The following only makes sense if you think it is time to invest in the cannabis industry or marijuana stocks.
Cannabis is a commodity. It is traded based on the market demand and supply. The demand for cannabis has been steadily increasing for thousands of years while the supply has been only gradually legalized in the last decade. In the U.S., total cannabis revenue grew from $50 billion in 2010 to over $100 billion in 2017, and is expected to exceed $150 billion by 2020 (see Figure 1 below).
The pace of states legalizing the use of cannabis is the single most important determinant for the market supply. Between 2000 and 2010, for every one state legalizing cannabis, the legal cannabis revenue has increased by nearly 50%. Between 2020 and 2026, it is forecasted that revenue will increase by 24% for each additional legalized state. By 2026, the legal cannabis revenue will amount to $79 billion, 10 times 2014's level. It is this speculation of outrageous growth that makes investing in cannabis stocks so speculative.
Out of the 238 current U.S. cannabis stock universe, 25 stocks or 10% have already been delisted. 75% of the stocks are trading at levels 80% below the first trade prices. Only 25% of them are at levels 150% higher than their IPO prices. It is this lottery-like returns which make investing in cannabis stocks almost like gambling. To see an updated current U.S. cannabis stock universe, click here.
Why A Cannabis Index?
Even if you buy into the story it is time to invest in the cannabis industry, it is clearly and extraordinarily risky to just invest in one stock. Basic finance principals suggest that owning around 15 stocks will effectively eliminate most of the idiosyncratic risk and leave the industry bet intact. Therefore, we seek to establish a 14-stock Cannabis Index ("Index") which is not a mathematical exercise but both liquid and investable by retail investors.
The Index offers direct exposure for retail investors to the stocks that are involved with medical marijuana bioengineering and production. The Index includes publicly traded stocks of life sciences companies and other firms with business activities in one or more of biopharmaceuticals, medical manufacturing, distribution, bio products and other ancillary businesses to the marijuana industry. Out of an initial 238 cannabis-related stock universe, the following screens are applied to reduce the liquidity and trading risk. The goal is to identify both the more established companies which will weather well during volatility, and quality small companies which will benefit most from legalization.
Entry Criteria into the Cannabis Index
1. A significant amount of the current or future revenue has to be related to cannabis.
2. Both the IPO price and the first trade price cannot be less than $5.00, as low prices accentuate price volatility.
3. In order to avoid high execution cost in terms of bid-ask spread and market impact, the average daily trading dollar amount is at least $1 million.
4. To assure the validity of the business model, the initial asset size is over $50 million.
5. To ensure the equity requirements, the initial market capitalization is at least $50 million.
6. The company and management do not have credibility issues.
If the stock consistently violates any of the above criteria over a 6-month period, it will exit the Index.
Credit Risk OK! Credibility Risk Never!
As in the infancy stage of potentially explosive growth, there has been a large amount of scams, misinformation, and manipulation in the cannabis industry. While significant credit risk is anticipated in a young industry, credibility risk cannot be tolerated. This is the reason why CannaGrow Holdings Inc. (OTCPK:CGRW) was excluded from the Index. The company doesn't file financials with the SEC. John Hicks of Desert Vista Capital, a low profile penny stock financier, has been known to burn retail investors in the past. The company is insolvent. Current assets at Q1 were less than $30,000 and over $3 million debt will be due next year. As a result, the $250,000 intangible assets seem meaningless. The company issued a lot of convertible debt but does not share the terms with shareholders. Another red flag is that Affiliate Brent Crouch, who holds 33 million shares as well as convertible preferred and convertible debt, also prepares the "unaudited" financials. By the way, the company just did a reverse split of 17,000 to 1.
Did I mention that CGRW is not included in the Index?
In Table 1, the current constituency of the Index, 14 stocks are listed (as of 4/7/2017 from Bloomberg).
Some of the more notable current company-specific risk is identified below:
General Cannabis Corp. (OTCQB:CANN)
There is limited operating history in an evolving industry, which makes it difficult to accurately assess the future growth prospects of the company. The history of losses may not let the company achieve profitability in the future; the company's reputation and ability to do business may be negatively impacted by improper conduct of business partners, employees or agents.
Innovative Industrial Properties (NYSE:IIPR)
The company is still small in size and if they are not able to grow their capital base, they could be facing problems operating their company. The high return on investment capital helps in that the threshold for sufficient size could be lower for IIPR than it is for lower return property types. The company's new largest tenant is a new company which does not have a credit history. It remains to be seen how well this translates into profitability.
