This article first appeared in Personal Wealth, The Edge Malaysia Weekly on December 3, 2018 - December 9, 2018

Could the new gold rush be green? Once condemned in fiery political speeches as a “gateway drug” into harder substances, cannabis is now eliciting investor excitement on a scale not seen since the technology bubble at the turn of the millennium.

Cannabis (also known as marijuana) producers have taken centre stage in North American stock exchanges, particularly Canada. Certain names currently boast billions of dollars in market capitalisation. They are attracting rich valuations and even richer investments from venture capital and private equity firms.

Medical cannabis has been legal in many countries for years now, but there are very strict rules on its cultivation, production and distribution. North American companies are leading the private sector charge in this area, with Canadian concerns currently ahead of the curve.

Canada has long allowed medical cannabis, but on Oct 17, it broadened the legal scope to include recreational use. It became only the second country in the world to do so, following Uruguay’s blanket legalisation in 2013.

The cannabis industry is still at a very early stage of maturity from a market valuation and institutional investor acceptance perspective. US-based cannabis supplement start-up SunHealth Therapeutics director Miles Gilman tells Personal Wealth that market demand was established in recent years so investors began to match growers in the private market. “From 2014 onwards, the market became more sophisticated, evolving from just selling the raw [cannabis] flowers to creating differentiated products such as vapours and edibles.”

When it comes to cannabis’ medicinal value, Budding Equity Asset Management president and ETF Managers partner Jason Wilson tells Personal Wealth that there is potentially a multibillion-dollar market in pain management. “Last year, more than 55 million Americans received prescriptions for some form of opiate-based painkillers. Total prescriptions issued were in excess of 200 million,” he says.

“Opiates are a huge problem the world over and are a major cause of overdose death in the US, Canada and Europe. If we could replace even half of those prescriptions with a medical cannabis prescription — say, half a gram over 30 days — that is a US$22 billion market opportunity in the US alone. And this is just supplementing, not replacing outright opiate-based painkillers.”

There are also applications for patients with sleep disorders, various forms of epilepsy and glaucoma, he adds. “A lot of these cannabis growers are now creating technological moats, running serious medical research and clinical trials, as well as filing patents on various cannabis extractions, gel capsules and oils. These companies are fast becoming biopharmaceuticals, rather than just pure play growers.”

In fact, the medical potential of cannabis is just the tip of the proverbial iceberg. Canada’s recent blanket legalisation has prompted a lot of excitement in the recreational use of marijuana.

Even in the US, where cannabis is still illegal at the federal level (but has been legalised to varying degrees in many states), the market is growing at a compound annual growth rate of over 17%, says SunHealth’s Gilman. “The market could be worth US$50 billion by 2028. By comparison, the US market for spirits, wine and beer is projected to be US$58 billion, US$65 billion and US$117 billion respectively.”

The US is also on the path to federal legalisation and the revival of the 2018 Farm Bill will be key. Championed by Republican Senate Majority Leader Mitch McConnell, the bill contains a key amendment that will fully legalise hemp (the fibrous part of the cannabis plant) production in the country. It is one of the few pieces of legislation to receive bipartisan support.

US giants Walmart Inc and The Coca-Cola Company are said to be considering an entry into the cannabis market. This could become a reality, assuming that the US Congress passes the bill that contains McConnell’s proposed amendment.

The broader Asian region has not caught on to the drive for legalisation that is currently sweeping through the West. However, Thailand and even Malaysia are at varying stages of consideration for the legalisation of medical marijuana.

Last month, Thailand’s National Legislative Assembly proposed amendments to the health ministry, which would effectively legalise marijuana and its local variant, a plant known as kratom, for medical purposes. In Malaysia, Water, Land and Natural Resources Minister Dr Xavier Jayakumar announced in September that the Cabinet had conducted informal discussions on the merits of medical marijuana, along with the possibility of amending the relevant laws to accommodate this.

Here, industry experts discuss the potential of cannabis as an investment option.

Investment options

Investors looking for more broad-based exposure to the cannabis industry could consider the US-based ETF Managers’ Alternative Harvest ETF (MJ). The ETF, however, has been underperforming of late due to several challenges.

A fairly recent addition to the ETF universe, MJ was listed in 2015 as a Latin America real estate ETF. Due to a lack of investor capitalisation, the firm applied to and received approval from the US Securities and Exchange Commission (SEC) in December last year to convert the ETF into its current iteration, says Wilson.

