Cannabis stocks are generally flat since I sent you the March 27 issue of Cabot Cannabis Investor.
Given the potential magnitude of near-term catalysts, I suggest continuing to hold exposure to the group, and accumulating on weakness. If you have zero exposure, consider buying some now. Portfolio names are summarized below.
If you have full exposure, consider adding on any substantial weakness of 2%-4% or more in this highly volatile group.
Options for Income and Better Entry Prices
I’d also like to encourage you to consider using options as a way to increase exposure. I’ve never suggested using options in this letter, but it is a tactic I use regularly in my personal accounts.
If you know nothing about stock options, you need to spend some time studying them. There are plenty of good resources online, and your brokerage may even offer a “how to” explanation.
If you know the basics, here are some high-level insights and concepts as a guide. It also could be the case that you know far more about options than I do, and what follows is pretty basic. That’s fine. After explaining some key concepts, I offer some real-world examples I am using right now to extract premium from the cannabis market or angle for better entries, which you may want to consider. These strategies entail quite a bit of risk, however.
Some Basic Concepts
* Let’s start with the real basics. A call option gives you the right to purchase a stock at an agreed price, in an agreed amount of time. A put option gives you the right to sell a stock at a set price in a set amount of time. Think of it this way. Call options let you call a stock away from someone. Put options allow you to put a stock to someone. The prearranged price is called the strike price. Now for some key insights.
* Most options expire worthless, so you have a natural advantage if you sell options rather than buy them. Buying options seems to be a loser’s game unless it is part of a complex options strategy. Or else it is the purview of people who have illegal insider information. Otherwise, it’s just too hard to get the timing right on news flow that may boost options you own. I suggest you avoid buying options (except as part of complex strategies which I will not suggest here).
* When you sell options, you are selling someone insurance. Very often people pay for insurance that never gets “used,” in the sense that no claims are ever filed. Warren Buffett loves to sell insurance for this reason. It is no coincidence that he also sells puts to generate income.
* When you sell options, you are monetizing volatility. Related to this concept, options prices (premiums) will be very small and uninteresting unless the underlying stock or exchange traded fund (ETF) is fairly volatile. If a stock is not volatile, the odds are low that it will hit a price above or below where it trades. No one would want to pay a premium for an option giving them the right to buy or sell a stock at prices it is not likely to hit.
* In other words, when selling options (insurance) to collect premium, you want to do this with underlying stocks that have a fair amount of volatility.
There are two ways to earn premium by selling options.
* One is to sell covered calls. Covered calls means you own the underlying position that your counterparty can take from you. So, if you sell one call, you have to own 100 shares to backstop the call you sold. That’s because each option represents 100 shares. Selling naked calls means you own no underlying position. I do not like to sell naked calls because of the risk that a stock might rocket higher on extremely good news like a buyout.
* The other way to extract premium is to sell puts. Here I do not mind selling naked puts (no short position to offset it). I know this sounds contradictory. But the reason is that I like to sell puts in names I favor. Since I have researched the company and like it, this implies (but does not guarantee!) that the stock or ETF will not tank. (Though it might.)
A key concept here is that if the stock or ETF does fall slightly and it gets put to me, I don’t mind too much because I like the name and this simply means I got the stock at a better price: The strike price on the option minus the premium I got from selling the put.
Cannabis Put Selling
Let’s walk through an example I am using right now in my portfolio to collect some premium with options in cannabis. You may want to consider this, too, to bring in some additional income, or get better entries compared to market purchases.
First, as I said, you want volatility in the underlying stock or ETF, since this enriches the premium on options you want to sell. Cannabis is already quite volatile, and the AdvisorShares MSOS 2X Daily (MSOX) leveraged ETF is even more volatile. The MSOX options have a lot of premium to harvest.
Now, when selling options for premium, a good tactic is to keep the timeline short, to one or two months. Then look for a strike price far enough away from the asset price so that it won’t get exercised against you. But close enough that there is some premium to earn.
Note that you should prefer to sell puts when the underlying stock or ETF goes down intraday, or intraweek, which increase the value of puts. (Likewise, you want to sell calls when the underlying stock or ETF goes up, which increases the value of the call. More on this, as it relates to cannabis, below.)
Now let’s take a look at some options for MSOX premium extraction. For reference, MSOX closed April 9 at 6.35. Note that all proceeds exclude commissions on options contracts, which are small.
Looking at the options chain, we can see that the April 19 MSOX puts with a strike price of $5 sell for about 30 cents. This means you get $30 if you sell one option, since each option represents 100 shares.
The May 17 MSOX $5 strike put sells for about 90 cents, which means you get $90 per contract if you sell them.
