California’s official entrance into the legalised cannabis market on 1 January has heightened interest in both the market and its huge investment potential but investors who fail to sniff out the risks could see their investment go up in a puff of smoke.
Investors keen to get in at the ground floor of the legal cannabis ‘green rush’ need to be fully clued up on the sector’s investment potential.
Here in the UK, cannabis is classified as a controlled substance under the Misuse of Drugs Act 1971 and is therefore illegal, but there is a growing movement that challenges the UK’s prohibition of the drug.
To highlight just how much interest it’s generating, the Guardian newspaper launched a new column on New Year’s Day that invites ‘adult conversations’ about cannabis.
UK moving slowly
These conversations seem to be on the increase and are happening here in the UK and everywhere. Back in October last year, England hosted its first medical cannabis conference called CannaTech, which was organised by an Israeli entrepreneur Saul Kaye, founder and CEO of iCAN: israel-cannabis. The conference drew together a number of global players in the industry to talk R&D, innovation and investment among other things.
Israel is already a developed market for medical cannabis and was among the first wave of countries to legalise medical use (adult use is still prohibited). Kaye’s choice of London as a venue may seem odd at first glance given the UK’s legal position but he described in a blog that London remained the financial capital of the world and a gateway to Europe in spite of Brexit. He added:
“The Medical and Healthcare products Research Authority (MHRA) and regulators are starting to see the need for better regulation that reflects the current social and medical status of cannabis, yet they are moving slower than pretty much everyone else out there.”
“Interest from UK investors in the sector is at an all-time high. Mothers are outraged over the lack of access to products for epilepsy, pain, and cancer treatments. As we have seen in other countries this is one of the biggest drivers towards better access for patients.”
Medical relief gaining
Canada has been in headlines for its sweeping change in national law to legalise marijuana, with adult use marijuana to be allowed in July 2018.
In Europe, Portugal and the Netherlands have been true pioneers with Portugal making marijuana legal in 2001. Greece recently came in to the fold legalising medical cannabis earlier this year joining other countries such as Finland, Spain and the Czech Republic.
In the US, as cultural norms have changed – a recent Gallup poll showed a 64% support for legalising weed – 21 states in the US have legalised cannabis for medicinal purposes. Eight allow adult use.
Frontier feel to legal marijuana
Legal marijuana is the fastest growing industry in the US and retail revenue of $6.7bn in 2016 is forecast to grow at a 27% compound annual growth rate (CAGR) over the next five years to $22.6bn in 2021 according to research by ArcView, which focuses on research and investment in the cannabis industry.
It is a pioneering time. ArcView’s projection could prove to be conservative if the pace of state-level legalisation campaigns continues. It’s also a market in which growth will impede on other sectors, such as alcohol and pharmaceuticals due to the substitution factor, with marijuana replacing, not complementing, existing products.
There are signs makers of beer, spirits and wine are investigating ways to enter the industry. Brett Roper, CEO and co-founder of Colorado-based Medicine Man Technologies, believes that today’s spike in investor interest in the sector “boils down to the perceived opportunity and risks”.
He says that clearly people are hearing “some amazing stories about how other people are becoming wealthy or cashing in on the cannabis paradigm.”
A whiff of sector breadth
The legal cannabis sector in the US is similar to other industries in the variety and number of sectors.
Broadly, there are:
- Cultivators that grow the plant.
- Processors that turn the cured plant into various branded products through several methods such as extracting substances.
- Consumer packaged goods suppliers. The extract can be used in a slew of other products from candies, cookies, candles, through to beverages. Companies will want to measure how a product is faring in a particular market, which is stimulating the growth of a number of consumer packaged goods firms to meet that need.
- Consumption device makers: devices that people use to consume cannabis.
- Dispensaries - the retail outlets.
- Agricultural technology developing as a result of growing marijuana. The hemp industry, industrial hemp and all the textiles and other valuable products emanating from it, plus pharmaceutical development and the range of biotech and science-oriented research discovering new ways to utilise this plant for medical applications.
Cannabis’ myriad uses
This interest is underscored by solid data on the industry’s growth. ArcView’s CEO, Troy Dayton, writes in his research report covering the US legal marijuana markets that “the cannabis industry will never be smaller than it is today and there are so many areas of it that have not been fully developed.”
