Doug Kass: Cannabis' Reward vs. Risk Has Never Been as Attractive as Now

I have had a love/hate affair with cannabis stocks over the last five years — consistently buying weakness and selling strength (most recently about a month ago).

But first let me remind you of my process.

I am a fundamental and dispassionate investor who selects securities based on the calculus of "intrinsic value" and probability distributions surrounding projected operating outcomes.

I also seek a "margin of safety," which, in theory and when employed properly, provides a buffer of protection against unreasonable and outsized losses.

Based on my (security) analysis and an evaluation of upside reward/downside risk, I have, in the aggregate profited from my cannabis positioning over the last two years.

Bad Weed

Cannabis investors are an especially emotional, committed and overly enthusiastic group. More than any other sector they seem to be in a bubble chamber of bullishness and have an almost religious attachment to the sector. (My sometimes outspokenly skeptical view has led to numerous cannabis devotees blocking me on X, formerly Twitter.)

Despite their bullish protestations, cannabis investors, however, have been unrewarded. Indeed, with the largest cannabis ETF MSOS having fallen from over $40 to about $7 and with many second and third-tier cannabis stocks retreating into penny status, there has been carnage in the space.

To be direct, with the benefit of hindsight and based on disappointing operating results and burnt capital over the last half decade coupled with the pattern of historic share price movements (from the upper left to the lower right) — it can be concluded that cannabis investors have been unduly and obsessively enthusiastic/optimistic.

I have been consistently of the view that the multiple rallies (principally off of legislative catalysts) should be sold. My concerns (and the steady sources of disappointment to cannabis investors) were based on recognition of some of the following issues:

* That legislative inroads and path to reforms (rescheduling, safe banking, elimination of Section 280E, etc.) would be slower than consensus expected given the hollow promises of politicians and the schism (and extreme partisanship) in Washington, D.C.

* Custody and uplisting restrictions would not easily be remedied and, as a result, limited institutional involvement would plague the sector.

* As retail investors have been consistently disappointed/exhausted and lost such huge sums — it would be difficult, without the support of larger and plain vanilla institutions to sustain rallies in cannabis equities.

* The total addressable market (and potential sales, profits and cash flow) was also lower than the consensus forecast.

* Though heralded as a growth industry, growth would stall out, causing some to question the bullish industry thesis.

* The current state silo structure creates diseconomies of scale and could, in the fullness of time lead to misallocation of capital and writeoffs.

* Certain state dispensary limitations (Maryland, New Jersey, Ohio, etc.) worked against the build of industry consumer brands.

* The trading dynamics of the cannabis sector in which one large, liquid ETF (MSOS) is the tail that wags cannabis' dog (of company illiquidity) is structurally sub optimal. (It is inherently unhealthy for MSOS to notionally trade $100 million/day while the basket of cannabis stocks trade under $25 million/day.)

* Speaking of suboptimal, the cheapest cost of capital outlet was for many companies to essentially "borrow" from the U.S. government by deferring taxes. That speaks volumes to the limited access to capital that I predicted.

* As we moved out of a period of near zero interest rates to a higher level, the industry's cost of capital would plague a sector that was getting more and more leveraged. I was of the view that most second and third-tier cannabis companies would take on too much debt in planting flags in new states and would have no path to profitability. (The industry's management has been generally weak and some created their own self inflicted wounds.)

Why I Am Now Optimistic on Cannabis

To begin with, most of the above ongoing concerns I have had over the last several years have finally been acknowledged and, arguably, have been materially discounted by market participants.

Here are some additional reasons (and catalysts) for my short and intermediate-term optimism:

Legislative Reform Lies Ahead

The ramifications of reform are multi-faceted and dynamic — and will, in the fullness of time, unlock the most cannabis industry value.

The likely rescheduling process from Schedule 1 to Schedule 3 (whether a 2024 or 2025 event) has major and positive implications for cannabis businesses, capital markets reform (AG memo at the minimum) and share prices.

There is little question that we are now closer than ever to the most important legislative reforms ever seen for the industry. That path, as I have mentioned in the past (see below), will no doubt be bumpy but the reform inroads are now inevitable and, for the first time, lie within a reasonable investing timeframe. This inevitability is not, in any way, being discounted in the market. In fact, MSOS is trading at a price below before the rescheduling announcement.

Rescheduling reform will also provide relief from overly indebted balance sheets. Moreover, a revision of Section 280E (which prevents cannabis companies from claiming tax credits and deductions for expenses they incur in operating their businesses) will be a cash flow, debt repayment and profit boon for the space — making the Tier One companies even more dominant operationally and financially.

Uplisting and Custody Issues Will Ultimately Be Resolved

Uplisting is an important ingredient to a rerate in valuation. It is even more likely impactful than S3, but the two may go hand in hand because if S3 becomes passed both fixing uplisting and custody (though unpredictable) could come swiftly after the most significant change in federal policy in decades (particularly if an AG memo is forthcoming).

