How to profit as marijuana becomes mainstream

Next year recreational cannabis use becomes legal in California. With Canada also set to lift its ban, Big Weed will soon present a host of investment opportunities, says Ben Judge.

Next year recreational cannabis use becomes legal in California. With Canada also set to lift its ban, Big Weed will soon present a host of investment opportunities, says Ben Judge.

Ever since Harry J. Anslinger, the single-minded head of America's Federal Bureau of Narcotics from 1930 to 1962, introduced the Marijuana Tax Act of 1937, cannabis has been illegal in the US. And in 1961 it was added to the UN's Single Convention on Narcotic Drugs, and became illegal in virtually every country in the world. A few most famously the Netherlands pursued a policy of turning a blind eye in certain circumstances, but the drug was effectively under a global ban, with production and supply confined to the black economy. But now things are changing fast most notably in the US, the land that dreamt up "reefer madness" and painted marijuana as the drug of Mexicans and jazz musicians in its efforts to turn the public against it.

This week, for instance, streaming giant Netflix promoted its new TV series set in a medical cannabis dispensary by pairing different strains of marijuana with various TV shows and selling them through a "pop up" shop in West Hollywood, California. There were a few legal hurdles to jump to ensure it stayed within the law, but far from fostering outrage, the stunt met with acclaim on social media. It's an indication of just how mainstream cannabis is becoming across the US, and how it's throwing up all sorts of opportunities for business and investors.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free
https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The road to legalisation: medical marijuana

The medicinal properties of cannabis have long been trumpeted there is evidence that it can reduce nausea in patients undergoing chemotherapy, combat the muscle spasms of multiple sclerosis, and help manage chronic pain, for example. So in 1996, after bowing to the growing tide of public opinion, the state of California legalised the use of medicinal marijuana, even though the drug was still categorised by the US federal government as a "Schedule 1" controlled substance, alongside heroin and cocaine, with "no currently accepted medical use and a high risk of abuse". Since then, it has become legal for medical use in 29 US states, plus the District of Columbia; other countries, including Germany, Colombia and Canada, have also embraced cannabis as a medicine.

By 2012, with attitudes towards cannabis and the war on drugs in general continuing to evolve, Colorado and Washington voted to legalise the drug for recreational consumption. Now, eight states, as well as the District of Columbia, allow legal recreational cannabis. Meanwhile, Canada is also expected to legalise it next year. But by far the biggest boost to the cannabis industry will come in January 2018, when recreational use becomes legal in California, the world's sixth-largest economy (were it a standalone nation). The recreational market in California could be worth as much as $5bn a year, says Eli McVey in Marijuana Business Daily (one of the many publications that have sprung up to report on the burgeoning industry) that's more than the entire industry made in 2016. The same publication reports that cannabis-related businesses in the US now employ between 165,000 and 230,000 people, both full time and part time.

It's not all plain sailing, however. While recreational marijuana is legal in an ever-growing number of US states, it remains illegal under US federal law and that's causing some serious headaches on the commercial side. Under President Barack Obama, the federal government tended to tread lightly; in 2013, then-attorney general James Cole issued a memo saying that, while federal prosecutors would still "aggressively enforce" the law, the government was "deferring its right to challenge" laws made by states legalising recreational cannabis use, as long as those states had established "strict regulatory schemes" to prevent sale to minors or money flowing to criminal gangs. But the current attorney general, Jeff Sessions, is likely to be more hawkish. While President Donald Trump has declared his support for medical marijuana, there are suggestions that he will not be so accommodating to the recreational marijuana industry. Campaigners hope instead that the size of the industry will leave him little choice but to allow it to continue to develop, or risk a backlash as thousands lose their jobs.

As a result of this precarious federal legal status, much of the cannabis economy is still transacted in cash. Banks and other financial institutions don't want to do business with marijuana businesses, and the US Treasury has imposed tough due diligence requirements that banking institutions must go through to ensure prospective customers possess all the permits and licences that each state requires. They are also required to file "suspicious activity reports" to the federal government. This half-legal world is itself throwing up opportunities for profit: transport companies regulated by the US Department of Transport are not allowed to carry cannabis, for example, so a parallel transportation sector is forming. CannaGuard Security was formed to shift cannabis from growers to vendors in armoured trucks not only due to the merchandise being valuable, but also because the business being transacted in cash means it has to be transported securely.

