June Update, 2018: Canada Is Going To Pot

Within a matter of months, Canada will have a new industry that, until now, has been beneath the clutches of the “Tax-man” and hence, illegal. Illegal pot is a very big business right now. Estimates are about $8 billion per year. After years of fighting, the government has decided it’s a good business and that they want in. Whether you approve or not, criminals are earning billions and not paying taxes. The government wants their cut and businesses smell opportunity.

Davis Rea first investigated marijuana investments 3 years ago. We spoke with the CEO of a startup who had hoped to capitalize on the medical marijuana business and the likely decriminalization at some future point. We walked away from the meeting certain of two things: weed was a farming operation and he had no farming experience. If this business was going to grow, it would require many years, lots of luck and lots of money. We don’t do venture capital investing. We were and remained highly skeptical that early investors would make money. We wished the CEO luck.

Today, that company is part of the largest marijuana company in the world. The now-retired CEO is wealthy. We are still working. All proof that an investor can be right about the facts and still make the wrong decision.

Marijuana stocks have made spectacular advances in price. Rewarding players willing to bet on the future of a highly uncertain outcome. As we watched from the sidelines and the government promised advancement toward legalization, we started our investigation. The debate advanced and the stocks marched higher. Higher prices brought about enormous claims from an increasingly growing number of startup marijuana companies. The stock prices went higher. We watched in disbelief as a VERY small number of aggressive offshore hedge funds played fast and loose with the companies needing to raise money to execute on their wild promises. When markets take on highly speculative behaviors unsavory practices are sure to lead to tears. We believe within 1 year the real business leaders will emerge and the business will look very different than today. Is there an investment opportunity now?

After 8 months of investigating, our conclusions are as follows:

Of the 45 companies we have examined, only one makes real—not accounting fantasy—profits.

The claims about the benefits of marijuana and its major constituents THC and CBD are large and various. Some of the claims are likely complete speculation. The claims about the size of the market opportunity, while possibly true, will take years to evolve and validate. The price of the product to be sold is highly uncertain, but the price will be very low because the cost to produce is falling fast. In the agriculture business, that means low prices and margins unless you are a very efficient and low-cost supplier. The profits will accrue to those who add value and who innovate.

Cannabinoid oil (CBD) is one of the two primary ingredients of marijuana. CBD is a non-narcotic chemical. Its 113 different chemical constituents are cited for various health benefits. For example, there is some clinical evidence that it does aid in the suppression of pain and its effects on epilepsy are encouraging. There will be more research. The ‘big idea’ about CBD is it doesn’t do any harm and thus you can pretty much say anything you like about its usefulness. Your eggs have Omega 3; they must be good… Right?! The fact is there is no representation they are good for you, (do you see any fine print on your eggs?). There’s an inference that they are good. They are in eggs. Why would they put them there unless it was good? Imagine what a company like Nestle or Proctor & Gamble (or on a smaller scale Starbucks) could do with a new product to jazz up their old lines of business. Pharmaceutical companies will surely get involved.

The large-scale adoption of CBD’s by consumer packaging and pharmaceutical companies will require very large, clean and sophisticated manufacturing processes. We believe CBD’s will be a big business. We are not certain how the economic relationship between large multinationals like those mentioned above and the surviving marijuana companies will evolve. Skills needed to qualify for partnership would include highly specialized manufacturing and research abilities—pharmaceutical grade characteristics.
THC is the narcotic of marijuana. It will have both medicinal and recreational indications. The possession and consumption of THC is being decriminalized but its abuse will be a criminal act. Consumption of THC will increasingly be in a refined oil form introduced via some type of delivery other than inhalation. Skills needed for success will include highly specialized manufacturing, research abilities and marketing and branding expertise. The THC producers that make money will be the lowest cost, highly efficient, organized, professional, highly specialized botanists, pharmacists, and marketing savvy survivors.

For 70% of the Canadian population, the wholesale, distribution and retail marketing of THC will be controlled by the government. The government has effectively stolen the market from the crooks. Eventually, the Government will admit that some form of branding is required and will quickly become hooked on the revenues. The Government makes huge money from “Sin Taxes.”

Is Canada going to pot? Yes, and the business of pot is very likely to be bigger than we originally might have imagined. We have a timeline to market. We have (some) professionals in the business. It’s no longer venture capital. Now may be when real wealth is not just made, but kept. The government is betting a legal market is good business. Perhaps we should too.

Watch John talk marijuana on BNN