Financial news websites in the U.S. and Canada reported earlier this month that a modest investment of $2 million had been made in Trellis, a Canadian software company, by an American whose legal name is Calvin Cordozar Broadus. The investor has made a name for himself in business related to that company’s activity, having led to a 330 percent spike in the value of shares of Canopy Growth, a company he started collaborating with a year and a half ago.
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The extensive media coverage of this modest investment was related to the investor’s identity. He is better known as the rapper Snoop Dogg. However, the companies this musician has invested in during recent years are unrelated to the music world but to one in which he is a cultural icon – cannabis.
Trellis is a company providing software that assists cannabis growers, with Canopy Growth being the largest legal grower in the world. The fact that both companies are Canadian is no coincidence. Many supporters of the cannabis industry have been looking to that chilly country over the last year. Canada permitted the use of medicinal cannabis back in 2001, and from this summer it will allow extensive use of this weed for leisure and relaxation, based on a platform that helped make Justin Trudeau Canada’s prime minister.
On this backdrop and based on the accumulated experience in Canada, including the illegal grass industry which has flourished there for years, several of the major publicly traded companies in this area operate in Canada. Horizons, with its headquarters in Toronto, was the financial services company quick to identify the potential of this industry, launching the first exchange-traded fund (ETF) devoted to cannabis, traded on the Toronto exchange under the Horizons HMMJ label. It is the world’s first weed ETF.
The largest companies on the index developed by Horizons and which are tracked by the fund (with Canopy Growth being the largest, comprising 11% of the index) are mainly Canadian ones, but there is also a large British company and several American ones. The fund’s offering came after a steady and unusual growth in the value of its stocks, due to a large extent to the prolonged process of legalization of grass in the U.S.
However, since its launching in early April, the euphoria which caused a spike equalling hundreds of percentage points in the value of some of these shares over the last two years has somewhat dissipated, partly due to the fact that the Trump administration has signaled that it is not keen on promoting the legalization of marijuana. Accordingly, the Canadian ETF dropped somewhat as well, only returning last week to trading above the value at which shares were issued, with overall returns of 3% over this period.
The lack of clarity currently surrounding the cannabis industry is connected not only to its incompletely defined future legal status, but also to issues of defining its activities and determining its boundaries, an issue which is confusing analysts and investors. This is expressed in decisions regarding the determination of which shares are included in the index underlying the fund.
Canopy itself is a good example of this. On one hand it is an R&D company which employs biologists and physicians. On the other hand it is cooperating with Snoop Dogg. The hip-hop star is indeed a successful and wealthy artist-performer but he’s built his image, in part, on his criminal past and on his declarations of heavy usage of cannabis during the years in which U.S. authorities were waging an all-out war against the weed.
The issue is broader. Like Canopy, almost all the other dominant companies in the Canadian ETF market define themselves as companies that are in the drug (medication) business, even though in most cases they appeal mostly to retail supply of medicinal cannabis, at least for now. Meanwhile, though, the index includes companies that actually develop drugs, but their weight is smaller and they are afflicted by the usual problems besetting the development of new drugs.
Drug development, including cannabis-related ones, is a prolonged and expensive process, and even though its profit potential is large, in many cases it ends in failure, even when development is led by talented professionals. Due to the lengthy development process and hefty investment required, biomed companies are considered high-risk ventures.
In that sense, including such shares in the index gives investors exposure to the potential of cannabis-based drugs developed by some of these companies, but this is not based necessarily on legalization, but rather on the granting of licenses by the FDA.
In the meantime, investors are following mainly those companies that market medicinal cannabis, whose managers are getting ready for a significant expansion of the Canadian market following its legalization. Full legalization, expected in the summer of 2018 following completion of the legislative process, is driving companies to increase their investments in increased production capabilities and in marketing, in the hope of reaping future returns.
Growing revenues and losses
Canopy, the most prominent company in this area, employs 550 people. Its headquarters and main plant lie in an old chocolate factory in a town called Smith Falls, situated halfway between Lake Ontario and Ottawa. The company has other farms not far from Niagara Falls, as well as growing the plant in Holland, the global pioneer in legalization.
Canopy’s revenues grew to $31 million Canadian (about $25 million) over the first half of this year, three times higher than in the first half of 2016, but its losses grew by the same rate, from C$9 million to C$24 million in the first half of 2017, following a doubling of general, marketing and managerial expenses.