This issue of access to financial services is not only a problem for US businesses. Uruguay recently became the first country in the world fully to legalise recreational marijuana, with the drug available to buy via pharmacies since July. But now, reports Ernesto Londoo in The New York Times, American banks say they are to be restricted from doing business with any banks in Uruguay that provide services to cannabis-related businesses as a result of the US Patriot Act.

California's state treasurer, John Chiang, has convened a Cannabis Banking Working Group to explore ways of opening up the banking system to cannabis-related businesses. It includes representatives from the financial and marijuana industries, as well as from law enforcement, state government, regulators and, of course, the tax authorities collecting taxes is clearly far harder to do when businesses deal mainly in cash. Even so, Colorado managed to raise $105m in tax revenue from recreational and medical marijuana in 2016/2017.

The growing investment potential

The appeal of additional taxes for cash-strapped states is another good reason why the cannabis sector is likely to overcome the remaining obstacles to mainstream acceptance. If it does become legal under federal law, the market's annual value could expand eightfold to $50bn in the next decade, says Jennifer Kaplan on Bloomberg.com, citing a report from New York analyst Cowan & Co. Full legalisation would open the doors to mainstream businesses as well as the new crop of smaller start-ups currently in the sector. The report's author, Vivien Azer, believes there would be a significant opportunity in cannabis for big tobacco firms (more on that below). On the downside, brewers' profits would be likely to take a hit cannabis smokers tend to drink less alcohol than non-smokers.

It's a slightly different story in Canada, where the government plans to make recreational cannabis legal by July 2018. That would make Canada the second nation after Uruguay to legalise both recreational and medical cannabis. There, big businesses are expected to cash in pretty rapidly. Consultant Deloitte reckons that legalisation represents a "bold new landscape for Canadian businesses and governments alike" it could be worth more than $22bn to the Canadian economy, when you take account not only of the growing and retail operations, but also a whole host of ancillary businesses, including tourism, testing labs, security, licensing and taxation. Canada, where medical cannabis has been legal since 2001 (with growers operating under licences issued by Health Canada), already has perhaps the highest number of listed cannabis-related companies. The biggest listed grower is Canopy Growth, which has a market capitalisation of C$1.5bn, and looks likely to become a major player in Canada's new legal industry.

And despite the legal uncertainty, investors are still putting significant sums into US cannabis. According to private-equity group Phyto Partners (citing New Frontier Data), $100m was invested in the cannabis industry in 2014, $250m in 2015, and almost $1bn in 2016, spread across 275 companies. Among the biggest investors are MedMen Capital, Phyto Partners, Casa Verde Capital, Poseidon Asset Management and Arcview Group, says Debra Borchardt in Forbes. MedMen's vision is to "mainstream marijuana", making cannabis a consumer product. Its Opportunity Fund has made seven investments totalling more than $90m across projects in Canada, California, Nevada and New York. Casa Verde Capital was set up with $25m in 2015 by rapper Calvin Broadus (better known as Snoop Dogg). It focuses on "ancillary" cannabis start-ups, including agricultural technology ("agtech"), financial services, media, compliance and packaging. Hedge fund Poseidon, meanwhile, owns stakes in more than 25 businesses in agtech, compliance, industrial hemp and data analytics.

But it's not just start-ups. One high-profile investor is Jim Hagedorn, CEO of seed, fertiliser and pesticide maker Scotts Miracle-Gro. Cannabis is "the biggest thing I've ever seen in lawn and garden", he told Forbes last year. He proposed to invest "half a billion in the pot business". Traditional pot growers look with some scorn on big fertiliser firms, in much the same way as craft beer devotees hold big brewers in disdain. So adopting a similar strategy to the big brewers Hagedorn created a subsidiary, Hawthorne Gardening Co, in 2014 to capture growth in the cannabis industry at arm's length. Hawthorne is run by his son, Chris Hagedorn. His investments include spending $130m on California's General Hydroponics which sells growing equipment to cannabis growers and $136m on Gavita, a Dutch lighting and hydroponics equipment supplier. He has also bought Arizona-based hydroponics supplier Botanicare for an undisclosed sum.

