Marijuana stocks – if there was any question of over-valuation

This post applies to the recent December 5, 2017 press release by the British Columbia government regarding how they plan on implementing marijuana regulations in the province.

Saving you from reading the actual release, they plan on having a sole wholesaler (the BC Liquor Distribution branch) and a private/public retail distribution mechanism.

This is very similar to how liquor in other major provinces are distributed – the government gets to keep the lion’s share of the profit on the wholesale side.

In British Columbia, retailers can purchase product from the government monopoly wholesaler at a 16% profit margin for licensed retail stores. These stores will have to then sell enough volume in order to pay for the usual business expenses (leasing a physical location, maintaining inventory, staffing, etc.).

Using the liquor analogy, profits from the retail end of things will be minimal. The best example is Liquor Stores NA (TSX: LIQ) which, despite booking 25% gross margins on their product, when things are good, earn a 3% operating profit margin (not before financing costs, but this is after depreciation expenses).

People following this company will shout out that they are undergoing a significant restructuring, but the central theme still sticks – it is a very low margin industry when your only supplier is government-controlled and has every incentive to maximizing its own profit and not yours.

This is a miserable business climate to be in.

Another, much smaller, example is Rocky Mountain Liquor (TSX: RUM). They operate retail entirely out of Alberta. Cherry-picking their best results in the last year, they are earning a 2% operating profit margin (and this is BEFORE financing and depreciation expenses).

Is marijuana going to be any different than liquor?

I would float the claim that retail marijuana profitability will be even worse than liquor because people can easily grow their own product sufficient for their own consumption. Federal legislation actively encourages people to grow their own marijuana plants at home (4 plants that you can now grow larger than the original 100cm proposed in the initial draft of Bill C-45).

This leaves the question of wholesale – there will need to be suppliers of this. I will also make the claim this will be a race to the bottom, with the exception that the “grow it at home” market will erode profits to the point that wholesale will nowhere near justify the 3.6 billion market capitalization seen from Canopy Growth (TSX: WEED) today – even assuming they captured the entire Canadian marijuana market.

The hype is marijuana producers will be able to achieve tobacco company margins – Rothmans was the last publicly traded Canadian tobacco company and they achieved roughly 50% operating margins (before financing and depreciation). It won’t be happening this way again – this margin will be siphoned by the government from the very beginning.

Q3-2017 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the third quarter of 2017, the three months ended September 30, 2017 is approximately +4.3%. The year-to-date performance for the 9 months ended September 30, 2017 is +24.2%.

My 11 year, 9 month compounded annual growth rate performance is +18.2% per year.

Portfolio Percentages

At September 30, 2017 (change from Q2-2017):

20% common equities (+0%)
26% preferred share equities (-2%)
30% corporate debt (-1%)
0% net equity options (-4%)
25% cash and cash equivalents (+7%)

Percentages may not add to 100% due to rounding.

USD exposure: 48% (-4%)

Portfolio is valued in CAD (CAD/USD 0.8019);
Other values derived per account statements.

Portfolio commentary

This was mostly an inactive quarter other than cashing in the remnants of KCG and making a minor debt acquisition purchase (this is net of the KCG debt redemption which also occurred during the quarter). The largest movement was not of my own action, but rather the appreciation in the Canadian dollar – going up from 77 cents to 80 cents on the dollar was a 2% drag on portfolio performance this quarter.

The portfolio was in line with the performance of the S&P 500 and TSX. I am somewhat disturbed by this “rising tide lifting all boats” market environment.

Also a minor unforced error on my part is putting idle Canadian cash into the short-term VSB.TO instrument in a very ill-timed trade over the past few months. This has been a minor, minor drag on performance (less than 10 basis points on the overall portfolio), but it should be a painful reminder to me that even the most safest of short duration yields can still contain price risk.

A minor error of omission is that I was planning on deploying a significant amount of cash on a particular US insurance firm as a result of mild panic trading from Hurricane Irma, but sadly it did not depreciate to my desired price level. This would have been an “invest and forget” type investment as I believe its management is top-notch and their capital management applications have equally been as such. I did actually own shares of this company more than five years ago.

I am happy, however, to sit on cash until I can figure out where to deploy it. My research pipeline is still relatively dry. Indeed, I have been investigating more on the short sale side of things than long.