Canopy shares are trading at seven-fold higher levels than they did two years ago but they were even higher towards the end of 2016 and earlier this year. The valuation of this company is C$2.1 billion, a huge amount relative to its revenues.
The next biggest players on the HMMJ index belong to Aphria and Aurora Cannabis (holding 10% of the shares each), both of which are valuated at C$1 billion. These companies deal in medicinal cannabis, focusing on supplying patients in need. Aphria focuses on providing cannabis and cannabis oil to Canadian patients through a distribution network based mainly on a friendly website. Aurora also dedicates a website to medicinal purposes – aiming at patients and physicians, for whom they offer guidance in using cannabis.
Aphria and Aurora ended the year with revenues of only C$11 million, a bit higher than in the same period last year. Aphria had a mid-year profit of C$2 million, comparable to the preceding year, whereas Aurora lost C$5 million, also similarly to the previous year. Accordingly, Aphria’s stock climbed 42% since the beginning of 2017, completing a 727% increase in the last two years. Aurora has climbed 32% since the beginning of the year and 473% in the last two. Both stocks are currently trading at just under their highest-ever value.
Between medicine and gardening equipment
The fourth largest player on this index is unrelated to cannabis. It is a large Canadian company (valuated at C$5.7 million), which specializes in lawns and gardening. This is Scotts Miracle-Gro, which is included in the index thanks to its subsidiary Hawthorne Gardening, which produces equipment for cannabis growers.
The logic behind investing in this company is congruent with the insight that the biggest winners in the gold rush weren’t the prospectors but the people who supplied them with digging tools, room and board. So far Scotts Miracle-Gro has only yielded returns of 4% since the beginning of this year, growing by 57% in the last two.
Two other significant players in this index are the British company GW Pharmaceuticals (holding 9%), which is traded on the London exchange and on Nasdaq, and the American company Insys Therapeutics (with 8% ), also traded on Nasdaq. Unlike the larger Canadian companies, these companies focus on development. GW’s headquarters are in Cambridge, England. It is valuated at GBP 2.8 billion and already has one product on the market called Satiex. This is a spray based on cannabinoids, the active ingredients of marijuana. It is designed to alleviate moderate to severe symptoms of multiple sclerosis. The company has another product that is in advanced stages of development, a drug called Epidiolex, meant to treat epilepsy. It is now in the third and decisive stage of clinical trials.
GW’s future depends on these trials and on its market penetration, no simple task. Accordingly, the company registered small revenues of GBP 74 million in the first half of 2017, with a loss of GBP 74 million. These worrying numbers are expressed in an increase of only 3% in the price of its shares since the beginning of 2017, although its returns over the last two years stood at 30%.
Insys, operating out of Phoenix Arizona, also develops drugs, but it reached this area from another angle. Its first product is a fentanyl-based spray for supressing severe pain. It is meant for cancer patients who are unresponsive to milder analgesics. The company recently received FDA approval for a similar product based on synthetic cannabis.
This state of affairs is not placating investor worries. Insys did have revenues of $78 million midway through 2017 but it also lost $15 million. It is the most problematic company in this index, dragging it down in recent months. Its returns were -4% since the beginning of the year, with an aggregate negative 66% in the last two years.
What about the U.S.?
With all due respect to 35 million Canadians, the really big potential lies with its neighbor to the south, with its ten-fold larger population, a fact well-understood by investors. Canadian companies are well-positioned to operate in the US and are large compared to comparable American companies. However, legalization in the US seems less promising that it did a year ago, one reason for the sluggish Canadian ETFs.
Unlike in Israel, U.S. presidential elections also involve local issues. The biggest winner last fall, other than Trump, was cannabis. Nine states decided to legalize it and 20 others permitted its medicinal use.
However Trump and the Republicans may block this trend and may even reverse it. The upcoming legalization in California is raising hopes in the market but it still faces some hurdles. Without federal support public companies will find it difficult to operate. Anyone hoping for rapid legalization in all 50 states needs to be patient. This lack of clarity may give Canadian companies some future advantage, after they gain experience in Canadian markets with American players hesitating to enter the area. Until then, investors are waiting for Trudeau and the legalization he’s promised by next summer.