’s first and largest marijuana ETF, with more than CAD $1 billion in assets under management, as at October 9, 2018. One of the key features of HMMJ is that it’s a passively-managed index strategy, which means we don’t have any qualitative opinion on any of the stocks in the portfolio. Stocks in HMMJ are weighted by their market capitalization, with the larger stocks making up the bigger proportion of the portfolio. Each stock has a maximum index weighting of 10% in the Index at each quarter rebalance. 
At its last rebalance, the Index had 49 stocks holdings, providing robust diversification across the entire Marijuana sector.

The relatively frequent rebalancing of the ETF means that it can capture most of the big moves in its underlying holdings, but its depth of holdings also provide some offset from single-stock risk (although diversification can also limit the upside potential of owning certain individual stocks). Once investors start evaluating more of these stocks on revenue, there’s bound to be some disappointment, which we believe further underscores the need for diversification.

Just because stocks disappoint on revenue doesn’t mean they are bad investments. There is some potential for a wave of consolidation to occur over the next 18 months. In particular, companies that have established robust cultivation facilities (i.e. supply) but fail on distribution, could become attractive targets. The easiest way for larger producers to acquire distribution and scale is to acquire other producers that have already gone through the expensive and time-consuming process of getting licensed and establishing cultivation. In many cases now, it’s easier to acquire than build inventory and distribution.

Just this year we’ve seen Aurora Cannabis acquire MedReleaf, CanniMed and more recently, ICC Labs. Canopy Growth has acquired Hiku Brands. Many of these smaller producers have larger weights in the Horizons Emerging Marijuana Growers Index ETF (HMJR). When it became clear in mid-August that ICC was close to being taken over by a larger producer, the stock price jumped by nearly 30%. In HMMJ, the stock, at the time of the acquisition announcement, was about a 0.6% weighting, whereas it was a nearly 4% weight in HMJR.

In our view, using a combination of HMMJ and HMJR would provide exposure to a significant portion of investable Marijuana equities that have enough market liquidity to be held in ETFs. Using this diversified approach could be a way to continue to benefit from the potential long-term growth of the sector while possibly limiting the worst of the significant single-stock risk that exists as we transition from the unknowns of what could be with recreational marijuana sales. Then, we’ll have a clearer picture of what companies are actual industry leaders able to generate real sales.

1 Source: Bloomberg.com, September 18, 2018.
The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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