Perspectives 2021 FEB - Marquette Associates

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Into the Weeds on Cannabis Stocks INDEPENDENT INVESTMENT CONSULTING Perspectives In recent years, successful marijuana legalization efforts in the United States have led to increased investor interest in the prospects of upstart cannabis-oriented businesses. Indeed, the development of a new industry often precipitates unique opportunities for market participants, as well as uncertainty of which investors should be cognizant. The aim of this newsletter is to examine at a high level the emergence of publicly traded cannabis stocks vis-à-vis the broader equity landscape and the ESG-related risks these securities may pose. Evan Frazier, CAIA Research Analyst, U.S. Equities BUDDING COMPANIES IN A BUDDING INDUSTRY Since the mid-1990s, the number of states in the U.S. to legalize cannabis for medicinal use has climbed steadily and sat at roughly 40 at the end of 2020. It was not until the past decade, however, that recreational marijuana use gained support among the majority of U.S. citizens. Though the drug remains a Schedule I controlled substance under federal law, 15 states have legalized recreational cannabis since 2012, and more are expected to follow suit in the near future. FEB 2021 Source: The Marijuana Policy Project as of December 31, 2020 Exhibit 1: States by Cannabis Legalization Status Fully Illegal Decriminalized Medicinal Medicinal and Decriminalized Legalized

Transcript of Perspectives 2021 FEB - Marquette Associates

Page 1: Perspectives 2021 FEB - Marquette Associates

Into the Weeds on Cannabis Stocks

INDEPENDENT INVESTMENT CONSULTING

Perspectives

In recent years, successful marijuana legalization efforts in the United States have led to increased investor interest in the prospects of upstart cannabis-oriented businesses. Indeed, the development of a new industry often precipitates unique opportunities for market participants, as well as uncertainty of which investors should be cognizant. The aim of this newsletter is to examine at a high level the emergence of publicly traded cannabis stocks vis-à-vis the broader equity landscape and the ESG-related risks these securities may pose.

Evan Frazier, CAIAResearch Analyst, U.S. Equities

BUDDING COMPANIES IN A BUDDING INDUSTRYSince the mid-1990s, the number of states in the U.S. to legalize cannabis for medicinal use has climbed steadily and sat at roughly 40 at the end of 2020. It was not until the past decade, however, that recreational marijuana use gained support among the majority of U.S. citizens. Though the drug remains a Schedule I controlled substance under federal law, 15 states have legalized recreational cannabis since 2012, and more are expected to follow suit in the near future.

FEB 2021

Source: The Marijuana Policy Project as of December 31, 2020

Exhibit 1: States by Cannabis Legalization Status

Fully Illegal

Decriminalized

Medicinal

Medicinal and Decriminalized

Legalized

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Given this sea change and the momentum surrounding continued legalization pushes, it should come as no surprise that entrepreneurs have seized the opportunity to develop businesses that center on medicinal and recreational cannabis products. As of February 22nd, 2021, MSCI ESG Manager listed 211 public companies with production, retail, research, or ownership ties to the cannabis industry around the world. This figure is indicative of a significant increase in global cannabis-related businesses in recent years, as there were only 86 such firms at the end of 2018. Of these 211 enterprises, the majority of which are classified as pharmaceutical or beverage companies, 62% were domiciled in Canada compared to just 24% in the United States. This follows from the fact that national marijuana laws in Canada are less stringent than those in the U.S., and the proximity of the two countries allows Canadian-domiciled companies to access U.S. markets with relative ease. Some of these companies have even been able to become listed on U.S. stock exchanges. To this point, the distinctions between the ways in which securities of these companies can be transacted are worth summarizing. At the time of this writing, roughly 75% of the 211 businesses with cannabis ties traded in over-the-counter (OTC) markets as opposed to on a centralized exchange. Companies whose shares trade off-exchange are usually small and unable to meet the listing requirements of formal platforms and the OTC marketplace is highly speculative as a result. Given the fledgling nature of the marijuana industry, it should be expected that the vast majority of these businesses trade OTC. Indeed, only a few of the 211 cannabis-related securities trade on U.S. exchanges like the NASDAQ (6%) and NYSE (2%), and the remainder trade on foreign exchanges. That said, a few of these exchange-traded companies are actually constituents of broad-based domestic equity benchmarks like the Russell 1000 and Russell 2000 indices, and the extent to which these indices are exposed to cannabis-related companies is reflected in Exhibit 2.

