BY: MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS
September 24, 2018
Marijuana investing is not a slam dunk. As we’ve seen over the last year, while many Marijuana stocks have generated eye-popping returns, the sector has also experienced large drawdowns. With the sector currently flirting with all-time highs, it’s forcing many investors to question if they’ve missed out.
I believe opportunities in the Marijuana sector continue to exist, but investors may have to be more patient and accept a longer time-horizon, given how much of the Canadian recreational opportunity has been priced-in to the stocks – particularly amongst the larger producers.
Narrow Leadership
We operate the Horizons Marijuana Life Sciences Index ETF (HMMJ), the world’s first and largest marijuana ETF, with more than $1 billion in assets under management, as at September 5, 2018. HMMJ is a passively managed index strategy, tracking the North American Marijuana Index (the “Index”), which means we don’t employ any qualitative opinion on any of the ETF’s holdings. Index constituents are weighted by their market capitalization, with the larger equity constituents making up the bigger proportion of the Index. Each Index constituent has a maximum Index weighting of 10% at each quarterly rebalance.
The fact that Aurora Cannabis and Canopy Growth are the largest positions in the Index as at September 5, 2018, is merely a reflection of the fact that their values have risen the most intra-quarter since the last rebalance from initially relatively large weights in the Index due to their market capitalization.
It does highlight that the most recent rally in the Marijuana sector is heavily skewed towards the larger companies in the space, which are being viewed as prime takeover targets for big tobacco, alcohol and beverage companies. HMMJ had a one-month return of 32.1% as at August 31, 2018 and 16% year-to-date. Going into September, however, many of the Index constituents were still negative on a year-to-date basis with the exception of Canopy Growth and Cronos.
Annualized Returns*
* Source: Morningstar Direct, as at August 31, 2018.
** The inception date of HMMJ, which is April 4, 2017.
The indicated rates of return are the historical annual compounded total returns, including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return above are not indicative of future returns. The ETF and the securities shown for comparative purposes are not guaranteed, their values change frequently and past performance may not be repeated.
HMMJ benefits from the big moves in the Index’s larger holdings, but it also underscores that certain constituents are trading at a bigger premium. The reason for this primarily hinges on three key factors.
1. Consolidation and Takeovers
The biggest driver of returns for much of the industry right now stems from the prospect of large tobacco, alcohol and beverage companies buying into the Marijuana sector. There’s a big reason for this – it does appear that in areas where marijuana sales are legalized, alcohol sales decline. An academic study released earlier this year showed that there’s a 15% decline in alcohol sales in states that have legalized medical marijuana1.
We see in places like Aspen, Colorado, that marijuana sales actually exceeded alcohol sales. A key to this shift is the Millennial demographic – generally consumers between the ages of 20 and 40 – who use cannabis-related products at nearly twice the rate of any other demographic2.
There’s a natural desire then for large alcohol manufacturers to protect or expand the market share of the nearly $22 billion Alcohol industry in Canada by directly investing in the Marijuana sector. An example of this is Constellation Brands’ investment in Canopy Growth for USD $5 billion. Since that announcement in mid-July, Canopy Growth is up more than 105%, as at September 12, 2018.
Constellation’s continued interest in getting a foothold in the upstart Marijuana sector – presumably with a strong focus on the marijuana-infused beverage market – started a fresh round of speculation as to which other producers could be natural takeover targets.
As highlighted in the performance chart above, the bigger producers that have the economy of scale to market and distribute products like marijuana-infused beverages are trading at a bigger premium than smaller-scale producers, precisely because they appear to be more attractive takeover targets for companies outside of the industry.
The premium that the larger Marijuana companies are trading at now presents some new challenges – primarily evaluating how much opportunity exists on a go-forward basis. Canopy Growth is a prime example. The company now has a market capitalization that is starting to rival companies like Barrick Gold and Verizon Wireless. As big as the opportunity might be in the Marijuana sector, have the company’s valuations overshot reality?
This is where the advantage of an ETF solution comes in, because it’s diversified. Using Canopy Growth (or any of the larger Marijuana companies) as a single stock proxy to get exposure to the Marijuana sector might be more dangerous than getting exposure to the broad sector across a diversified portfolio of stocks. It must be noted, however, that although an ETF provides diversification, it can limit the upside potential of owning an individual stock as well.
You can see this dispersion once again in the volatility from the last year in HMMJ vs. the large producers. The diversified approach of the ETF has resulted in much lower drawdowns than most of the big stocks, apart from Canopy Growth.
