As the Canadian cannabis industry blazes a path of growth in the run-up to October’s legalization, so does the number of related publicly listed stocks trading on North America’s largest indexes.
Getting in on the action, some of Canada’s public pension funds are starting to look for exposure to cannabis companies, according to a report obtained by BNN Bloomberg. It showed the Alberta Investment Management Corp. and the British Columbia Investment Management Corp. participated in cannabis producer Canopy Growth Corp.’s $200.7-million financing deal earlier in 2018.
While AIMCo declined to comment on any investment in the sector, BCI told Benefits Canada its exposure is purely passive. “It’s held within our indexed fund that tracks the S&P/TSX composite index,” wrote Gwen-Ann Chittenden, director of corporate communications and investor relations at BCI, in an email. “BCI’s investment interest is aligned with the weighting within the S&P/TSX composite index.”
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With investor interest budding, how long will it take for the cannabis sector to reach a mainstream reputation as a viable commodity like timber or beef? Or will it ever get there?
Puff or pass
“About three years ago I was in a pension meeting with one of our clients. One of the pension committee members actually raised this question of whether we should try to start investing in marijuana-related businesses,” says Ruo Tan, president of Segal Rogerscasey Canada. “At the table was the pension plan’s lawyer, who said, ‘Stop, we need to stop for now because down south it’s illegal.’”
Of course, at that time, the drug was also illegal in Canada. But that’s all about to change, with a set legalization date of Oct. 17, 2018. The sector is looking more realistic every day, says Tan, noting any pension plan investing passively along the TSX can’t avoid cannabis, since it continues to make up an expanding portion of that index every day.
The three largest common stocks for cannabis have a weighting in two Canadian index exchange traded funds — the iShares Core S&P/TSX capped composite and BMO S&P/TSX capped composite — with Canopy Growth at 0.38 per cent, Aurora Cannabis Inc. at 0.24 per cent and Aphria Inc. at 0.09 per cent of the iShares index on Aug. 20.
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“Of course, they’re no Royal Bank, they’re not 8.5 per cent, but there is a percentage there,” says Tan.
Indeed, the majority of cannabis companies are small-cap stocks, so investing in them directly is currently less appealing to large pension plans, he says. These plans tend to shun small-cap stocks because their preferred purchase size, around a minimum of $50 million, may mean owning too much of the company’s stock relative to its overall size, adds Tan.
Typically, large plans won’t take on more than 10 per cent of a stock’s total capitalization, which means the company’s market cap must be at least $500 million, he says, noting the vast majority of marijuana stocks just aren’t there yet. In fact, only a handful of Canadian cannabis stocks have reached a capitalization of more than $1 billion.
But with change on its way, individual money managers are facing major challenges in assessing specific companies on both a qualitative and quantitative basis, says Steve Hawkins, president and co-chief executive officer of Horizons Exchange Traded Funds Inc. As such, some are choosing to focus on cannabis-themed exchange-traded funds to diversify their marijuana options, as well as dipping into the ancillary businesses, he says.
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Spreading the risk around is important when investing in such a nascent and malleable sector, says Hawkins, noting he doesn’t anticipate all public marijuana companies will shoot straight to the top once legalization takes effect. For his part, he’s taking a particular stance, focusing on growing with the small caps.
“From a long-term growth perspective, we thought there were going to be significant short term plays which affect that industry. There are going to be more and more producers [accessing capital markets]. They’re going to be small, we’re going to invest in them and then they’re going to get taken out by the big boys,” he says, referring to pharmaceutical, tobacco and alcohol companies.
WEED GROWTH
While many predictions expect major gains in the sector once Canada legalizes recreational cannabis, it remains difficult to pinpoint how big the Canadian industry will become. A report, published by Deloitte Ltd. in June 2018, provides a multi-billion-dollar range, though many variables are still up in the air, such as what prices consumers will be willing to pay for different products and whether all consumers will switch to legal channels for acquiring the drug.
$1.34 — $2.75 billion:
Estimated current illicit recreational cannabis market
$1.81 — $4.34 billion:
Projected recreational market once cannabis is legalized
“They’re going to want to get access to that marketplace. And how are they going to do that? They’re going to do it by acquisition.”
Private party
Public equities aren’t the only option for investors considering the flourishing cannabis sector. Everett Knight, portfolio manager of Matco Financial Inc’s small-cap and cannabis fund, says private equity investments in marijuana companies make up a big part of his firm’s strategy for the sector.
Private equity is particularly appealing because it usually comes at a discount compared to public companies, some of which are quite richly valued, says Knight. Although, he adds, there are plenty of public cannabis companies with upside potential.
Another way to find value is to look at the marijuana industry’s ancillary businesses, he says. A company that tests cannabis products to ensure they’re certified free from some pesticides and that they contain the specified cannabinoids, for example, is especially interesting.
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“The testing market will be the bottleneck for the space,” says Knight. “Testing companies have to test for 56 pesticides today. They’ll have to test for 95 pesticides in the future. And clients are waiting two weeks to finally get their product tested before they go and sell it.”
Taking on private equity, either directly or through managed funds, is really the only way to access the broader array of opportunities in the market, including these supplemental companies, he adds. Capturing businesses with exposure to the sector, but which aren’t direct cannabis producers, can provide a more complete picture of the sector’s future, he says.
