Recreational Marijuana: A Boom Waiting for a Bust?

Douglas explores what the legalization of recreational cannabis in Canada means for investors. Hint: It's complicated.

Photograph from Thinkstock.

Hooray, Canadians can now consume cannabis in their own homes (subject to health and rental restrictions) without fear of reprisal from the justice system — and the various levels of government can’t wait to get their hands on the anticipated tax windfall while producers and retailers have visions of green gold filling corporate coffers.

Unfortunately, like all drug-induced visions, the realities of legalized pot will leave some parties with a hangover once the impacts of Bill C 45 and C 46 set in.

According to the newly minted law, when cannabis becomes legal on October 17, adult Canadians can purchase fresh or dried cannabis, oils and seeds from provincially regulated retailers and possess up to 30 grams and cultivate up to four plants at home.

DID YOU KNOW? In 2017, Stats Canada estimated household consumption of 773.4 Tons per year at an average price of $7.15 per gram

Consumers and investors must realize that prior to October 17, all cannabis dispensaries/stores/outlets in Canada have actually been selling products from illegal growers. Licensed producers in Canada are only permitted to sell cannabis to medical patients (delivered via the mail). All other products, potions, lotions and gummies will continue to be illegal until the federal government passes additional provisions int he act.

Like many ill-conceived ventures, this foray into legalizing cannabis will come with a bucket-load of unintended consequences. The feds ramrodded the law through parliament and the senate with little regard for the distribution, monitoring, enforcement or treatment. Those functions will be handled by provincial and municipal governments operating in a Wild West arena, and I hope administrative costs do not exceed anticipated tax revenues.

The Gold Rush

From an investment standpoint, it’s a gold rush as hundreds of companies vie for a piece of the action, with the early entrants relying on the medicinal market in hopes of garnering a share of the recreational market.

The feds have released proposed requirements for the cultivation, processing and sale of cannabis. There doesn’t seem to be a barrier to entry aside from physical barriers (fences), visual monitoring (cameras), alarm systems, background checks, and adequate record keeping (to ensure no black market participation). They even have a website to get you started. I’ve heard everyone and their dog is applying.

The only real hurdle is getting through a backlog of existing pre-approvals in the system, which may take years. Well, that, and I imagine the feds will want to ensure consumers don’t get ill from products tainted by pesticides or mold. Health and safety will be paramount, something current black-market participants aren’t abiding by.

Changing Markets

From an investment standpoint, the market has gone crazy, bidding up prices of existing licensed producers on the premise they’ll be able to capture a significant portion of a potentially huge market and rake in huge profits. In 2017, Stats Canada estimated household consumption of 773.4 tons per year at an average price of $7.15 per gram. That’s expected to grow significantly once the recreational market opens to products other than oils and buds. And that will translate into a lot of sales but not necessarily profits for the licensed growers, especially if we look at producers in Washington, Oregon and California where farm-gate prices have crashed in the last two years.

Cannabis, like any agricultural commodity, will be affected by the laws of supply and demand, with the low-cost producers surviving along with some specialty or craft growers. The rest will either be bought out or go bankrupt. So if you’re considering buying a cannabis stock, caveat emptor.

Retail Opportunities

None of this is to say there won’t be significant winners in the marketplace. In my opinion, the real potential lies with retail, but the rules are still up in the air in most provinces notwithstanding the fact that all retailers will have to source their products through a provincial distribution branch, retailers in provinces like B.C. and Alberta must be licensed through municipalities.

But to be effective, the powers that be will need to weed out (pardon the pun) all of the black-market supply (which will likely go underground, making it that much harder to stamp out). I’m guessing that will take a lot longer than governments anticipate.

The Power of Niche Markets

Bottom line? Cannabis companies are trading like dotcom stocks back in 2000, and that didn’t end well. To be successful, retailers need to carve out niche markets through branding initiatives (that are being completely hampered by federal regulations) while governments try to eliminate black-market supply. The winners will be low-cost producers at one end and successful marketers at the other.

Full disclosure: PI Financial Corp has extensive coverage of the cannabis sector in Canada

Steve Bokor, CFA, is a licensed portfolio manager at PI Financial Corp, a member of CIPF. 

This article is from the October/November 2018 issue of Douglas.