The sector he says is most analogous to coffee and wine, but cannabis remains unique in a number of ways.
Dayton contrasts other psychoactive legal products where there are only two axes to change it: you can make it stronger or you can change the taste. But with cannabis, you are not just dealing with volumes, there are also different feelings associated with it and its effect.
There are different routes of administration with differing onset-offset times whether that be lozenges, sprays and or patches.
Ready for mainstream investment?
Indicative of the fact that marijuana is on the cusp of moving mainstream is illustrated by a recent deal in October 2017 by Corona beer seller, Constellation Brands, to buy a minority stake in a Canadian medicinal marijuana company, Canopy Growth for C$241m ($191m).
Other drinks companies such as Diageo, Molson Coors and Pernod Ricard are also said to be investigating entering the cannabis market. Industry analysts say that these companies may be getting into the game early because they see the cannabis sector as a threat on the horizon.
Last year proved to be a watershed moment for the cannabis sector because so many states passed new laws, in particular California, which is baked into the growth rate.
In 2018 laws will get implemented but they’ll be rocky starts according to experts. Once laws are passed, plainly it takes some time for a market to develop until perhaps in 2018 when you begin to see growth take off in states such as Massachusetts and California as well as Canada.
Room to play
What else is driving investor excitement? Rob Hunt, principal of ConsultCanna, a boutique consulting firm that provides high-level market intelligence, points out that traditional private equity players such as Blackstone, KKR or banks like Goldman Sachs and JP Morgan are restricted from this space because of federal laws prohibiting them.
This provides opportunity to high-net worth investors who says Hunt, “a) are not competing for deals b) the return profiles are fantastic and c) the ability to structure a transaction is completely commensurate with the access to capital that companies have.”
Alan Lien, co-founder of SolisTek, which provides digital lighting solutions to the industry agrees, “More and more people will see the potential earning power from this industry driven by the cannabis plant. The cannabis plant and the variety of different strains that exist can benefit the world in many different ways.
“From a recreational point of view, it's a high consumable plant product that is highly lucrative because of the high expertise needed to be able to create and maintain all the desired attributes of higher cannabinoid and terpene content at scale with consistency.”
Mind the barriers
There is plenty of potential upside but the fact is the upside sits on a major fault line that is the legal landscape. There isn’t uniformity of law or model of legalisation at state level. Hunt, who trained as a lawyer, says the primary difference with investing in this industry is that you “need the added element of truly understanding 100% the legislation because every state is different.”
Colorado though is emerging as the Goldilocks scenario of getting it just right with just enough regulation that the public is protected and order maintained, tax revenue is generated and the market can compete with the illicit market effectively. Colorado did have a leg up because it had a for-profit medical marijuana market and adjusted its laws for adult use, evolving its laws.
Even with Colorado’s relative success and California, as the world’s fourth largest economy, about to make weed legal, the biggest barrier for companies remain at federal level. Roper warns, “While there is a lot of talk and a lot of momentum and excitement, there is also a little bit of a wet blanket which is the federal government continues to overhang into the industry.”
Federal wet blanket
The Department of Justice is no fan of cannabis or of legalising it federally. However, under the Obama administration, the-then attorney general, Eric Holder, outlined the government’s position on cannabis through various amendments and memoranda and drew a line in the sand which boiled down to a hands-off approach.
As long as states had good laws on the books that worked to restrict access to adults then the federal government would not pursue companies operating in that space. This was pretty much a green light to the Colorado, California and Washington states’ models.
Companies were assured that following the state’s rules, obtaining a licence and following the guidelines assured them that the federal government wouldn’t come in and shut them down.
Political risk in Sessions
However, there is a political risk (albeit slight according to industry insiders) as the current Trump administration has made it clear it is no fan of legalising marijuana and was reviewing Obama-era policy that allowed states to legalise marijuana without interference from the federal government.
The US Attorney General Jeff Sessions’ dislike is a matter of record. He said in September 2017: "I've never felt that we should legalise marijuana. It doesn't strike me that the country would be better if it's being sold on every street corner. We do know that legalisation results in greater use."
A number of insiders see Sessions as more of a nuisance and a worry than a real threat. One described that the view is stamping out cannabis companies is not a priority of either the attorney general or the current administration
Change federal law to eliminate barriers
Arguing that if Sessions did have the kind of power to do such a thing he would have already done it and privately believe that given Trump’s penchant for firing members in his government the attorney general’s days may be numbered anyway.