Outlook

I’ve been examining the rise of the Canadian dollar and it is difficult for me to figure out. I’m generally of the impression that things will stall out at present levels (maybe up to 85 cents or so just strictly on technical momentum) simply because I do not see where foreign demand for Canadian dollars can come into play when we are simply not in a position to competitively facilitate exports of primary industry commodities. Almost every relevant government in this country is hostile to natural resource production and this leaves urban real estate as the other primary export. My policy to keep a range between 30-70% CAD/USD balance is still the most prudent course of action given my completely lack of investment edge on the currency situation or the lack of compelling alternatives in either currency.

I note with mild amusement that marijuana seems to be a hot sector again, with Canopy Growth (TSX: WEED) jumping over $10/share again during the quarter. Although I will not short them, I most certainly will not go long on them either. I find it incredibly fascinating how a commodity industry that will be controlled like liquor distribution could command a market value as if they were like the Microsoft of the marijuana industry (Microsoft earning monopoly-like margins on sales in their hay-day). It will not work this way for marijuana. Take a look at a miserable liquor store retailer like Liquor Stores (TSX: LIQ) for what the end-game of these companies are – even though WEED is involved in the production part of the value chain, most of the value is going to get extracted out from the regulatory protection aspects of marijuana distribution (in other words – taxes for money-hungry governments, paid for by both the consumer and companies alike). WEED’s insiders will make a fortune and should be commended for this, but third party investors will (pun definitely intended) go up in smoke.

I’ve also been eyeing what this year’s tax selloffs are going to be as this usually provides for a ripe picking ground for stocks that are force-sold in already weak conditions. There are two sector candidates for this type of action: retail and fossil fuel production.

Retail is getting annihilated by Amazon. I am contemplating whether there will be any traditional retail winners after retail’s transformation into a winner-take-all situation. I am barely seeing enough evidence that Walmart is getting its act together and should survive in some form, but I also question whether the space is big enough for Target to compete in as well. Smaller retailers are most certainly doomed unless if they specialize in a niche that cannot be commoditized by clicking or otherwise require an “in-person” presence to conduct. Has Sleep Country (TSX: ZZZ) peaked last July?

Fossil fuel companies deserve a bit of examination. Although they have spent the year in perpetual decline (the rise in the Canadian dollar has not helped them any, nor is the fact that getting oil to market has been severely hampered by government regulation), they are deserving of another examination. Crude demand, despite the media thinking that electric vehicles will make fossil fuel demand in terminal decline, is increasing and capital expenditure budgets will lag in the existing price environment. Eventually there will be a point where that supply-demand balance will tip – when this will be is anybody’s guess. There’s been somewhat of a revival in share prices in September, which obviously is some sector rotation going on with large funds.

In terms of expected future performance, if the quarter proceeds to fruition, I am expecting a 2% or so quarterly performance in the fourth quarter. Ideally, however, some sort of market crisis will hit and prices will go lower again. I’m not holding my breath – there’s just too much cash still sloshing around, looking to scrape a yield above the risk-free rate. As a result, the opportunity to make outsized gains is not in the current market environment.

Portfolio - Q3-2017 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
11.75 Years (CAGR):+18.2%+6.2%+8.4%+2.8%+5.7%
2006+3.0%+13.6%+15.6%+14.5%+17.3%
2007+11.7%+3.5%+5.5%+7.2%+9.8%
2008-9.2%-38.5%-36.6%-35.0%-33.0%
2009+104.2%+23.5%+25.9%+30.7%+35.1%
2010+28.0%+12.8%+14.8%+14.5%+17.6%
2011-13.4%+0.0%+2.1%-11.1%-8.7%
2012+2.0%+13.4%+15.9%+4.0%+7.2%
2013+52.9%+29.6%+32.2%+9.6%+13.0%
2014-7.7%+11.4%+13.5%+7.4%+10.6%
2015+9.8%-0.7%+1.3%-11.1%-8.3%
2016+53.6%+9.5%+12.0%+17.5%+20.4%
Q1-2017+18.6%+5.5%+6.1%+1.7%+2.2%
Q2-2017+0.6%+2.6%+3.1%-2.4%-1.6%
Q3-2017+4.3%+4.0%+4.5%+3.0%+3.5%