The constituent stocks of the Prime Alternative Harvest Index tracked by MJ were caught up in the recent correction that hit much of the US market in October. Then, the cannabis sector was dealt another blow last month, when key players posted disappointing earnings results.

Consequently, MJ’s return for the year to Nov 27 was -11.59% while its one-year return was -2.38%. Prior to the correction, however, the ETF was up by as much as 26%, says Wilson.

MJ is currently the world’s second biggest cannabis ETF, with its total asset value in excess of US$643 million as at Nov 27. By comparison, the total assets of one of the better performing large-cap general ETFs — the SPDR S&P 500 ETF Trust (SPY) — was under US$300 million. SPY was up 1.89% for the year to Nov 27 while its one-year return was 5.02%.

Many cannabis stocks have become overvalued since Canada’s Oct 17 legalisation of recreational marijuana. Although seen as a long-term shot in the arm for the industry, the move has prompted a great deal of short-term retail interest in these stocks.

In addition, there have been unforeseen supply bottlenecks, with growers in Canada struggling to satisfy a flood of demand. The combination of these factors, as well as the global spotlight on the legalisation, has sent the valuations of these stocks soaring. However, their fundamentals do not necessarily justify the lofty valuations.

Canadian cannabis giant Tilray Inc — the largest constituent stock of the Prime Alternative Harvest Index — posted underwhelming numbers recently. In a Nov 11 conference call with analysts, its executive team reported revenue growth of US$10 million, nearly double from the previous corresponding quarter.

But the company had suffered a huge net loss, its earnings report revealed. “Net loss for the quarter was US$18.7 million or US$0.20 per share, compared with US$1.8 million or US$0.02 per share for 3Q2017,” said its financial statement.

Its net loss year to date stands at US$36.7 million. Tilray is a pharmaceutical company that develops cannabis-based medicines, drugs, drops and oil products.

Canopy Growth Corp, another top constituent of the Prime Alternative Harvest Index, posted second quarter revenue of C$23.3 million, down from C$25.7 million in its previous quarter. According to Refinitiv, the company’s net loss this quarter had ballooned to C$330.6 million, or C$1.52 per share. During the same period last year, it posted a net loss of C$1.6 million, or C$0.01 per share.

According to Bloomberg, Canopy Growth is a producer of medical marijuana. The company’s various subsidiaries and brands take up distinct positions in the market and are designed to appeal to various classes of customers, including regular consumers and healthcare professionals.

Canopy Growth attracted international attention in October last year, when alcoholic beverage giant Constellation Brands purchased a 9% stake in the company. Last month, the maker of Corona beer significantly upped its equity interest in the company to nearly 38%.

“As a result of the new shares Constellation is acquiring, Canopy Growth will immediately upon closing have proceeds of about C$5 billion to bolster its leadership position in the global cannabis industry,” says a recent joint press release.

Despite the mixed performances, Wilson is optimistic about the industry’s long-term prospects. “It is important to remember that these companies have global operations. Canopy Growth, for instance, is in 15 countries,” he says.

“In addition, Canada’s legalisation of cannabis, both in the recreational and medical space, means these companies now have unprecedented access to funding. They can more readily access capital markets and raise institutional investor money. Some have already established lines of credit with Canadian chartered banks.”

Meanwhile, the passive nature of the ETF presents a good opportunity for investors who want to dip a toe in the industry, says Wilson. “Our passive strategy and broad exposure to the whole sector is our biggest defence [against market correction]. Also bear in mind that there are not too many expert analysts in this industry. That means it is very hard to pick winners and losers right now. Thanks to the low-cost passive strategy, we are able to provide investors with efficient access to broad-based cannabis exposure.”

But not everyone is optimistic about the future of Canadian cannabis stocks. CNBC contributor and short seller Andrew Left has taken short positions in a basket of Canadian stocks. “Once the US licensed [cannabis] producers come in — the faster it becomes legal in the US, the quicker the [Canadian stocks will] go lower,” he told CNBC recently.

Other ETFs that invest in cannabis include the Horizons Marijuana Life Sciences Index ETF (currently the world’s largest ETF with total asset value in excess of C$1 billion) and the Horizons Emerging Marijuana Growers Index ETF.

