Ted Ohashi's Marijuana Stock Market Review & Outlook

Summary: The cannabis stocks turned the corner in the third quarter prompted by the Constellation/Canopy transaction. We think there are three events that will keep the fire stoked; one that is certain, one that is probable and that is possible. First, legalization in Canada is less than three weeks away for certain. Second we think it is probable that another of the major licensed producers will be involved in a significant transaction. Third we think it is possible that we will see a breakthrough on the cannabis front in the United States. Although we expect the upswing to continue, we also think the added volatility will also be a factor. We are in the trading phase of the cycle so buy and hold on for dear life is not as appropriate as sell on strength and buy on weakness. The market volatility will create several opportunities to trade.

Toronto Stock Exchange has performed poorly so far in 2018. The threat of a trade war hangs heavily over the heads of Canadians as the Americans have renegotiated the North American Free Trade Agreement with Mexico but not Canada. The negotiators are trying to convince everyone there is still a chance but this is close to falling apart. In the talks, Mexico took the lead and came to an agreement leaving Canada out in the cold. Not good for a trade weighted economy. In the meantime, the battle of words became personal as it often seems to do when one of the participants is named Trump. In the quarter ended September 2018, the TSX/S&P Composite lost 1.3% and is up only 2.8% year over year. This left the Canadian cannabis stocks swimming against the tide but at least NAFTA doesn’t’ have much impact on the cannabis trade.

Despite initiating what might prove to be the mother of all trade wars and with a President who seems to pick fights at every opportunity, the U.S. markets remain positive. As measured by the Dow Jones Industrials, American stocks appreciated 9.0% in the third quarter and 18.1% year over year. Fortunately there are no tariffs on Initial Public Offerings and raising money. IPO funds and new listings flow freely. The larger Canadian cannabis companies led by Canopy are seeking listing on the U.S. markets, primarily the NASDAQ while smaller, early stage American entrepreneurs seek listings on the Canadian Stock Exchange. The Toronto Stock Exchange finds itself a little left out because of its own policies.

For the second time in less than a year, Canopy Growth (NYSE: CGC) (TSX: WEED) and Constellation Brands (NYSE: STZ) were the cavalry riding to the rescue with guns a-blazing. In mid-August, STZ stepped up to invest CA $5 billion into Canopy to essentially lock up control. Had they not come to the rescue, the Canadian cannabis stocks might have been in trouble. Still, the Let’s Toke Business Composite gained 4.1% on the quarter and 21.1% in the previous year.

On the domestic front, we have legalization less than a month away (October 17th) although like the entire process, things are delayed. In British Columbia, for example, there will be one legally constituted cannabis dispensary open on legalization day and that will be in a town called Kamloops. It doesn’t appear any others will be licensed and open until early 2019. In Ontario, a newly elected government decided to open the market up to non-government owned and operated dispensaries but then delayed the opening of such stores until April 1, 2019. The good news is sales are rising and Canopy is running around with $5 billion burning a hole in its pocket and, yes, even the much delayed legalization will be an important issue. But whereas the market went directly higher after the first STZ investment in CGC, this time investors are being a little cautious. This is a good thing especially if there is another major investment/acquisition in the Canadian Licensed Producer group before year end and/or a break in U.S. legislation.

The next chart shows the Canadian Cannabis Composite Index (3Ci). The components of this index are the higher quality, larger market cap companies including some more volatile U.S. companies such as Tilray (NASDAQ: TLRY). As a result, this index has been consistently more volatile. For example, in the latest quarter the index is up 32.9% and up 47.2% in the year to date. We continue to use the index to provide intraday readings on the cannabis group.

The LTB Marijuana Stock Momentum Index bottomed out with prices and is making a recovery as well. These are all positive signs. As the chart shows momentum has been on the wane almost all year but now may be recovering. As we look at cannabis stock prices, we need momentum to confirm the trend in prices. If we look back at the LTB Composite from April to July, we can see prices flattened and were threatening to advance. But momentum continued to decline. When prices and momentum diverge it is important to follow momentum. As the Composite Index shows, prices did eventually give ground as expected. Now, however, prices and momentum are moving in tandem and that is bullish.