Now if MSOX stays above $5 through April 19 or May 17, the ETF cannot be put to you and you keep the money. Nice.
If it does get put to you, you effectively own the ETF at $4.70 for the April put, or $4.10 if you sold the May put. The calculation here is the strike price you were forced to buy the ETF at minus the options premium you took in.
In either case, I’d be OK because those are reasonable prices for entering MSOX, considering that there are two potentially powerful catalysts, near term:
We may see the Drug Enforcement Agency (DEA) publish a proposed rule soon on cannabis rescheduling to Schedule III from Schedule I, as recommended by the Department of Health and Human Services. Otherwise, we could see news on SAFE banking, since politicians are talking about progress there again (see sector news, below, for details on this).
Naked Put Selling Risks
The risk here (or with any stock or ETF) is that some terrible disaster strikes while you have naked puts outstanding. An example might be if the DEA rejects rescheduling. In that scenario, cannabis stocks will fall hard. Something bad like this can always happen with an ETF or a stock. If MSOX fell to $1 with little prospect of recovering soon, you’d be out several hundred dollars per hundred-share lot, and the $30 or $90 premium you got (in the examples above) would not help much.
Selling naked puts is quite risky, in this sense. Keep position size small. Do not use this tactic at all if it seems unsuitable because of your age, number of dependents, overall wealth and so forth. I cannot advise you on risk or investing in general, because I do not know these kinds of particulars about you, and I am not a financial advisor. Just know you can lose a lot of money, fast, by selling naked puts. It is risky.
Cannabis Call Selling
Now is not the time to sell cannabis stock or ETF calls. But that time may soon arrive. So, let’s look at the call side of the equation for MSOX. You can currently sell the April $9 strike calls for about 25 cents. This means you take in $25 per contract. MSOX would have to rise above 9.25 for you to “lose” money on a covered call. Again, covered means you own 100 shares for each call you sell. You are not really losing money above $9.25. You’d just be losing the profit you’d have if you did not sell a covered call.
Note that I’m not selling MSOX covered calls just yet, because I believe the DEA could soon drop a proposed rule on rescheduling cannabis at any moment now, and if it does that MSOX could go above 9 or more.
If the DEA does drop a rescheduling rule sending MSOX up into the 9 to 11 range or more, which is possible, I will be selling some of my MSOX. And I will also sell some calls against the MSOX I keep. If MSOX went up to 10 I would probably sell calls with an $11 or $12 strike. If MSOX settled back down into the 7 or 8 range, the prices on these calls would decline. In time, the calls I sold would expire worthless, which is exactly what I want.
In other words, and this is a key lesson, you want to sell calls when the underlying ETF or stock is strong because that enriches the premium you collect. Likewise, puts plump up in value when the underlying stock or ETF falls, so that is the preferrable time to sell puts.
One other important consideration here. The bid-ask spread on options can be quite wide. Don’t use market orders. Instead, put in limit orders midway between the bid and the ask. Some brokerages (like Robinhood) have software which gives you the odds of getting a fill, depending on where your limit order is inside the bid and the ask.
What to Do Now
If you have no cannabis exposure, I suggest you consider getting some given the two big potential catalysts on the horizon: 1) rescheduling news, which may happen fairly soon, and 2) progress on SAFER banking (timeline may be more like months). Once you get some exposure, consider accumulating on weakness of 2%-4% or more.
Otherwise, consider selling naked puts in MSOX to reap some income or get a better entry if MSOX gets put to you. Note that naked put selling is a high-risk tactic.
If you have a position in cannabis, consider adding more on weakness of 2%-4% or more. Or consider selling naked MSOX puts to generate some income, or get the ETF at a cheaper price if it gets put to you.
Puts to Consider Selling
I’d focus on the MSOX puts with an April 19 expiration and a strike price of $5, which currently sell for 30 cents per contract, or $30 in revenue per contract (minus commissions). Also consider the May 17 expiration with strike prices of $5, $4 or $3. They sell for 90 cents per contract or $90 in revenue per contract; 45 cents per contract or $45 in income; and 15 cents per contract or $15 in income per contract.
Likewise, if you have no position, consider purchases of any of our portfolio names now, and then consider adding on declines of 2% to 4% or more.
Portfolio names are: Ayr Wellness (AYRWF), Cresco Labs (CRLBF), Curaleaf (CURLF), Cronos (CRON), AdvisorShares Pure U.S. Cannabis (MSOS), AdvisorShares MSOS 2X Daily (MSOX), ETFMG Alternative Harvest (MJ), Green Thumb (GTBIF), Organigram (OGI), Tilray Brands (TLRY), Trulieve (TCNNF) and Verano (VRNOF). For simplicity, consider getting exposure via MSOS or the leveraged version MSOX.