Nor they say is the US government willing to take on a majority of people who clearly believe that legalisation for adult use or medical use is something that should go on.
Still, the industry is hard at work lobbying for the federal law to change, because if it did then other barriers immediately disappear.
For example, many companies in the legal marijuana business have difficulty accessing bank services due to the illegality at Federal level. Some legal marijuana companies are turning to credit unions or find other edgier routes such creating a limited liability companies supposedly in a different line of business to put their cash into a bank.
These challenges constrain the industry’s capital. People don’t want to invest in something where they can’t get a bank account or where they know the IRS will tax businesses at very high rates.
Also, in a Forbes interview, Derek Peterson, CEO of Terra Tech, which is the first publicly traded cannabis company in the US, (listed on the OTC Market) noted that the difficulty of finding service providers willing to work with cannabis businesses “can make many simple tasks prohibitively challenging.”
What does it mean for investment potential?
Any time there is an industry that is nascent, fragmented and growing really fast, the best opportunities are going to be in private companies according to Dayton. For any investment you must carry out due diligence to understand the business behind your investment.
However, cannabis is a far riskier investment as very few businesses operating in this virgin territory will have had a long track record or, as yet, made any money.
Dayton advises that while “there are some very exciting things in the public markets in Canada and the markets even in the US over the counter is starting to get a little more wise but it’s a very dicey thing to be in the public markets because there’s a lot of schemes.”
He warns, “There’s just so much opportunity for manipulation you have to be very careful.”
Listen for drum beat
It’s a volatile sector and therefore plenty of care needs to be taken. Roper advises: “If you’re only investing your lunch money then obviously you can throw it up into the air and see what happens but if you’re investing substantial sums then it’s always going to be better to have an adviser to help you vet or look at the universe of investments.”
Retail investors are likely to look at stock markets and may find their attention drawn to stocks recommended by friends or family pretending to know the next big thing in cannabis.
The warning remains the same – be detached, proceed with caution. Check that people aren’t just banging on a drum to drive up a stock price.
There are also less analytics available for the retail end but Roper recommends that Alan Brochstein’s 420 Investor, a subscription service, may be a good place to start for independent analysis and guidance about the industry.
For those that rise…
Hunt is excited about the possibilities of the industry and as an investor himself sees potentials if you know how to play it. There are many sub sectors in cannabis.
You can decide where it is best to invest: is it a retailer or a processor, or consumer software provider or an enterprise software provider?
Each will have a different risk profile and a different place where they fit into the legislative landscape of each state.
Hunt cautions there is a flip side: “For every great company…there will be 20 that fail. There’s a prevailing belief that a rising tide floats all boats and that is simply the wrong premise.”
Turning again to the tool of due diligence, he suggests you need to conduct the same forensic look you would undertake in any other industry from checking a company’s margins through to checking out their management team.
“The good news is that the investors who are willing to be the pioneers…willing to invest in the uncertainty despite the barriers are getting better valuations because they are not having to compete with the bigger institutional players,” says Dayton.
These individuals have a chance to take a run at a multi-billion market before they have to compete with other bigger players. Once the barriers are lifted over the next few years they get rewarded for taking the early risks.
If you are actually thinking about investing in a physical business then do your due diligence. This is really key:
- Always ask to see the books
- Verify the independence of their CPA accountants
- Engage legal counsel to review an investment agreement before signing it
Roper also recommends if you have a substantial amount – a minimum six figures – to invest consider joining a club of investors.
Using Angel groups can be an option for high-net worth individuals with at least a $100,000 to $2m. These network investment groups explores opportunities in the industry and offers some protection helping you to navigate the legal complexities.
ArcView has one such network of investors with around 600 high net worth accredited investors. The group according to Dayton has placed over $150m into 160 companies so far.
You can determine whether you are going to invest in the cultivators and processors those that deal with the physical plant or in companies that deal with other aspects of the industry and not the plant itself.
If you proceed with direct investment in cannabis production then legality is a big hurdle if the table turns, particularly at federal level. But early investors could find they are on the cusp of an industry that is set to grow by leaps and bounds.
Lien concurs: “More and more money will come in to try and grab a piece of this ever-growing market share as legislation continues to roll through the country and eventually the world.”