In order to understand investment trends and cannabis stock prices we need to understand the industry’s make up and its growth potential.  There is a tendency to take the market for granted and assume that the companies are claiming a stake as legalization unfolds, but the story is much more complicated and, every decision requires careful study before buying or selling existing stocks, investing in IPOs, or participating in private placements.  We can’t provide you with a comprehensive study in a couple of pages, but at least offer a few reference points.

There are no reliable industry statistics at this stage, but rough estimates suggest that cannabis sales across North America are in the $50-60 billion range; most of this is still the black-market, where illegal sales can’t be traced to source.  Best estimates of legal sales in 2018 are around $10 billion, roughly 40% for medicinal and the rest for recreational uses.  As legalization unfolds we will naturally see a transition, but this takes time, as illicit segments do not disappear as soon as laws come into effect.  No matter how we look at this transition, however, there is 5-6 fold growth potential based on current sales estimates.  Moreover, there is a consumption increase to take into account, which may push growth to 10-fold in the coming years – let’s say 5 years in Canada and 10 in the US.

In USA by 2018, 31 states had already legalized medical marijuana.  It may be tempting to think that the job is two-thirds done but huge regulatory obstacles remain – among them the road blocks placed by the US Food and Drug Administration, still treating marijuana as a banned substance.

In Canada, legalization of medical cannabis came as early as 2001, and Health Canada took a much more enlightened view, but trials and approvals take time. It took 15 years before sales started taking off – increasing from 3,300 kg in 2016-Q1 to over 12,000 kg in 2017-Q2, and the process has a long way to go yet.  Over the same period number of registered patients also quadrupled, from roughly 50,000 to 200,000, but this only scratches the surface of the growth potential.  Huge markets in pain and sleep management, as well as anti-depressants, are yet to open up in full – if the resistance from drug lobbies can ever be overcome.  While most of the research efforts go into the futile mission of discovering or inventing health-risks and addiction-effects, the obvious benefits for a variety of applications are still being overlooked.

On the recreational front, 9 states (plus DC) already legalized marijuana for recreational uses, and on November 5, 2018 one more state voted to legalize.  The already legalized states account for 22% of the US population; if marijuana consumption was proportional to population, legal sales of recreational marijuana within their borders would account for more than 50% of recreational consumption but nowhere near 100%.  More than a year into legalization, and in some states two years, black-markets still exist and will prevail for some time.

More than three quarters of the country (in population) is yet to legalize and there is no indication that per capita consumption in these markets will be any less promising than in the already legalized states.  Thus, there is room for at least 5-fold increase in sales at current rates of consumption and even more with expected increases (at least modest ones) in consumption.  Opinion surveys reveal that a quarter of the population sees illegality as a deterrent but at the same time 70-75% view marijuana as less risky than tobacco or alcohol.

Canada legalized recreational use on October 17, 2018 across the entire country, 2nd in the world to do so after Uruguay.  There are no legal-sales reports yet, but potential market size estimates range from $2 to $5 billion – it may be even higher based on our sales estimates for already legalized US states, without taking into account further growth in per capita consumption rates.

Production, sales, and distribution channels are not yet in place for consumers to buy cannabis from licensed outlets, and there is no indication that regular cannabis users are going to be deterred from continuing to buy through illicit sources, particularly in view of the availability of much better quality products at lower prices in the black market.  We believe the transition to a fully legalized recreational cannabis industry will take at least 2 years, and illegal channels may linger for even longer in view of licensing impediments and supply bottlenecks.

Now let’s turn to supply sources.  Channels for medicinal cannabis (growers supplying drug companies) have long been established and are now going through a growth spurt fueled by the recognition of its benefits.  Licensed Producers (LPs) serving medical markets have now turned their attention to recreational demand, but do not have the capacity to fulfill the outstanding orders from licensed distributors.  Until production, processing, and sales channels form and are licensed to serve the huge demand for recreational cannabis, the black-market will not go away.

Hundreds of brick-and-mortar dispensaries and online-platforms have been selling marijuana illicitly across the country for a long time – mostly raw-weed but lately infused edibles and drinks as well.  After legalization, provincial boards (liquor boards, now liquor-cannabis boards) became sole distributors, placing huge orders that LPs cannot meet.  In most provinces these boards are supposed to supply cannabis to licensed retailers but only a handful have been licensed to operate.  Even if enough retailers were licensed, what’s available from provincial boards is not only inferior in quality but also more expensive than what consumers can get from illicit sources.

The market for infused edibles and drinks is almost as large as for raw-weed to smoke.  The federal government had already conceded to a delay (perhaps up to a year) in coming up with proper regulations for edibles-drinks, while processors cannot even apply for licenses.  In this market segment there is a need for extracts or concentrates (THC or CBD), but processing-licenses for these types of producers still remain a mystery.  Even licenses for making simple products like rolled-joints are up in the air.  In the meantime online platforms operate with impunity, delivering marijuana and marijuana-products like regular groceries.

In a nutshell the market for a substance that has already been legalized is still in its infancy at best – even the most rudimentary processing, distribution, and sales channels do not exist, and the establishment of a viable system with proper supply-chains is going to take time and money.  The investment rush to cannabis may have speculative elements, but much of it is driven by real needs in a market where demand is evident and expected to grow.

Starting from the bottom of the supply-chain, LPs have been taking in most of the investment flowing into cannabis, and this will continue as they need capital to expand their production capacity.  Cannabis growth is expensive, requiring land, facilities, and power infrastructure (lighting and temperature-control).  Investors can take their pick of already established LPs or new ones in craft-niches.  There will be plenty in the offering for investors to pick from – producers at different levels of maturity, offering different terms-and-conditions, and varying future prospects (survival-risk, scalability, profitability, etc.).

Another tier to consider is secondary processors, mainly derivative products like concentrates or oils.  Then there will be the next tier, producers of edibles-drinks as well as creams, lotions and anti-aging products.  There will also be a tier focused on distribution-logistics – resellers, packagers, warehouse operators, and transporters.  Finally, there will be the customer-interface layer, retailers, brick-and-mortar stores and online-portals.

All these tiers or layers will require further analysis as they do not exist in the legal arena yet, but they are bound to emerge eventually.  Existing cannabis companies now focusing on growth will enter these spaces through vertical-integration efforts while new entrants contest the same spaces.

There will be no shortage of investment opportunities in the cannabis industry, but one must be careful during any gold-rush.  Due diligence, now more than ever, will be instrumental in picking a portfolio of existing stocks, while further opportunities exist in identifying and nurturing worthy startups in order to position them for success in the years to come.

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