In a volatile sector like this, I prefer to add on weakness rather than strength. One of the reasons Cabot Cannabis Investor has outperformed so much over the past 18 months is that on several occasions I have taken advantage of sector weakness to lever up the portfolio (shift from MSOS and some stocks, to MSOX). Likewise, there will come a time to de-lever.
If we do get major rescheduling news from the DEA in the form of a proposed rescheduling rule, that will create a rally in which to trim positions and de-lever a bit. De-lever in this instance will mean trimming MSOX and putting the funds into cash or the MSOS which would fall less in any post-news declines, and selling covered calls on MSOX against the holdings of this ETF which I retain.
Cannabis News from Around the World
Part of my core thesis for being bullish on cannabis stocks is that there continues to be tremendous cultural momentum toward cannabis reform around the world. I’m convinced cannabis stocks will not remain ignored forever.
We see evidence of this powerful cultural momentum in the changes in laws to legalize cannabis, big tobacco investments in the space, robust cannabis sales growth in states that legalize, increased cultural acceptance in the form of relaxed drug testing standards in sports leagues and the workplace, and poll results that show a growing majority of people support legalization regardless of age and party affiliation.
These trends tell us cannabis stocks are a strong contrarian buy that will turn very profitable for patient investors with a medium-term horizon. The sector is so volatile it is easy to get shaken out of names by heightened emotional reaction to drawdowns. So, it is important to catalogue evidence of this cultural momentum. That is the purpose of this section of Cabot Cannabis Investor.
* A Drug Enforcement Administration (DEA) official recently said it can take up to six months for DEA to complete its review of Department of Health and Human Services (HHS) recommendations.
This could be a key insight for cannabis investors because it has been a little over seven months since HHS recommended to the DEA that it move cannabis to Schedule III from Schedule I under the Controlled Substances Act (CSA). HHS made its recommendation to the DEA on August 29 last year.
The comment suggests a proposed rule on rescheduling from the DEA – the next step in the process – could be imminent. Of course, we don’t know the DEA will go along with the HHS recommendation, but that’s normally the case.
The comments on the timeline were made by DEA Senior Prevention Program Manager Richard Lucey in a DEA podcast which was part of the agency’s “Prevention Profiles: Take Five” series. Vice President Kamala Harris recently urged the DEA to finalize its cannabis review “as quickly as possible.”
DEA publication of a proposed rule would spark a major rally in cannabis names. That will likely provide an opportunity to reduce exposure to the group by reducing leverage. I’ll do this by selling some MSOX, which is more volatile, and using the proceeds to buy some MSOS.
After the DEA drops a proposed rule there will be a comment period that can last two months and possible hearings on the issue. Cannabis stocks theoretically will have plenty of time to weaken again during this lull in major news flow. Though progress on cannabis banking reform remains in the mix as another potential catalyst for the group, and news could land in that timeframe.
* President Joe Biden in late March reiterated his administration’s goal of rescheduling cannabis under the Controlled Substances Act (CSA). His March 29 comments confirmed that rescheduling progress could be a near-term catalyst for the group. The comments also underscored the importance of cannabis in the presidential election.
The U.S. Department of Health and Human Services (HHS) has recommended moving cannabis to Schedule III from Schedule I to Schedule III of the CSA. The next step should be a Drug Enforcement Administration (DEA) proposed rule advancing the change, which would be published in the federal register.
Rescheduling progress will put a bid under cannabis stocks because the change would create a lot of cash flow for cannabis companies by eviscerating an Internal Revenue Service rule that prohibits the deduction of operating expenses against revenue from the sale of Schedule I drugs.
Biden made the comments in a White House website proclamation that April is “Second Chance Month,” a reference to federal pardons for cannabis convictions.
* Senate Majority Leader Chuck Schumer (D-NY) on April 5 reiterated his goal of seeing cannabis sector banking reform passed in the “weeks and months ahead.” A Senate banking committee has approved the Secure and Fair Enforcement Regulation (SAFER) Banking Act. But the full Senate has not taken it up. Progress on this bill would be a major sector catalyst. Schumer made the comments in an open letter to colleagues outlining a busy legislative agenda.
* Rep. Nancy Mace (R-SC) in early April said Republicans should pass cannabis banking reform if they want to maintain control of the House of Representatives. She also said there is enough support in the House to get this done. She made the comments in a podcast.
The background here is that a Senate banking committee has approved a version of the Secure and Fair Enforcement (SAFE) Banking Act, which would allow banks to serve cannabis companies. But neither the full Senate or House has taken up the measure.