Source: Morningstar Direct, as at August 1, 2018.
2. The Consolidation Domino Effect – Targeting Smaller Names
By looking at metrics such as price-to-book (“P/B”) value, many of the mid-tier and smaller producers look relatively attractive versus the larger, more widely followed names. For example, the two biggest movers in the sector right now, Canopy Growth and Cronos (both of which have U.S. listings), have P/B values in excess of 10. This compares to many of the smaller names that are expensive, but have P/B ratios in the 3 to 4 range.
As the big names become flush with access to cash from rising stock prices and external investment, a key source of deployment of that capital could potentially involve acquiring the mid-tier and smaller producers. Indeed, we’ve seen a wave of consolidation of the smaller companies with the bigger producers.
Just this year, we’ve seen Aurora Cannabis acquire MedReleaf, CannaMed and most recently ICC Labs. Canopy Growth has acquired Hiku Brands. Many of these small marijuana producers have larger weights in our second marijuana-focused ETF – the Horizons Emerging Marijuana Growers Index ETF (HMJR). When it became clear in mid-August that ICC Labs was close to being taken over by a larger producer, its stock price jumped nearly 30%. In HMMJ, the stock is about a .06% weighting as at September 12, 2018; compared to a nearly 4% weight in HMJR.
HMJR therefore provides a lot more exposure to the mid- and smaller-tier producers which could potentially become prime targets for acquisition over the next 18 months. 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.
3. The International Medical Opportunity
Much of the excitement over the Marijuana sector is related to the Canadian retail market, which on the low-end, according to Deloitte, will probably require a minimum 600,000 kilos of marijuana – suggesting a market size of approximately CAD $4.5 to $5 billion. We could argue at the current valuations on the top-tier producers, much of this is already priced-in to the stocks.
One area that has potentially been overlooked is the global medical marijuana market. Remember that the core business of most of the established licensed producers (“LPs”) is currently selling medical marijuana. On average, the prices on these goods are higher than the anticipated entry-level recreational prices.
This makes overseas sales of medical marijuana to new markets that have opened up, such as Australia and Germany, very lucrative. A report from Grandview Research suggests the aggregate global medical marijuana market could be worth USD $55 billion by 20253.
Major developed markets that have legalized medical marijuana include:
- • Germany
- • Australia
- • Denmark
- • Finland
- • The Netherlands
- • Norway
- • Mexico
- • Switzerland
Many Canadian LPs have already invested substantially in these foreign markets. The challenge is that the regulatory and political systems in these regions favour domestic providers; the world is not going to give the global Cannabis industry to Canada. However, through strategic local partnerships, many of the Canadian LPs seem well-positioned to capitalize on global growth.
An interesting example of this arrangement is AusCann, which is Australia’s dominant player in the country’s relatively new Marijuana industry. While AusCann works to develop its own domestically approved medical cannabis, it has the ability to import supply from its major shareholder, Canopy Growth.
AusCann is not in HMMJ, but is a holding of HMJR – an ETF which has the ability to hold Marijuana producers listed outside of North America. Ultimately, the international growth of the medical market could be a dominant driver of valuations globally for producers.
Who Are the Winners?
A key thing to remember is that we’re looking at an industry with no revenues from recreational usage. Therefore, we don’t know who will emerge victorious in establishing a dominant market share in the Marijuana business. Certainly the larger providers have significant cash flows that allow them to have both scale in distribution and the ability to acquire successful smaller competitors. These large providers are also trading at a significant premium relative to most of the sector. For this reason, if you have a bullish outlook on the sector, then it’s likely worth considering HMJR and the smaller offerings which don’t have quite the same lofty performance expectations built into them as the larger names – but still should meaningfully benefit from the growth of the sector and possible acquisition opportunities.
For this reason, we continue to believe that diversification is the key to success in the Marijuana sector. HMMJ and HMJR offer comprehensive exposure to almost the entire spectrum of opportunities available in this space.
1 Source: Baggio, Michele and Chong, Alberto and Kwon, Sungoh, Marijuana and Alcohol Evidence Using Border Analysis and Retail Sales Data (August 23, 2018). Available at SSRN: https://ssrn.com/abstract=3063288 or http://dx.doi.org/10.2139/ssrn.3063288.
2. Source: Deloitte, 2016.
3 Source: Grandview Research, 2017. https://www.grandviewresearch.com/press-release/global-medical-marijuana-market
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.