Cannabis stocks are up sharply – 20% or more – since I suggested buying them on weakness in a Cabot Cannabis Investor update sent to you on January 10.
Using my two favorite exchange-traded funds (ETFs) as proxies for the sector, the AdvisorShares Pure US Cannabis (MSOS) has advanced 20%, and AdvisorShares MSOS 2X Daily (MSOX) is up 37%.
Those are nice trades. I hope you participated. What’s going on? Cannabis stocks advanced sharply January 16 after we learned more details about the nation’s leading health agency’s recommendation of sweeping changes to federal marijuana laws.
Despite all the hoopla, it’s really still up in the air whether the proposed changes will ultimately help cannabis companies and investors any time soon – if at all.
That’s possible. Below, I’ll share key investor pros and cons in the major reform proposal rolled out Friday by the Department of Health and Human Services (HHS).
But traders should take note that there’s a potentially huge and tradable catalyst on the way soon.
First, given the polarizing nature of cannabis culturally and politically over the past century, let’s take a second to acknowledge the remarkable nature of the 252-page HHS proposal – especially for anyone familiar with the federal “war on drugs.”
The HHS proposal (released in response to a lawsuit filed by attorney Matt Zorn) asks the Drug Enforcement Agency (DEA) to soften its stance on cannabis by downgrading it to Schedule III from Schedule I under the Nixon-era Controlled Substances Act (CSA). The change would help cannabis companies by boosting cash flow enormously as I will explain below.
To make a credible recommendation, HHS had to find that cannabis has acceptable medical uses and a relatively low potential for abuse and dependance. HHS builds its case by citing extensive research and the now-widespread doctor-recommended usage across the country. This new policy proposal is a sea change for the federal government.
“It really goes back and covers a lot of the misinformation that has been out there on the effects of cannabis over the last twenty years,” says Boris Jordan, the founder and executive chair of Curaleaf (CURLF). “It is easy to forget all the stuff that was being said about cannabis during the War on Drugs. Now there is almost a 180-degree flip on the benefits and side effects of cannabis.”
What to Do Now
Given the strong advance in cannabis stocks since I suggested adding back on January 10, it probably does not make sense to chase the stocks or purchase here, unless you have zero exposure. In that case, I suggest getting some exposure, and accumulating on weakness. Otherwise, consider adding on weakness of around 10% or more, at this point.
Aggressive traders may want to book profits because the strength on the HHS document release could continue to fade. However, there is another major catalyst on the horizon (DEA publication of a proposed rescheduling rule) so it is risky to trim exposure now, in my view. My approach to investing is to take long positions in attractive names, and then accumulate on weakness of 2% to 5% or more, rather than attempting to dart in and out around daily moves. That’s a tough game to win.
Portfolio names are: Ayr Wellness (AYRWF), Cresco Labs (CRLBF), Curaleaf (CURLF), Cronos (CRON), AdvisorShares Pure US 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.
Investing Takeaways in the HHS News
Here are my eight key investor takeaways on the proposed federal cannabis law reform based on my own analysis, and input from two of the best regulatory attorneys in the space and Curaleaf CEO Jordan.
1. Rescheduling would rain cash on cannabis companies. The reform would boost cannabis company cash flow by exempting them from an Internal Revenue Service rule (called 280E) which bars the deduction of operating expenses against Schedule I drug revenue. “It would release a lot of investible capital into the sector,” says Jordan. Cannabis companies effectively work for the federal government, he likes to joke.
Curaleaf, for example, would get a $200 million boost. For context, the company reported $61.8 million in operating cash flow and $115.5 million in losses in the third quarter. If rescheduling happens in late 2024, the 280E nullification would apply to the whole year, says Jordan. Any eventual 280E exemption might only apply to medical-use sale revenue, though, which would blunt the benefit.
2. There’s a big short-term catalyst on the horizon. Near term, the next step will come in the form of a proposed rescheduling rule from the DEA. The timing is critical. It has to happen soon for the Biden administration to reap election-year boasting rights – obviously part of the plan here. To clear all the hurdles to get full rescheduling done before a potential administration change in January 2025, the DEA will have to publish its proposed rule by March or April at the latest.
I’m guessing that naturally volatile cannabis stocks may give back some of this week’s gains, but then they should bounce a lot higher on the proposed DEA rule publication. I prefer to take multiyear positions and then accumulate on weakness. But traders should take notice of this looming and potentially big catalyst.
