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The following segment was excerpted from this fund letter.


Given the volatility in the markets, I spent a lot of time looking at potential new investments over the past several months. the primary companies that are “working” have been resource companies from oil and gas to mining. This is largely driven by macro forces – rising commodity prices lift all resource-related shares. However, these tend to be capital intensive businesses where earnings are driven by commodity price, which is out of the operators’ control, and high prices generally create additional supply leading to a boom/bust cycle. Fortunes have and will be made, but in general these resource companies are not good businesses, and we have not invested in one yet.

This quarter, our largest new investment is in a basket of cannabis stocks, or more accurately, companies that happen to sell cannabis. The investment thesis is not predicated on a strongly held belief in the benefits of marijuana – rather it is a much more cynical belief that there is an investment opportunity created because of a broken regulatory framework that has distorted the earnings and valuations for cannabis companies. With more than two-thirds of Americans supporting the legalization of adult-use cannabis and 18 states already adopting it, I believe it is a matter of when, not if, full legalization happens. There is too much potential tax revenue at stake and too much popular support. When legalization is formally addressed, valuations may improve dramatically. In the meantime, valuations are quite reasonable for profitable growing businesses. The most knowledgeable and vocal investor on this topic is Aaron Edelheit of Mindset Capital, which has a cannabis-dedicated fund. I would not have ended up in this corner of the financial markets without his writing, podcasting, and general proselytizing.

At a federal level, marijuana is classified as a Schedule 1 drug. This means that, even though it is completely legal in 18 states, cannabis is treated the same as heroin. Being a Schedule 1 drug at the federal level has implications in both the “real” world and the financial world. In the financial world, where we invest, any company that “touches the plant” faces the following challenges:

  1. Cannot be listed on US stock exchanges: The leading cannabis companies selling product in the United States cannot list on the US stock exchanges. The only companies able to list in the US are those that do not “touch the plant” or those that operate only outside of the US such as Tilray (TLRY), Canopy Growth (CGC), and Aurora (ACB). There are large valuation gaps between those listed in the United States (higher) and those listed in Canada. If the laws change at the federal level, a company that touches the plant will be able to both operate in the US and list on US exchanges.
  2. Shares cannot be held at many brokers: Even if you are willing to purchase the Canadian-listed shares of the

US operators, many of the largest US prime brokers such as Pershing, JPMorgan (JPM), and Credit Suisse (CS) do not allow accounts to hold shares in companies that touch the plant. The net result of these regulations is that shares in leading US cannabis companies have virtually no institutional or passive ownership.

  1. Severe banking restrictions: Companies that touch the plant have difficulty accessing the interstate US banking system, including the credit card networks. As a result, business is conducted in cash and multi-state operators have overly complex financial operations as they need accounts in every state. In addition, cannabis companies have very high costs of capital – it is common to see profitable operators paying interest rates in the mid-teens.
  2. overtaxed: Today, even though 18 states have legalized adult use of cannabis and 32 other states permit medical use in some form, cannabis retailers must pay taxes under a regulation called 280E. This tax code essentially makes cannabis companies pay taxes on gross revenue – a huge financial burden that makes it difficult to turn a profit. The law defies common sense and addressing this would dramatically reduce the tax bills / increase the earnings of the US operators selling products legally.
  3. Massive Black Market: The illegality of cannabis products at the federal level, as well as in many states, creates a massive “black market” that has effectively developed consumers. As legalization happens, assuming the taxation is not overly aggressive, legal players can take share from this already built market.

Beyond the nonsensical laws and the distortions that they create, cannabis companies may not actually be “good businesses” or good investments. In fact, I would be surprised if many of today’s listed cannabis companies are enduring businesses. I am highly skeptical that the growers are going to earn supersized returns over time. In a fully legalized environment, the smaller farmers without regulatory protections may look a lot like grape growers – in a decidedly mediocre business. Similarly, while I believe that brand will matter over time (as it does in all consumer package goods categories), I am skeptical that there is enduring brand equity built up yet by any of the current operators. Of more promise, in my opinion, are retailers that operate in states with limited license opportunities.

Currently, retail licenses are typically granted at the state level and individual cities and towns determine if they want dispensaries in their communities, and how many they may allow. Many communities have voted against any having dispensaries in their community while others are limiting the number to one or two. The net result is that local regulations artificially limit the number of retailers (supply). This dynamic of constrained supply leads to a 4,000-square-foot dispensary in the Chicago suburb of Naperville, IL doing over $12M in revenue last year. That is clearly an outlier, but the notion of local regulations creating local monopolies for retailers is an attractive set-up.

Cannabis investors have been waiting for years for regulatory change at the Federal level. Various legislation has been proposed, but nothing has passed the House and Senate. Proposed changes range from sweeping legalization including interstate commerce to more modest proposals addressing banking. Given the gridlock in Washington, it may take a long time to see any real shifts. At the state level, some of the adult use rollouts have been slow, in part because many states are awash in federal stimulus dollars and do not have financial holes to fill. When budgetary issues do arise, cannabis is an attractive place to look. In 2020, Illinois took in $205 million in tax revenue from cannabis vs. $72 million from alcohol. In my opinion, even if federal legislation continues to stall, the siren songs of tax revenues and public opinion will lead to further legalization in more states. The existing US-focused multi-state operators are best equipped to navigate the patchwork regulations and the logical acquisition targets when the federal laws change.

A few years ago, there was a frenzy where anything marijuana related got “bid up” because there was a core group of enthusiasts who wanted exposure to the market and there was a limited supply of public equities to own. Investor enthusiasm has waned since. We now own a basket of Canadian-listed, US focused cannabis companies. They have high growth rates (20%+) with mid-single digit EBITDA multiples and are generating cash. They have long runways for profitable growth driven by licenses in soon-to-be adult use markets such as New York, New Jersey, Connecticut, Pennsylvania, and eventually Florida. They should be very profitable for the foreseeable future even without federal law changes. If and when federal changes do occur, they could see a dramatic re-rating of their valuations.

Editor’s note: The summary bullets for this article were chosen by Seeking Alpha editors.