Mace has long tried to convince fellow Republicans that they can exploit cannabis reform as a wedge issue to win votes from Democrats. “If Republicans want to keep the House, it’s a good bill to have on the floor,” she said in a Dales Report podcast. She also criticized Virginia Gov. Glenn Youngkin (R) for vetoing a bill that would have legalized cannabis sales in the state. “It’s mind-boggling,” she said, citing public support for the reform. Mace has said she has used medical cannabis to treat trauma symptoms after being sexually assaulted as a teen.
* An overwhelming majority of U.S. adults, or 88%, say cannabis should be legal for medical or recreational use, says a new Pew Research Center poll released in late March. About 57% say cannabis should be legal for both purposes, and 32% say that cannabis should be legal for medical use only. Just 11% of Americans say that the drug should not be legal at all. The poll found that young people, Democrats, and minorities are more likely to approve of legalization.
* Florida Gov. Ron DeSantis (R) thinks voters will reject a referendum that would legalize recreational cannabis use. He said the change would “reduce the quality of life” in the state in part by increasing the odor of cannabis in public places. Trulieve Cannabis (TCNNF) Kim Rivers says she is confident voters will approve the initiative.
A lobbying group called Smart & Safe Florida, which supports the referendum, says it has raised an additional $15 million in funding from cannabis companies to boost voter support for the initiative.
Cabot Cannabis Investor portfolio name Trulieve Cannabis has been the major Smart & Safe Florida financial backer. The fresh funds came in part from these names in our portfolio: Verano (VRNOF), Curaleaf (CURLF), AYR Wellness (AYRWF), Cresco Labs (CRLBF), and Green Thumb Industries (GTBIF).
A University of North Florida survey found that 67% of voters back the referendum. To become law, 60% of voters must approve the referendum.
* Cannabis sales in New Mexico hit a monthly record of $52.5 million in March. The previous record was hit in December.
* Arizona cannabis sales topped $1.4 billion last year, for the third year in a row.
* Cannabis use by teens in Washington has fallen sharply since the state legalized marijuana in 2012, according to a survey of students. Last year 8.4% of 10th graders in the state said they had used cannabis in the past 30 days, down from 20% in 2010. The data are from the Healthy Youth Survey. Respondents also said cannabis is harder to get now.
* Minnesota will soon expunge about 66,000 misdemeanor cannabis convictions. The expungements could begin as soon as next month. Massachusetts, Colorado, Nevada, Oregon, Illinois, and Washington have granted pardons for cannabis convictions.
* Virginia Gov. Glenn Youngkin (R) has vetoed a bill that would have legalized cannabis sales, saying the change would have endangered the health and safety of state residents. Cannabis use and possession is legal in the state, but sales remain illegal.
* Efforts to legalize recreational use of cannabis in Hawaii hit a roadblock in early April when the House Finance Committee chair tabled hearings on reform. That scuttled the measure, which had been passed by the Senate and by several House committees. A survey by the Pacific Resource Partnership found 58% of residents support the change.
* Former Minnesota Gov. Jesse Ventura is launching a new line of cannabis products including some he says he would “offer to you if you were visiting me in the Governor’s mansion.” Called Jesse Ventura Farms, the line includes a “Governor’s Select Collection” that he says is “bold and powerful” just like his politics. Ventura has long supported cannabis reform. Possession is legal in Minnesota but the state is still in the process of setting up legal sales. Ventura’s partner Retro Bakery offers hemp-derived THC products, which are legal to sell under state law.
Company News
This section offers a roundup of developments at portfolio companies since the last Cabot Cannabis Investor update was published. One of the key trends to note is that our companies continue to open stores in states that recently legalized recreational use or are about to make this change. You want to own shares of companies that are doing this.
Tilray (TLRY)
Tilray reported 30% first-quarter sales growth compared to the year before, driven by a 33% advance in cannabis sales and a 165% growth in alcoholic beverages. Cannabis sales growth was linked in part to the acquisitions of HEXO and Truss, and beverage growth was driven by the purchase of several brands from Anheuser Busch.
Gross profit came in at $49.4 million, and gross profit margin was 26%. Net loss decreased to $105 million compared to net loss of $1.2 billion in the prior year’s quarter. Net loss per share narrowed to $0.12 compared to $1.90 in the prior year quarter.
The company reduced its outstanding convertible debt by $50.7 million compared to the prior quarter and $41.9 million subsequent to the end of the third quarter.
Tilray says it closed the quarter with the number one market share in Canada where it has an 11.6% share. It has the number one share in cannabis flower, oils, concentrates and THC beverage products. Tilray says it also has the number one share in Germany, which is in the process of liberalizing cannabis laws.
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