The Opportunity In Cannabis Stocks

Source: Energy and Resources Digest

Whitney Tilson’s email to investors discussing the opportunity in cannabis stocks.

The Opportunity In Cannabis Stocks

Speaking of Empire Investment Report, one of our best recommendations was cannabis company Green Thumb Industries Inc (OTCMKTS:GTBIF), which was one of eight stocks we recommended on September 16 last year to take advantage of the “blue wave” we correctly predicted in the 2020 election.

Since then, these eight have risen an average of 94% versus 32% for the S&P 500 Index – and the second-best performer after discount retailer Citi Trends, Inc. (NASDAQ:CTRN) was Green Thumb, which had soared 112% by the time we recommended selling it on June 16.

I continue to think the cannabis sector is extremely attractive, however, which is why I doubled my position in my personal account two days ago in the AdvisorShares Pure US Cannabis ETF (NYMARKET:MSOS).

Two of the smartest investors I know share my enthusiasm for the sector. First, here’s Tom Carroll, who writes the Cannabis Capitalist newsletter for our corporate affiliate Stansberry Research and was the source of our highly profitable Green Thumb pick last year:

Cannabis stocks rocketed through the “Cannabis Election Trade” I aggressively highlighted last fall.

The sector today, however, has sold off and is now almost back to where it was before the election, which makes no sense because the fundamentals are much better.

Most importantly, cannabis companies’ earnings and cash flows have been outstanding, making their stocks downright cheap, despite margins that rival software-as-a-service companies. Plus, the legal/regulatory environment continues to improve.

And here’s Doug Kass of Seabreeze Partners:

It’s Time to Buy Cannabis Stocks… And to ‘Stash’ Them Away

  • Cannabis stocks have high growth prospects and are virtually recession resistant but are trading at value multiples.
  • With few institutional owners, the cannabis space may now provide the best upside reward vs. downside risk of almost any market subsector.
  • Low industry stock prices are the friend of the rational long-term buyer and the possibility of a 3x to 5x gain over the next five years may now be in sight.

After experiencing a swift rise in share prices from September 2020 to February 2021, cannabis stocks have [given] up most of their gains in the last seven months.

From my perch, this might be creating an unusual intermediate to longer-term opportunity…

In my view the slow roll of the Secure And Fair Enforcement Banking Act of 2019 and the failure to make inroads on federal legalization, coupled with associated custody issues, have contributed to the precipitous share price drops, and forced retail and institutional liquidations in a relatively illiquid setting.

But, time – and low share prices – are now on the bulls’ side as there seems to be an inevitability that these three factors will be addressed with a positive outcome in the not so distant future.

Despite the slow roll, budget-broken states, with an immediate need for more revenues, are moving quickly and, as a precursor to further state and federal progress, decriminalization appears the likely next step.

Importantly, as pointed out by Barron’s over the weekend, despite the plant’s illegality at the federal level and the lack of access to the capital markets, second quarter earnings reports exhibited continued growth and above-expected profitability/prosperity.

Compelling Valuations After The Long Squeeze

Let’s now consider the compelling valuation argument:

The leading companies in the largest cannabis ETF [exchange-traded fund] (MSOS) trade at 7x 2023 EBITDA [earnings before interest, taxes, depreciation, and amortization] while offering over 25% compounded earnings growth over the next 3 to 5 years.

The S&P Index, by contrast, trades at over 13x EBITDA while offering only 5%-8% annual EPS growth.

If we grant MSOS the same multiple/growth ratio, the MSOS ETF “should” trade at over 40x – representing, in theory a 5x rerating opportunity.

The individual company market capitalizations are remarkably small (total enterprise value of only about $50 billion) relative to the industry’s opportunity in both recreational and medical/health/wellness applications. The largest ETF, MSOS, which consists of U.S. operators, has a market cap of only $900 million. Perhaps, above all, this observation highlights the magnitude of the sector’s (under-owned) opportunity.

And, if I am correct in that the long squeeze of legislative activity and forced liquidations (by custodians) are almost over, the industry’s upside is immense – both in absolute and relative term. The potential unleashing of surprisingly large cannabis demand for the product and the shares lie ahead.

For more on this, see this post by CB1Cap’s Todd Harrison, The Canna FAANG Cometh, in which he discusses the FAANG-ification of the cannabis business – and displays his tiers and preference toward the likely winners.

The Winners

In my research, I have always been at a loss in determining who the cannabis winners and losers would be, so I have simply been acquiring shares in the two largest ETFs, MSOS, and MJ.

Note: This article originally appeared at ValueWalk.