Cannabis stocks look buyable in the current weakness.
For simplicity, I use AdvisorShares Pure U.S. Cannabis (MSOS), and the 2x leveraged version AdvisorShares MSOS 2X Daily (MSOX) as cannabis group benchmarks.
A glance at the charts in the year-to-date trading environment shows that MSOS looks like a buy when it trades in the 8 to 9 range. This is where it seems to bottom and find support.
MSOX looks like a buy when it trades in the 4-5 range.
Likewise, all portfolio stocks (listed below) look buyable when these two benchmarks trade in these ranges.
At these levels, sentiment is dark enough to consider the group buyable in the contrarian sense.
This is more than just a technical call.
Cannabis stocks look buyable when they are down, but there are potential near-term catalysts on the horizon. That is the case now. There are three to expect over the next few months, and possibly as soon as the middle of May.
Near-Term Catalysts
Potential catalyst #1: We see meaningful progress on rescheduling.
This is the biggest potential near-term catalyst and the one likely to happen the soonest.
The background here is that the U.S. Department of Health and Human Services (HHS) has recommended that the Drug Enforcement Administration (DEA) and the Department of Justic (DOJ) move marijuana to Schedule III from Schedule I of the Controlled Substances Act (CSA).
Industry sources say the DEA has sent a proposed rule to the Office of Management and Budget (OMB) for review. They expect OMB to review the rule fairly quickly and send it back to the DEA. At that point, the DEA should publish a proposed rescheduling rule. This will be a significant catalyst.
Predicting timelines for government action is notoriously fraught with difficulty. But industry sources like Boris Jordan, founder and executive chair of Curaleaf (CURLF), expect this could happen by around the middle of May. I like to listen to Jordan on forecasts of the timing of action in Washington, D.C., because his company spends a lot on lobbyists. He’s connected. However, I’d take that projected timeline with a grain of salt since it involves the government.
There does seem to be momentum behind rescheduling, though. “We are very confident this will go through,” says Jordan. Drug law regulatory expert Howard Sklamberg, partner at law firm Arnold & Porter and former Food and Drug Administration deputy commissioner, predicts rescheduling will be in place before November.
These experts expect an accelerated timeline because they say President Joe Biden wants to show significant rescheduling progress by early September, which is when early voting starts in the presidential election. To allow time for the mandatory 60-day comment period after DEA publication of the proposed rule, and the 30 days it takes for a final rule to become effective after publication, the DEA would need to publish a proposed rule soon.
Rescheduling will provide a boost to cannabis stocks because it eviscerates the impact of Internal Revenue Service (IRS) rule 280E, which blocks cannabis companies from deducting operating expenses against revenue. “This frees up a tremendous amount of cash,” says Jordan. At his Curaleaf, the amount would be $175 million. He estimates the federal tax rate at cannabis companies would fall to around 28% from the current 70%.
Jordan thinks the rescheduling rule will become effective by September 1.
Risks
* Note that this is a very aggressive timeline by historical standards. The rescheduling process can normally take around nine years. Completion by September 1 would have it done in around two years.
* Another risk factor is that opponents of cannabis reform will no doubt challenge rescheduling in court. Jordan thinks HHS and the DEA have done a thorough enough job that rescheduling will ultimately hold up in court. But lawsuit headline risk will make cannabis stocks vulnerable to pullbacks along the way.
“A lot of Republicans will not want to give this to the Democrats as a win because this is a major vote getter. Everybody knows that,” says Jordan. “Because of that, there will be challenges.” The challenges may result in a lower court injunction blocking the change. But Jordan predicts the government would ultimately win on appeal.
* I’ve also pointed out that predicting government timelines is notoriously difficult. The projected timelines above can only really be a rough guideline.
“You are going to see a lot of volatility over the next couple of months,” says Jordan.
Potential catalyst #2: We see progress on cannabis banking reform.
The Senate may soon rekindle efforts to approve cannabis banking law reform, known as the SAFER Banking Act. The change would allow banks to serve cannabis companies, which currently have to deal with the burden and safety issues of operating in cash only. Lawmakers on both sides of the aisle have recently suggested we may see progress soon. This one seems possible, but less likely than progress on rescheduling. The reason is that we regularly hear hopeful comments from the likes of Senate Majority Leader Chuck Schumer (D-NY) and others in Congress, to no avail. Senate Minority Leader Mitch McConnell (R-KY) opposes cannabis banking reform.
Potential catalyst #3: We get a Cole Memorandum redux soon.