The private market route

Navy Capital founder Sean Stiefel is part of a growing number of fund managers with significant holdings in the cannabis industry. Nevertheless, while he continues to hold cannabis equities, he sees better investment opportunities in the private markets for the time being.

His US-based hedge fund firm launched its only fund to date — the Navy Capital Green Fund — in May last year. It was introduced as a long-short fund with a mandate to invest in both privately held and public-listed cannabis companies.

According to Bloomberg, Navy Capital increased its assets under management to nearly US$100 million, up from just US$10 million at its inception. This year, the firm has returned more than 100% net of fees to investors.

As at late October, Stiefel had pivoted to private-market opportunities. “We are not moving out of public equities, but we are seeing better opportunities on the private side. To date, Navy Capital has a total of 50 investments [in both privately held and public-listed companies],” he tells Personal Wealth.

Stiefel cites widespread overvaluation in the public markets, particularly in the days before and after Canada’s legalisation of cannabis. “Valuations are now a little more attractive of course [compared to when recreational cannabis was legalised], but I still believe cannabis counters are overvalued. As a result, we find it hard to justify underwriting some of the popular names [in the public markets].”

Navy Capital’s strategy is to focus on private companies with strong brand recognition and distribution capabilities. Stiefel is lukewarm on the cannabis production segment,

however. He believes that the plant itself is just another commodity and that the long-term value lies in a company’s ability to create a quality product with lasting appeal.

The firm’s most recent investment was a late September investment in F/ELD, a recreational cannabis extract manufacturer that operates in the high-end recreational use market. The company produces very high-quality cannabis extracts for recreational consumption.

The US$6 million funding round was led by Navy Capital, with further contributions by high-profile investors such as Eitan Popper, Igor Gilemshtein and Tarik Ouass. Serruya Private Equity also participated in the funding round.

“Not all cannabis products are created equal. Like any other consumer industry, cannabis is going to be quite segmented. You are going to have a premium range, a mass market range and a cheap range,” says Stiefel.

“Our research and findings indicate that F/ELD already has the best premium segment product in the marketplace right now. I think it has a genuine brand identity and it is true to what it offers.

“Its customers are extremely conscious of what they put into their bodies, so the company does not use any additives, oils or synthetics. It has a clean process that results in a very high quality product. As consumers develop a taste and appetite for cannabis, I believe there will be a large segment that wants the premium cannabis experience.”

F/ELD’s rise in the sector thus far is comparable to that of cigarette manufacturers, says Stiefel. Smoking tobacco used to be a very conspicuous and tedious affair. As recently as 100 years ago, it was characterised by large pipes that had to be manually filled and emptied out. Over time, it evolved to become more discreet, compact and easier to carry around. This is what led to cigarettes becoming such a popular (but dangerous) global habit, he adds.

Similarly, the practice of smoking raw, dried out cannabis flowers will give way to more discreet and sophisticated forms of consumption such as via vape pens, edibles and even cosmetics, Stiefel contends. This will eventually attract a much bigger user base. He is making an early bet that F/ELD has made a name for itself in the high-end recreational use market and is banking on the company building a significant competitive moat for itself.

Over the longer term, however, Stiefel thinks recreational cannabis consumption patterns will be similar to that of alcohol, rather than tobacco. To this end, F/ELD will continue to trial a variety of products and business models as it continues to make inroads into a gradually liberalising marijuana market.

As a member of F/ELD’s board of directors, Stiefel has spoken to company executives about trialling a range of “vintage” products. The cannabis will be produced with the view of being “barrelled” and subsequently aged for a length of time, not unlike fine wine or premium scotch whiskey. These vintage products, he adds, could be a compelling draw for discerning users.

“We have discovered that there is actually a big segment of recreational users who enjoy the taste and smell of cannabis and are not necessarily out to get high. This is analogous to alcohol — there are people who drink to get drunk, but there are also plenty of people who drink just for the taste. This could be an exciting proposition, so long as we are able to provide a high quality and consistent experience to the end user,” says Stiefel.

By investing in brands that enjoy a strategic head start and strong distribution capabilities, Navy Capital can potentially benefit from the wave of legalisation currently sweeping the globe, without the heavy overvaluations and hype in the public markets. “There are a lot of countries in Asia with monopolistic or oligopolistic conditions. If we are able to access these markets and establish brands in those countries, it will be a very compelling investment for us,” says Stiefel.