Hagedorn senior wants the company to become "the best supplier of hydroponic growing products in the world to both the consumer and professional markets". According to Alicia Wallace in The Cannabist a marijuana-focused subsidiary of the Denver Post Hawthorne is contributing nicely to Scotts' bottom line. In the quarter to 1 July, Scotts' core business in the US grew sales by just 5%. Hawthorne saw growth of 146%. That may have been driven partly by acquisitions, but even so, assuming Hawthorne owned its most recently acquired businesses at this time last year, underlying growth was still 21%.

Will Big Tobacco become Big Weed?

If marijuana is legalised at the federal level in the US, Big Tobacco is likely to muscle in. Sales of tobacco are falling, and with governments hiking taxes on those who still smoke, it's a logical area to move into. As food, beverage and tobacco analyst Ken Shea told Bloomberg last year, the US marijuana products industry "is so sizeable now that consumer products companies can't ignore it". It's a "compelling opportunity for the tobacco companies". Altria is the biggest tobacco firm in the US, with Reynolds American, now part of British American Tobacco, the second largest. Earlier this year Imperial Brands appointed medical cannabis expert Simon Langelier as a non-executive director.

There is also a huge potential market for ways of delivering marijuana that don't involve inhaling smoke or vapour. The market for edible products containing cannabis will grow, too. Much of this is currently done on an artisanal level, but big companies will be keeping a keen eye on the state of the market, and on the political temperature. The variety of products is huge: drinks, confectionery, balms, and infusions even "pet pot nibbles" are now available. We look at some of the best potential ways to profit below.

How best to profit from pot

The biggest listed marijuana grower is Canada's Canopy Growth Corp (Toronto: WEED), which is expanding rapidly ahead of Canada's expected full legalisation. An alternative, more speculative, punt is Cannabis Wheaton Income (Toronto: CBW), which describes itself as a "cannabis streaming company". The firm's novel business model is similar to that of many in the mining industry, providing financing in return for an equity stake and a proportion of future income. Meanwhile, Scotts Miracle-Gro (NYSE: SMG) looks like a good "picks and shovels" play, with its fertiliser and hydroponics subsidiary, Hawthorne Gardening Co.

The big tobacco firms Altria (NYSE: MO), British American Tobacco (LSE: BATS) and Imperial Brands (LSE: IMB) are for those who are betting on legalisation at a federal level. Along with e-cigarettes, these could offer a new lease of life for the tobacco business but for now, marijuana plays no role in generating these companies' earnings.

If you're looking to invest in medical marijuana, the biggest player is UK-based GW Pharmaceuticals (NASDAQ: GWPH). Its cannabis derivative Sativex is a mouth spray used to alleviate symptoms associated with multiple sclerosis. Another drug, Epidolex, currently in development, is intended for rare, drug-resistant epilepsy symptoms. Alternatively, if you're looking for a fund, there is an exchange-traded fund (ETF), listed in Canada, called Horizons Marijuana Life Sciences Index (Toronto: HMMJ). Horizons is a very concentrated ETF (it holds around 15 stocks, including all of the non-tobacco stocks listed above) and like many themed ETFs, it launched at precisely the wrong time the price has fallen from a peak of nearly C$13, reached just after launch in April, to around C$8.50 now. But if you like the look of the sector and are willing to trade Canada-listed funds, then this does offer a more diversified (though still risky) way in.

Ben Judge

Ben studied modern languages at London University's Queen Mary College. After dabbling unhappily in local government finance for a while, he went to work for The Scotsman newspaper in Edinburgh. The launch of the paper's website, scotsman.com, in the early years of the dotcom craze, saw Ben move online to manage the Business and Motors channels before becoming deputy editor with responsibility for all aspects of online production for The Scotsman, Scotland on Sunday and the Edinburgh Evening News websites, along with the papers' Edinburgh Festivals website.

Ben joined MoneyWeek as website editor in 2008, just as the Great Financial Crisis was brewing. He has written extensively for the website and magazine, with a particular emphasis on alternative finance and fintech, including blockchain and bitcoin. 

As an early adopter of bitcoin, Ben bought when the price was under $200, but went on to spend it all on foolish fripperies.