Don't Give Up on Non-US Equities
December 19, 2019
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Abstract: History is replete with manias and bubbles. But it is also full of examples of disruption and innovation. Which bucket will cannabis fall into?
The investment industry has always suffered from storytelling and chart chasing. Examples include the tulip mania of the 1600s, the South Sea Company Bubble in the 1700s, and more recently, all the hype surrounding cryptocurrencies. Now history has shown that if the story does not pan out and deliver promised outcomes, i.e. cash flows, there will be pain. However, not all stories disappoint. So for instance, smartphones, cloud computing, e-commerce, are innovations that have benefited society enormously, unleashing cash flows and ultimately return for investors.
A new story the market has become increasingly focused on of late is cannabis. It's one I'm asked frequently about. In recent years, there's been a trend toward legalizing cannabis for either medical or recreational use, or both in many countries. In the United States, the situation is more complicated, but the trajectory is similar. While illegal at the federal level, beginning in the mid-1990s, many states began legalizing in some form the medical use of marijuana.
As this map shows, cannabis has been broadly legalized in 10 U.S. states. Now let's set aside the question of whether or not legalized cannabis is a societal good or evil, and let's keep our focus on the investment implications. So as potential investors, we would want to know the answers to certain key questions. Such as, how big could the profit pool from cannabis be? Could it eclipse beer, wine, or even spirits? Is there intellectual property that could provide a business with a competitive advantage and superior returns, as what's happened with alcohol and coffee? Will there be, for example, a Johnnie Walker or a Starbucks of cannabis?
Now the answer to these questions are not yet clear, although the equity market's obvious euphoria in this space would imply otherwise. Today, 2/3 of the population of the United States has access to medical marijuana, and 1/5 has access to recreational marijuana. So while the cannabis profit pool could be pretty large if adoption rates grow, the question is, will there be free cash flow? That is hard to envision in a category where at least right now we see little product differentiation and no pricing power. For example, in early adopter states like Washington, cannabis prices have steadily declined. Why wouldn't they do the same in Massachusetts or the next region or country that legalizes the plant?
Here's another way we're thinking about this. Households have budgets. People generally budget how much they can spend on vacations, holiday shopping, or even lunch during the work week. If cannabis scales up, what might it take share from? As smartphones and tablets penetrated in the late 2000s, they cannibalized sales of personal computers. So what existing product categories may be at risk with the growth of the cannabis market? In other words, how will households deploy what we call a buzz budget? The amount they typically spend on alcohol, cigarettes and the like, if legal cannabis is added to that mix, who loses?
So in our view, potentially beer, wine, spirits, they could be candidates for cannibalization. So this is something we're obviously looking at closely and modeling a potential ranges of outcomes. So to summarize, fundamentals such as intellectual property and pricing power, that drives free cash flow. And free cash flow is ultimately what drives asset prices long-term, not stories. Thanks for watching.
The views expressed are those of the speakers and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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