Back during the Barack Obama administration, the president’s Deputy Attorney General James Cole in 2013 issued a memorandum stating that the federal government would not enforce federal law prohibiting cannabis in states that had legalized cannabis in some form. The memo added some clarity on cannabis law that supported the industry in legalization states. The policy was rescinded under the Trump administration. But now, we may get a similar memorandum from Biden administration Attorney General Merrick Garland. “I do think you will get a DOJ memo on the back of [rescheduling],” says Jordan, at Curaleaf. He expects this by mid-summer. This would be a major sector catalyst.
What to Do Now
Cannabis stocks have weakened enough again to consider entries. Because of the potential catalysts on the horizon over the next several months, and given the current weakness in cannabis names, consider taking both trading positions and multiyear positions now.
For simplicity, consider focusing on MSOS and MSOX. For targeted and greater potential upside consider individual portfolio names (below).
Then if a catalyst creates a 15%-25% kind of rally, consider exiting trading positions and selling covered calls against multiyear positions. Consider selling calls about a month out in time and starting at two to three points above the current price, and up. In the late April rally, I sold MSOX May 17 covered calls with strikes at $11 through $16, when MSOX was in the upper 6 to low 7 range. They are currently eviscerated in value, which is what you want when you sell covered calls.
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. When or if we do get major rescheduling news from the DEA (proposed rule publication), that will create a rally in which to trim positions and de-lever a bit. De-lever in this instance means trimming MSOX and putting the funds into cash or the MSOS.
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.
* News that the Drug Enforcement Agency is making progress on rescheduling triggered a slew of cannabis coverage from major news outlets including The New York Times, Wall Street Journal, BBC, NPR, PBS, Slate and local Fox channels. None of them really added any new insights to the unfolding story, but the coverage attracts new investors which is a positive for us. I expect more of this kind of coverage as the DEA and Department of Justice make further progress, sparking more investor interest in our cannabis stocks.
* Most Americans (64%) think cannabis banking reform, known as the Secure and Fair Enforcement Regulation (SAFER) Banking Act would improve public safety. The bill would allow banks to serve cannabis companies which currently have to operate in cash only, making them targets of criminals. An American Bankers Association (ABA) survey found 63% of Americans back the cannabis banking reform.
* New Jersey posted $201 million in legal recreational-use cannabis sales in the first quarter, up 5.2% from fourth-quarter sales of $191.1 million and 38% above sales in the first quarter a year ago.
“The rising sales figures demonstrate a shift in consumer behavior as more people are choosing the safety and reliability of the regulated market over untested or questionable products,” said Cannabis Regulatory Commission (CRC) chair Dianna Houenou. New Jersey’s market will surpass $1 billion in annual sales this year, predicts CRC executive director Jeff Brown.
* Ohio medical marijuana patients purchased $54 million of legal product in March, up from $38.4 million in February and $38 million the year before. Ohio is poised to launch legal recreational sales soon, probably this summer.
* The legalization of cannabis is not associated with an increase in the number of young people driving under the influence of either cannabis or alcohol, according to a study of trends in Washington state published in the journal Prevention Science.
* A new study challenges some typical stoner stereotypes. The study found no association between cannabis consumption and decreased motivation or paranoia among habitual users. It also found no evidence that cannabis causes a next-day hangover.
Frequent users did report more negative emotions and greater impulsiveness. The study also found chronic use “was associated with a host of increased positive emotions such as awe, inspiration, and gratitude, as well as reduced stress and fear at the within-person level.” The study said moralization linked to criminalization explained why cannabis users “are stereotyped as lazy, uneducated, and possibly criminal.”
The study left an opening for critics. “Our participants were recruited from online forums that cater to cannabis enthusiasts and growers, meaning our results might not generalize to novice or to less frequent users,” it said. Participants in the study used cannabis at least three times a week. The study was published in the journal Social Psychological and Personality Science.
* The U.S. District Court for the District of Massachusetts’s Western Division has scheduled oral arguments in an industry challenge to federal regulation of in-state cannabis business for May 22.
Cannabis companies bringing the suit assert that the commerce clause of the Constitution limits federal regulation of business to interstate commerce such that their intrastate business is exempt because they can track their product seed to sale.
One flaw in the suit is that a series of civil rights era court cases held that local intrastate businesses engage in interstate commerce if they make any purchases of supplies from out of state.