3. A big risk is that HHS invented an entirely new standard to support rescheduling. Change happens slowly in law and government policy. So, it’s jarring to see HHS set up a new test for assessing whether a substance has a currently accepted medical use. It’s a “newly minted standard,” says Shane Pennington, a controlled substance regulatory expert and partner at Porter Wright Morris & Arthur.
The test, which Pennington anticipated, examines the level of state-approved medical use to make the case there’s an accepted medical use. It also considers whether health care associations recognize a medical use, and “credible” evidence of a therapeutic effect for at least one indication. HHS found that 30,000 doctors recommend cannabis to six million patients and that there’s an accepted medical use to treat anorexia, nausea and vomiting related to chemotherapy, and pain.
Props to HHS for the creative thinking. But because this is a new standard, it opens the HHS rescheduling process to legal challenges by cannabis opponents. They will almost certainly question the validity of the new standard. And if the DEA ultimately approves rescheduling, cannabis opponents will launch more challenges in court. This matters for investors because uncertainty will be a sector overhang even if rescheduling happens.
4. Another risk is HHS’ low bar on scientific evidence. This also opens reform efforts to potential attack. To check the box on scientific support, HHS says it merely needed to see at least “some credible scientific support” for one medical use. Compared to the biopharma gold-standard of double-blind random sample trials, that’s a low hurdle.
What’s worse, some HHS logic seems questionable. HHS concludes there’s low potential for abuse. But then it cites evidence that nearly a third of cannabis users consume virtually every day. That seems like a big number for a substance with supposedly low abuse potential. Note that the study refers to non-medical users, only. Daily users for insomnia or cancer therapy side effects don’t count.
In fairness, people who know more about cannabis law than me tell me HHS built a credible case. “Both in thoroughness of the analysis and its tone this is a very, very substantial document,” says Arnold & Porter partner Howard Sklamberg, another controlled substance regulatory expert. “The part of the analysis covering the science and medicine would be very hard to challenge. You would have to show the agency was acting in an arbitrary way.” He doubts that will happen. “It would be hard for a judge to say ‘I am going to overturn the HHS science.’” Sklamberg is worth listening to because he chaired the Food and Drug Administration’s Marijuana Working Group, which set FDA cannabis policy.
5. HHS included alcohol in its analysis. This is new territory, too. Strictly speaking, when conducting a rescheduling review HHS should compare the drug in question for risk and abuse potential against other Schedule I and II drugs like heroin, fentanyl, cocaine and oxodone. The Controlled Substances Act excludes alcohol. HHS may be going for a tactical advantage against cannabis opponents given the widespread use of alcohol. “That has a lot of force. It puts burden on people opposing rescheduling,” says Sklamberg.
6. The proposed cannabis rescheduling reform covers medical use only. That leaves recreational use in limbo at the federal level. Curaleaf’s Jordan thinks the Department of Justice may clarify non-enforcement of federal laws against cannabis.
7. The DEA could reject rescheduling because of international law. The U.S. is a party to the U.N. Single Convention which directs participants to make cannabis a Schedule I drug. Pennington, an expert in this area, thinks the DEA has enough flexibility to sidestep this constraint.
8. The comment period could drag out. After the DEA drops its proposed rule there will be a 60-day comment period. But it the process could take longer. “I expect there will be a lot of public participation,” says Pennington. He calls the HHS proposal a “target rich” environment. “There is plenty to argue about and people are really fired up to engage.” If a robust debate ensues and a lot of experts call for hearings, the approval process could drag out.
Reform Timing
Sklamberg expects full rescheduling (as opposed to the proposed rescheduling rule from the DEA which should land over the next one to three months) to get finished by the summer. He reasons this should be the administration’s target if it wants to keep cannabis reform off the typically crowded year-end legislative agenda. But he admits he does not have a high level of conviction in this prediction, or any insight from the administration on the timing. He’s just applying the logic that for the administration to get this done before the year-end legislative agenda gets crowded, or before the potential end of the administration in early 2025, they’d want to wrap it all up by the summer. Pennington is skeptical, noting that the rescheduling process historically has dragged out for as many as nine years.
But these are unusual times, politically. So, Sklamberg’s timeline might make sense. It depends in part on how much the administration wants this. President Joe Biden is slipping in the polls even among young people, which provides motivation. Also consider the following: “This whole process was kicked off by an executive order, which is not normal,” says Sklamberg. “The fact that the White House initiated this process through an executive order shows it is a high priority.”