Pineapple Express (OTC:PNPL)
The company is being sued over $685 thousand in unpaid bills.
Eco Science Solutions (OTC:ESSI)
The company has been struggling generating cash flow as they have not yet been able to produce any cannabis revenue. ESSI has already burnt $12.5 million in shareholder capital since inception. With close to $1 million in payables, they only have $70,000 in cash with an annual cash burn rate of more than $200,000.
Zynerba Pharmaceuticals (NASDAQ:ZYNE)
ZYNE has not generated meaningful commercial revenue. Therefore, they have not yet been profitable. They are expected to generate revenue when their products ZYN001 and ZYN002 get approved and commercialized. In order to complete the development and commercialization of both products, they will have to obtain additional capital.
Cara Therapeutics (NASDAQ:CARA)
The main risk the company faces is their availability of cash. The company's operating expenses more than doubled because of increases in consulting and research and development costs. Their available cash is only enough to last until Q1 2018.
Insys Therapeutics (NASDAQ:INSY)
The company is highly dependent on one major product, SUBSYS, and they rely on third parties to perform this product's distribution, invoice, transportation, and storage. They may experience difficulties in executing the business model as they just recently expanded the number and complexity of their products.
GW Pharmaceuticals (NASDAQ:GWPH)
The company is highly liable to regulatory risks and failed trials of new products. The main drug that investors are banking on is Epidiolex. However, the company can face many regulatory issues before the introduction of this product to the market. The profitability of the new drug can be negatively affected by the costs coming from any delay in the launch date.
The Scotts Miracle-Gro (NYSE:SMG)
The company has highly seasonal sales, but the main concern is over their long-term debt. Over 70% of SGM's capital structure was made up of long-term debt.
AbbVie Inc. (NYSE:ABBV)
AbbVie is the largest and the most established company in the industry. ABBV is considered the bell-weather, blue-chip cannabis stock which is the first stock that investors want to buy. As a result, ABBV is currently overvalued.
How to Invest in the 14-Stock Cannabis Index?
Because of the speculative nature, most of the stocks in this space are low priced. The typical way of equally weighting each stock will exaggerate the return volatility and is very hard to implement. For example, the same and typical 5 cents bid-ask spread means a 10% move for a $0.50 stock, but a 1% move for a $5 stock. For the equal amount of capital, it requires 10 times of shares traded for a $0.50 stock than for a $5.00 stock, which will almost always increase the spread and produce significant market impact.
That being said, most of the trading problems can be avoided by investing in an equal number of shares in each stock, and the capital invested in a $50 stock will be 10 times the capital of a $5 stock. The lower portfolio weights in lower priced stocks will reduce the associated artificially high return volatility. An equal number of trading shares will not impose additional liquidity cost.
The construction of the Index is more appealing since it implies a buy-and-hold investment strategy. It is also intuitive to average investors since the index level is simply the sum of all per share prices of stocks in the Index. As in Table 2, the Cannabis Index is at 368.23, which is the sum of the 14 stock prices. Another way to think of the portfolio is like a price-weighted index, such as the Dow Jones Industrial Average.
Another popular way for indexation is market capitalization-weighted. This will yield a similar index as the current one, since low-priced stocks tend to have smaller market capitalization. However, it would be harder for investors to replicate the proper weighting by regularly adjusting to the current market capitalization.
In Table 2, a portfolio with an equal number of shares invested in each of the 14 stocks in the index is demonstrated. In Exhibit 1 at the top of this article, the portfolio, Cannabis 14, has produced 373% since 2010, compared to 98% of the S&P 500. To see an updated Index performance, click here.
In order to be included in the index, the quality screens used will invariably select the "surviving" firms. The historical performance of the C-Index may have been exaggerated. However, most of the screens are based on the initial conditions immediately following the IPOs and stocks will have to exit the index once such conditions have been violated. The indexation process has been closely mapped with the actual implementation of running an index-like real portfolio. The "survivorship bias" should have been kept at a minimum.
That being said, there is still some level of complexity in replicating the actual index performance. When a stock enters or exits the index, an adjustment factor will be applied to the index level to ensure that the mere changes in membership will not alter the value of the portfolio.
When you buy in any cannabis index, you are buying into the industry's secular growth for the next decade. Since the overvaluation can persist for a long time due to the momentum chasing, it is not a valuation trade. You do not trade but invest in cannabis stocks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.