Cannabis: Seven Avoidable Investment Mistakes

It is likely that Cannabis will prove to be the best performing asset class over the next decade. While this provides a rare wealth-creation opportunity, the road to maturity for this emerging market is also unusually impacted by legislation, taxation, regulation and margin normalization across every investable sector. Hemp will prove to be a major contribution to farmer livelihood as well as industrial and economic output, with the Cannabis complex likely a trillion-dollar market in the making. 

Cannabis is poised to impact every vertical in the economy, following a path similar in some ways to the one technology took when it went from being a sector to becoming an undeniable part of every sector. Despite similarities, the cannabis opportunity is also unprecedented, and many fortunes will be made and lost as the ‘rebirth of cannabis’ history books are written over the next decade. Lessons from previous cycles can serve as a useful guide towards better decisions for the informed investor.

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Below are the top mistakes investors make in Cannabis, as well as ways for the savvy investor to avoid them:

Management 

By definition, highly experienced cannabis operators have worked in unlicensed, unregulated and illegal environments. You invest in management teams when you invest in companies, and it is paramount that trust is based on claim verification.

It is important to conduct background checks on any beneficial owners of your investment target and also ensure that any prior cannabis convictions don’t disqualify the business from obtaining necessary licensure.

Valuation 

Public cannabis markets exhibit high volatility and generous valuations. Private market data is difficult to access and aggregate, while the abundance of non-cash transactions further complicates value assessment. 

Optimistic expectations on conservative assumptions are an advisable combination when determining potential investment return. The tendency to overpay is strong and often punished by volatility driven emotion. 

Accounting 

Banking remains an issue for the industry. The lack of available banking options encourages questionable accounting practices which can have an adverse impact on recorded corporate value. 

Look for third party audits on at least two years of historical company statements. Ask for tax returns and be wary of companies that are reticent to provide them.  

Legal 

Water-Cooler Advice 

Investment excitement combined with advertising restrictions means a large amount of word-of-mouth information sharing, a channel that often results in compromised information accuracy. 

There is thus an active grass-roots movement to raise capital, and investors are well served to create an effective barrier between excitement driven by social pressure and investment based on sound diligence. Hiring an experienced cannabis investment professional is advisable in this industry. 

Hedging 

Cannabis pricing declines are rampant in every legal market as supply shortages get addressed by conformant participants. While many companies are working to mitigate the effects of this decline by addressing cost and yield optimization, others that use cannabis as a raw material are benefiting from this price decline. 

Investors can adequately hedge their portfolios against price deterioration by seeking those companies with relative shelf price inelasticity that see margin benefit rather than revenue impact. 

Diversification 

Consolidation results from emerging markets moving from fragmentation towards oligopolistic structures, and this often has a negative impact on concentrated portfolios. Dynamic cannabis market eco-systems often defy rational market behavior as global regulations impact trade across the supply chain. While diversification is important to portfolio construction, the need for this basic Wall Street tenet is magnified in the cannabis industry. 

It is important to be adequately diversified across sectors, geographies and legalities when investing in cannabis.

Granular supply chain margin analysis is an essential precursor to alpha generation. Tactical tilts help normalize portfolio margins while diversification serves as a hedge against unpredictable regulation. While an optimally constructed portfolio continues to be driven by core investment tenets, fragmented legislation can impact the best-laid plans. Industry opacity makes informed investment decisions difficult, and investors are well served to understand the various moving parts prior to capital deployment.

Stigma Precedes Opportunity; Arithmetic Supersedes Optimism