Green Thumb's GTBIF interest in merging with Boston Beer SAM might be a way around uplisting. More permutations and more creative uplisting techniques likely lie ahead.

Curaleaf CURLF and TerrAscend TCNNF have been listed on the Canadian Stock Exchange — both companies are already getting some custody relief because of their moves. Without custody, industry share prices rely on inflows into MSOS. Custody resolution changes that reliance.

Remember, with such a small company market capitalizations (the top-five companies have an aggregate market cap well under $10 billion) it will not take much of an embrace by potential institutional buyers to have a measurable impact on stock prices.

November's Recreational Vote In Florida Will Be an Important Fundamental Industry Catalyst

Only four months away, this will help the return of the industry's growth story. My baseline expectation is passage. (This is particularly positive for Trulieve).

Product Price Compression May Be Ending

Industry fundamentals are stabilizing in some major markets. The aforementioned Florida opportunity and that of over large and populated states lie ahead.

Industry Bifurcation — The Rich Get Richer and the Poor Go to Prison

The last five years have served as a period of natural selection and survival of the fittest as the industry has dramatically consolidated under the pressure of limited legislative reforms, weak operating results and overleveraged balance sheets.

The top 5-10 Tier One cannabis companies are differentiated, have the scale/critical mass and path to profitability, are relatively healthy, have access to capital and will likely dominate cannabis' future.

Managements Slowly Have Gotten Religion

Cannabis company managements have been forced to manage their businesses' operations and finances more rationally. Out of necessity managements are concentrating on profitable growth and are finally implementing best practices after years of poor execution.

Managements' historically poorly thought out growth and expansion plans have been replaced with the objective of maximizing cash flow and the more efficient use of capital — all steps in the right direction.

The Tier One Cannabis Companies Trade at Low Free Cash Flow and Sales Multiples (Without Even Layering on 280E Changes)

The best run company in cannabis (which we own), Green Thumb, is now even buying back their own shares — that's testimony to the above observations. Should the industry's punitive tax rules be changed (our baseline expectation), more companies could follow with buybacks.

The Tier One Cannabis Companies Will Likely Become Attractive Takeover Candidates

The alcohol and tobacco business are stagnating (at best) and are being disrupted. Today there are more steady and daily cannabis users than steady drinkers.

I have spoken to numerous consumer product companies. The vast majority are quite interested in having ownership in the cannabis space as, among other reasons, the sales synergies are immense. To me it is only a matter of time. Indeed, several more aggressive consumer product companies might seek first-mover advantage and move even before they get an all clear legislative signal.

In theory, CPGs may even hold the key to pushing reform!

Finally, with such small market capitalizations (mentioned earlier) cannabis companies could be tempting takeover candidates for a large swath of companies. In theory and under the best of circumstances there could even be a buying frenzy and bidding wars for some of the major players who are morsels for the large consumer product companies!

Cannabis as the Next Meme?

There remains some possibility that if I am correct about the upcoming legislative reforms that cannabis stocks may be embraced in the same speculative way meme stocks have been. After all, if rescheduling and 280E reform is adopted, uplisting is resolved, institutions can buy and the state silo situation is resolved — this is an admittedly low probability but not entirely unrealistic scenario that cannabis becomes a meme.

Trump and Cannabis

What if, as Hedgeye's Howard Penney mentioned yesterday on Twitter, former President Trump said on the campaign trail...."I will decriminalize cannabis?" Answer: The stocks would rip higher!

That said, I am increasing less concerned about resistance to rescheduling.

Bottom Line: Reward vs. Risk

We are at a likely sentiment extreme as optimism has been thoroughly beaten out of the sector. With MSOS and many individual stock prices at or near all-time lows (in absolute terms and relative to current and prospective cash flows) and given the likely regulatory reforms, the share prices' upside dwarfs the downside (perhaps more so than any time in history).

Tactical Strategy

Most industry observers (and the consensus) expect cannabis stocks to be lackluster this summer as we are in the "comments period" for rescheduling. But those were the same industry observers (analysts, paid advisors, etc.) have been consistently bullish (and wrong) over the last several years. Now, with the share prices ar such lowly levels they have grown "objective" (tongue in cheek!).

It has paid not to listen to them in the last five years and it might not pay to listen to them now. Burned by their past opinions they have become consensus for the first time and I am not sure they will prove correct as markets tend to anticipate and discount the future.

I am using the current "comments" window (for rescheduling) to accumulate a large position in cannabis equities.

I am almost fearless at these levels — the lower the share prices fall, the more aggressive I will be.

The following compilation of recent columns tracks a lot of my recent views and trading/investing activity:

I'm Getting Close to Going Back Into the Cannabis Pool

This commentary was originally published JUne 7 in Doug's Daily Diary on TheStreet Pro.

At the time of publication, Kass was long MSOS common (M) and calls (S), CURLF (S), VRNOF (S), GTBIF (S), TSNDF (S) and TCNNF (S).