The one year chart for the LTB Licensed Producer Composite Index shows that the higher quality, larger cap stocks continue to lead the markets. This is not overly surprising since it was a licensed producer that triggered the rally starting in mid-August. In the previous quarter, the LTB Licensed Producer Index gained 11.9% and is up 43.0% over the previous year. It appears several of the Canadian LPs are seeking listing on the senior American exchanges following Canopy Growth that listed on the New York Stock Exchange and Cronos Group that listed on the NASDAQ. Listing on the senior exchanges provides more liquidity and generates interest from American investors. We expect the current recovery to continue for the foreseeable future.

This chart is the one year LTB Low-Priced Composite Index, that is, an index of cannabis stocks trading below $.10 per share. As is clear from the chart, this group has been seriously lagging the cannabis stocks in general. For example, in the last quarter the index lost 9.1% and on a year over year basis, the gain is only 4.0%. The good news is this means speculative investor psychology has not reached this very junior group of stocks. This is another difference between this upturn and the one that was triggered in October 2017. As the chart illustrates, in the previous upswing, this group participated quite well but that hasn’t been the case this year. But we think it will.

This chart records the lengths of rallies and reactions in the LTB Marijuana Composite Index. It shows another way in which the current recovery is different from a year ago. After the first time Constellation Brands invested in Canopy Growth, the cannabis stocks posted ten consecutive weeks of gains. So far since the second Constellation/Canopy transaction, there have been two up weeks, a down week, two up weeks and a down week. A year ago the consensus view was the market would continue to advance through to legalization that was expected in early July 2017. This time there is no such “blue sky” talk. Investors are being more realistic. But at the end of the day, this is a good thing. Excessive optimism is not what we want to see in the market.

International market returns: compared to the returns generated by international and domestic markets, the LTB Marijuana Composite and Licensed Producer indexes outperformed all major alternatives show. The cannabis returns are marked by the gold arrows while the Toronto Stock Exchange and the Toronto Stock Exchange Venture are identified by the red arrows.

The returns were:

• LTB Licensed Producers: +43.0%

• LTB Marijuana Composite +21.1%

• TSX/SP Composite + 2.8%

• TSX Venture - 9.2%

The remaining markets ranged from Japan at +18.5% to China at -15.8%.

Recognizing that past performance does not guarantee future results, this chart illustrates the difference rates of return make on the amount of capital you can accumulate for retirement. That is why we believe it is so important to diversify some part of a portfolio into the cannabis sector. Invested at last year’s return from the Toronto Stock Exchange for ten years, a $10,000 investment would grow to $13,180. This is barely satisfactory and well below the equivalent $67,833 that would have been realized applying the one year return from the LTB Marijuana Composite or the $357,569 from the return on the LTB Licensed Producers. Not only that a capable investment advisor outperform the average returns. This has been the case with The Cannabis Report Model Portfolio, for example.

Reiterating that past performance does not guarantee future results, if an investor had allocated 20% of a Toronto Stock Exchange portfolio to the cannabis sector as measured by the Let’s Toke Business Marijuana Composite Index, the amount of capital available would more than double. Put another way, if you have 35 years to retirement and you contribute $250 per month and you earn the average return from the S&P/TSX Composite last year ignoring taxes, your capital pool will be worth $178,009. By comparison, if you had earned a return equivalent to allocating 20% of your TSX portfolio into cannabis stocks and earned the LTB Marijuana Composite in the previous 12 months, your savings would increase to $394,497. This is an increase of 121.6%. If you had chosen instead to invest 20% of your portfolio in the LTB Licensed Producer Index last year, your hypothetical portfolio would be worth over six times more or $1,181,273. This is an indication of the benefit that is possible by simply diversifying a part of your portfolio to the cannabis group.

We are not presenting this as a forecast because, as we said above, past performance is not indicative of future results. So we are not projecting these rates of return for common stocks in general or the cannabis stocks in particular. But we are confident that the general rule will apply over time. Cannabis will continue to be an above average growth sector and diversification into cannabis stocks can make a dramatic difference to the amount of retirement capital you accumulate.

Conclusion: we continue to look for superior returns from the cannabis group. Before out next letter comes out, Canadians will be able to buy cannabis for medical use and recreational purposes. One thing The Cannabis Report Model Portfolio has shown is that even in the short term, you can take those above average cannabis returns and increase them even further. In the meantime, Canada has legalized, pressure is mounting to allow states in the U.S. to legalize without federal interference and cannabis continues to make inroads worldwide. This is not a time to miss out because of short term concerns.