“Everyone thinks of cannabis as a whole space, as just those public companies, whether it be Canopy or Aurora or Aphria. And they say, ‘Have I missed out?’ I think it’s the second inning and what they’re not seeing is the ancillary businesses,” says Knight.
Certainly, investors are facing a steep learning curve and they’ll have to build core competencies for analyzing the sector, he adds. “It will take them longer to do, but now that we have legalization on the horizon, it increases eyes on the space.”
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As well, the more institutional investors study the cannabis industry, the broader the opportunities they’ll see, he says. At first glance, the Scotts Co., which manufactures, markets and supplies products for lawn and garden care, doesn’t necessarily jump out as a way to play in the cannabis space, but it absolutely is, says Knight. Earlier this year, Scotts acquired Sunlight Supply Inc., one of the largest hydroponics distributors in the U.S., for US$450 million.
“It’s not what we would call direct exposure, given that it’s such a small portion of their overall company,” says Knight. “But it is one of those companies that is getting involved, and you’re seeing more and more of those companies pivot toward cannabis.”
Blowback
Despite the steady march towards the legalization of recreational cannabis and the obvious growth in the sector, some investors still consider it to be too young. While Norman Levine, managing director at Portfolio Management Corp., is highly dubious about the industry, he believes it will eventually be worth every investment manager’s attention.
“Nobody knows who’s going be a survivor and who’s going to fall by the wayside, and early advantage doesn’t necessarily mean anything,” he says. “At this stage, to me, investing in cannabis stocks is gambling as opposed to investing. And I would say that any pension fund manager that is using it is gambling with the pensioners’ money.”
Indeed, even allocating enough to cannabis stocks for a passive strategy demonstrates the risks of index investing, says Levine. “It shows you the problem with index funds, because people who follow the TSX used to have 36 per cent of their money in Nortel, they had 20 per cent of their money in Valeant. The Canadian index is a dangerous index to try and follow.”
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While Levine sees nothing wrong with making an allocation to what he calls “sin stocks,” he emphasizes the need for solid data regarding sales and margins in order to fully understand the value and growth potential of a company. The various projections for the future of the cannabis sector just aren’t based on enough strong data to convince him.
“With cannabis, people are in love with the industry and you should never be in love with your investments,” he says.
Sin stock or societal salve?
As institutional investors pay increasing attention to the environmental, social and governance implications of their assets, it isn’t yet clear where cannabis falls in that spectrum, says Tan.
However, John Downs, director of business development at the Arcview Group, an American based group of high-net-worth cannabis investors, believes it’s a socially responsible investment. The world has rarely seen such a rapid shift in the perception of a social issue, he adds.
There are several evident, societal benefits to normalizing the drug’s use, which could be the beginning of a paradigm shift in western perceptions of wellness, says Downs. Taking a puff from a vape pen at the end of a difficult day, as opposed to having a glass of wine, could have far-reaching implications for the health and wellness industries, he notes.
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Also, it’s a tangible benefit for marijuana users to have more knowledge about the product, says Downs. On the black market, illegal growers could be using dangerous pesticides and perpetuating irresponsible agricultural practices, so bringing production of the plant into a legal and regulated marketplace can only help consumers, he adds.
And, as the industry grows, investors will take the usual environmental, social and governance issues into consideration, says Tan, noting each cannabis grower’s carbon footprint could be hugely different, depending on their practices, and that’s something investors will want to analyze.
Must be this tall to ride
While Canada’s largest pension funds are staying mostly tight-lipped about their views on the cannabis sector, the first comer to the party will be important, says Tan. “When a significant, well-known institutional investor gets into this business, it certainly will help the whole segment.”
That’s not to say it has to be the Canada Pension Plan Investment Board or the Ontario Teachers’ Pension Plan, he adds, “but if there is someone, a reputable, well-known name, their entry to this particular business definitely will be viewed as important and positive.
“From a client point of view or even a consultant point of view, there has been an open discussion and education. From a manager point of view, I can tell you the well-known institutional managers so far in Canada have not really gotten into this particular scene yet.”
One way or the other, Oct. 17, 2018, is going to be an important psychological hurdle for investors, says Vahan Ajamian, managing director of analyst relations at U.S.-based cannabis company MedMen Enterprises Inc. However, with such rapid societal change, he anticipates institutional investors will want to get ahead of the pack.
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Currently, he sees institutional investors falling into two camps on cannabis: those that haven’t yet taken the plunge but are interested in the sector and those that have been ignoring it. Last year, in its first year on the scene, Canopy Growth was the best performing stock on the TSX/S&P composite index, points out Ajamian. “If you’re not taking the sector seriously, you almost have some explaining to do.”
As Knight notes, the marijuana industry is in its second inning. “If you look at how it’s happened in Canada, we had medicinal patients grow from 40,000 at the start of 2016 to 169,000 as of Dec. 31, 2017,” he says. “When you get that kind of rapid growth in a country . . . then it drives social acceptance, it drives the recreational market. And I think you’re going to find that growth around the world.”
Investors with a long-term focus will want to watch this sector because it stands out as one of the only serious growth sectors in Canada and globally today, says Knight. Canada is set to create the blueprint for how the world handles cannabis as a business and social issue, and it has a significant head start.
Martha Porado is an associate editor at Benefits Canada.