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Russell 1000 Index Russell 2000 Index Russell Micro Cap Index

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Sources: MSCI ESG Manager and Bloomberg as of February 22, 2021

Exhibit 2: Index Weightings of Companies with Ties to Cannabis as Defined by MSCI

Before proceeding, it is important to note that companies with “ties” to cannabis products as defined by MSCI are far from “pure plays” on the cannabis industry. Altria Group, Inc. (MO), for instance, is a holding company whose segments include smokable products and wine, and notably the parent organization of Philip Morris Companies, Inc. The firm’s ties to the marijuana industry primarily stem from its large minority stake in the Canadian cannabis company Cronos Group (CRON), which trades on the NASDAQ but is not contained within a major index itself. Although Altria made up 0.21% of the Russell 1000 index as of February 22nd and is classified by MSCI as a company with cannabis ties, it would be unfair to say that the entirety of its business is exposed to the cannabis space given the company’s diversified nature. Even smaller companies with ties to the marijuana industry like Zynerba Pharmaceuticals (ZYNE), contained in the

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HASHING OUT ESG IMPACTAlthough most publicly traded cannabis securities have not made a significant impact on the broad equity landscape, the growth of the industry has caught the attention of managers with a focus on environmental, social, and governance (ESG) factors. When viewing through an ESG factor exposure lens, cannabis agriculture has both the potential for positive and negative impacts. In the industry’s current form, cannabis-producing companies carry significant environmental risk as it relates to energy consumption. Indoor marijuana cultivation, while more efficient than growing outdoors, is a highly energy-intensive process. According to one study, it is estimated that indoor cultivation requires roughly six-times as much energy as the entire pharmaceuticals industry and at least 1% of all the electricity in the United States.1 Many indoor facilities also utilize gasoline or diesel generators, which lead to significant fossil fuel emissions. Barring technological developments that render the cultivation process more energy efficient, the ongoing maturation of the cannabis industry will likely result in continued negative environmental externalities. Looking at social impact, cannabis-oriented businesses pose both opportunities and risks. There are many investors that would argue that cannabis-related business ownership efforts for underrepresented minorities, coupled with the reversal of some laws, policing, and sentencing practices in relation to marijuana offenses in some states, is a form of both racial equity and social justice. However, the possible health impacts of prolonged marijuana usage are not yet fully understood. Lastly, the quasi-legal nature of the cannabis industry in the United States presents governance-related risks to investors. Most cannabis-oriented businesses require government approval for production and retail operations, which

Russell Micro Cap index, and Cara Therapeutics (CARA), contained in both the Russell 2000 and Micro Cap indices, are not entirely centered around cannabis. Rather, these businesses promote and utilize medicinal marijuana products as part of a larger health care focus and have no forays into the recreational drug space whatsoever. In fact, 78% of companies with cannabis ties that derive greater than three-quarters of their revenue from marijuana-related activities trade over-the-counter, and those that are traded on prominent exchanges are not components of well-known indices. So, it is fair to say that the “pure” exposure of major U.S. indices to the cannabis industry is negligible at present, but will likely grow in the coming years as marijuana legalization efforts continue to advance.

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0%–25% 25%–50% 50%–75% 75%–100%Co

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Max % of Revenue Derived from Cannabis

OTC Exchange-TradedSource: MSCI ESG Manager as of February 22, 2021

Exhibit 3: Percentage of Total Revenue Derived from Cannabis for Companies with Cannabis Ties

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could lead to unscrupulous lobbying efforts and dealings with public officials. Going forward, investors and ESG managers alike will have to weigh these issues.

CONCLUSIONDespite the significant uptick in the number of publicly listed cannabis companies in recent time, the industry is clearly still in its nascent stages. Most public companies with marijuana ties trade in speculative, over-the-counter markets given their budding nature, and those that are listed on centralized exchanges are likely not constituents of major equity indices. Still, the coming years are likely to see an increase in the number of exchange-traded cannabis companies given the projected growth of the industry. According to one study, strong consumer demand is likely to result in a 21% compounded annual growth rate of legal cannabis sales by 2025 in the United States alone. Annual legal transactions as a percentage of overall cannabis purchases in the United States are projected to double by 2025 as well.2 While these and other data points indicate promising opportunities for investors in the cannabis industry, the space is not without risks. Additionally, the fledgling nature of the industry indicates that cannabis companies are inherently less stable and more prone to failure than more mature businesses, which could discourage risk-averse individuals from purchasing their shares. As time goes on, investors should be well aware of these risks and have a robust understanding of their own risk profiles prior to allocating capital to the promising yet speculative cannabis space.

NOTES1 Warren, G.S. 2015. “Regulating Pot to Save the Polar Bear: Energy and Climate Impacts of the Marijuana Industry.”

Columbia Journal of Environmental Law, Vol. 40, PP. 385-432.2 New Frontier Data. 9 Dec 2020. “Cannabis in America for 2021 & Beyond: A New Normal in Consumption and Demand.”

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