In the cannabis case, the government has asserted that the Massachusetts companies bringing the suit engage in a form of interstate commerce because they attract cannabis tourism from out of state. “As the Supreme Court held decades ago, Congress has the authority to regulate businesses that cater to tourists from out of state, even if the businesses’ transactions occur wholly in-state,” the Department of Justice wrote in a brief.
Cannabis companies in the suit, Canna Provisions v. Garland, are represented by the law firm Boies Schiller and Flexner.
* The Florida Republican Party opposes a referendum that could legalize recreational cannabis use in the state. Gov. Ron DeSantis (R) says he plans to raise funds to support campaigns against the cannabis initiative which requires 60% approval to become law. “I don’t want this state to be reeking of marijuana,” says DeSantis. Given its population and tourist traffic, Florida would be one of the biggest recreational-use markets in the country if voters approve the initiative. Various surveys suggest the vote will be close.
* Voters in Lubbock, Texas, rejected a measure to decriminalize cannabis. Lubbock decriminalization campaign director Adam Hernandez said cannabis campaign volunteers “just weren’t able to get the voter turnout high enough.” Activists have been collecting signatures to put cannabis decriminalization initiatives on the November ballot in Dallas and Lockhart. Similar measures have been enacted in Austin, Denton, Elgin, Harker Heights, Killeen and San Marcos. A University of Texas/Texas Politics Project 2022 poll found that 72% of Texans support cannabis decriminalization. Gov. Greg Abbott (R) has opposed efforts by cities to legalize cannabis. “Local communities such as towns, cities and counties, they don’t have the authority to override state law,” says Abbott.
Company News
This section offers a roundup of developments at portfolio companies since the last Cabot Cannabis Investor issue was published. One of the key trends I like to see is our companies continuing 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.
Cronos (CRON)
Cronos on May 7 announced it has started supplying U.K. medical cannabis distributor GROW Pharma with cannabis flower. It already supplies Germany and Australia. “Supplying the U.K. market, which we think has the potential to grow significantly this year, is another milestone for Cronos as we enter and expand within international markets,” said Cronos CEO Mike Gorenstein. GROW Pharma is a wholesaler and pharmacy distributor and it sells directly to patients through the mail.
Green Thumb (GTBIF)
Green Thumb on April 24 announced it is opening a RISE Dispensary in Wesley Chapel, Florida. This is the company’s 16th retail location in Florida and 93rd nationwide. The store will offer popular Green Thumb brands like RYTHM premium flower, Dogwalkers pre-rolls, Good Green flower and &Shine flower, pre-rolls, vapes and chews.
Verano (VRNOF)
Verano is opening a Zen Leaf store in Naugatuck, Connecticut. The store is the company’s fifth outlet in the state.
Cabot Cannabis Plus Insider Portfolio News
To broaden out our exposure to cannabis, I created the Cabot Cannabis Plus Insider Portfolio. This portfolio holds names where insiders have bought shares in cannabis sector companies that do not touch the plant.
Chicago Atlantic Real Estate Finance (REFI)
Cannabis real estate lender Chicago Atlantic Real Estate Finance is primarily an income play. It pays an 11.8% yield. On May 7 it reported first-quarter results which suggest its income statement and balance sheet remain strong enough to support dividend payouts. The company’s stock also trades about a dollar above book value, which suggests but does not guarantee limited downside risk. Book value would erode if borrowers default. So far, the company has a track record of lending responsibly.
Here are the details.
On May 7 the company reported net income of $8.7 million or $0.47 per share, a sequential decline of 7.8%. Net interest income of $13.2 million fell 10.8% from $14.8 million because there were no loan prepayments and related fees. In the fourth quarter last year it got $1.8 million in prepayment fees.
Expenses of $4.1 million fell 28.4% sequentially because of a decrease in management and incentive fees. Reserves for credit losses increased sequentially by $400,000 to $5.4 million. Distributable earnings were $9.7 million, or $0.52 per share, a sequential decrease of 1.9%. Book value per share was $14.97 compared with $14.94 in the prior quarter. The company paid a quarterly dividend of 47 cents per share.
The company added one new borrower in the quarter. Gross originations were $22.5 million. Its $401 million book of loans to 28 companies had a weighted average yield to maturity above 19%.
“Our pipeline of actionable deals across the Chicago Atlantic platform currently stands at $585 million with our focus remaining on operators and limited license states and those transitioning from medical to adult use,” said executive chair John Mazarakis in the earnings call.
“The originations pipeline is robust as operators look to take advantage of improving sentiment in the industry and pursuing growth in states such as Maryland, Missouri, and Ohio,” said co-CEO Peter Sack.
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