“China is already a massive producer of hemp. If you extract the cannabidiol (another compound found in cannabis) on a large scale, there will be prolific applications in cosmetics, food and beverage and medicine,” he adds.

“[Investing in Asia] is a tremendous opportunity, given the regulatory shift that we are seeing. We will be in Asia at some point in the near future. We are seriously considering China. And since we have investors from Japan, these two locations will most likely be our starting points.”

Private equity and venture capital have become increasingly prominent features of the cannabis investment landscape. Notable investors include Gotham Green Ventures, Privateer Holdings, Craft Ventures (founded by PayPal founding chief operating officer David Sacks last year) and Canada-based Hawthorne Equity Partners.

Key risks

Stiefel acknowledges that the industry is still very young and mainstream acceptance is only just gaining momentum. Consequently, long-term market data on companies are difficult to come by.

“We recognise that our dataset is limited. But even so, F/ELD is currently the most sought-after brand and based on our data, people view it as the best company in the marketplace today. We are willing to bet on the company because we think its lead is sustainable,” he says.

The overall cannabis market is volatile and both Stiefel and Wilson say there are going to be many rounds of consolidation in the coming years as clear leaders and laggards start to emerge. “There is a lot of money going into the cannabis space right now and it has growth rates similar to that of tech. In fact, no sector has grown this quickly since the height of the dotcom bubble,” says Wilson.

“Now obviously, this is going to give way to competition and a lot of consolidation. There are going to be hits and misses so investors should expect volatility in this emerging sector.”

Finally, cannabis consumption remains a highly charged and politically divisive issue. Although legalisation is gaining steam, political realities could turn this modern-day gold rush on its head. “I am looking out for federal legalisation in the US,” says Stiefel, who is keeping an eye on two key pieces of legislation — the Farm Bill and Strengthening the Tenth Amendment Through Entrusting States (STATES) Act.

Debate over the Farm Bill has stalled in recent weeks as some House Republicans are using it as leverage to force through entitlement reforms in the US. Nonetheless, the Democrats’ victory in the House following the recent US mid-term elections could be a surprising catalyst for the passing of the bill’s cannabis amendment. Democrat Representative Collin Peterson is the presumptive incoming chairman of the House Committee on Agriculture and he has stated a desire to see the bill passed.

Even more impactful is the bipartisan STATES Act. The bill was introduced earlier this year by Republican Senator Cory Gardner and Democratic Senator Elizabeth Warren.

“If passed, this bill will effectively remove all federal barriers to participating in the cannabis industry. For example, a federally regulated bank could finance a local cannabis grower or a publicly funded university will be able to conduct research into cannabis,” says Stiefel, who believes this could open the proverbial floodgates for blanket legalisation in the US.

Marijuana cryptocurrencies

There has been a slew of cannabis-themed cryptocurrency offerings in the last few years. Ostensibly, many of these cryptocurrencies were launched to compensate for the lack of financial support from banks and other financial institutions.

There are at least 10 cannabis cryptocurrencies in the global market right now. HempCoin commanded a market capitalisation of US$2.55 million as at Nov 26, according to coingecko.com. In April, its market cap was close to US$31 million.Launched in 2014, HempCoin is meant to serve as a payment solution for businesses in the agriculture, hemp, legal cannabis and tobacco industries in the US. According to its website, HempCoin’s mission is to “have a cryptocurrency that can be used for online payment systems and peer-to-peer transaction services, including point-of-sales systems and card terminals”. As at Nov 26, the cryptocurrency was trading at US$0.0103 per coin.

Another cannabis-themed cryptocurrency is PotCoin, which was also launched in 2014. According to its website, it is the first digital currency created to facilitate transactions within the legal cannabis industry.

PotCoin is arguably the most popular cannabis-related cryptocurrency in the market. According to coingecko.com, it had a market cap of US$2.43 million as at Nov 26 and was trading at US$0.011 per coin.

PotCoin sponsored part of retired NBA great Dennis Rodman’s historic June 2017 trip to Asia in conjunction with the summit between North Korean leader Kim Jong-un and US President Donald Trump. The currency’s value spiked more than 90% the day after Rodman was photographed wearing a PotCoin T-shirt during the trip.

The growing international movement to legalise cannabis, at least for medical consumption, could encourage lenders to participate directly in traditional financial markets. If so, it remains to be seen what effect this could have on the many cannabis-themed cryptocurrencies in the market.

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