Why now might be a good time to buy U.S.-focused cannabis stocks

Cannabis exchange-traded funds soared at the start of the year from a combination of new investor interest and speculation the United States was set to lift a federal prohibition on marijuana. The buzz was eventually killed when it became clear Americans weren’t about to follow Canada’s lead on the legalization of recreational cannabis at the national level.

The Horizons Life Sciences ETF (HMMJ-T), the world’s first cannabis ETF, and the Horizons US Marijuana Index (HMUS-NEO), the first U.S.-focused play in an ETF format, have both fallen by more than 40 per cent since their one-year highs reached in early February.

While recreational cannabis is legal in 18 states, and medical marijuana in 37, as of July, it remains illegal under U.S. federal law. Efforts are under way in Congress to enact major cannabis reform, but it’s not considered imminent.

Canadian cannabis companies, which dominate most ETF holdings, are itching to expand into the higher-growth U.S. market. Canada’s legalization of cannabis in October, 2018, has given them a head start, but the industry is largely locked in a homegrown market with too much competition.

“Without federal legalization, most of the [Canadian] licensed providers have little to no access to U.S. market expansion,” says Mark Noble, executive vice-president of ETF strategy with Horizons ETFs Management (Canada) Inc.

U.S. cannabis operators, meantime, are methodically building up their businesses in the growing number of states that have either fully legalized marijuana or allow it for medical use. However, they’re restricted in raising capital. Banks in the U.S. are deterred from dealing with companies that sell marijuana or related products while it’s considered illegal at the federal level, and cannabis companies can’t list on large U.S. stock exchanges.

If those restrictions eventually ease, as many analysts expect, it will be a big boost for cannabis companies on both sides of the border.

U.S. multi-state operators are juicy takeover targets for Canadian companies. For instance, Smiths Falls, Ont.-based Canopy Growth Corp. has standing agreements to buy holdings in U.S.-based cannabis companies when federal legalization occurs in the U.S.

Mr. Noble says Canadian cannabis companies could see revenue rise rapidly “by engaging in aggressive U.S. expansion, through mergers and/or acquisitions, financed by their ability to tap into capital markets.”

His firm’s HMUS ETF offers diversified exposure to the world’s largest cannabis market through cannabis providers such as Curaleaf Holdings Inc., a leading medical and wellness cannabis operator in that country.

He says most of the underlying U.S. cannabis stocks have traded at a lower valuation to their Canadian peers this year “even though they are directly involved in the higher potential growth market” south of the border.

The “U.S. is best” view shared by Faircourt Asset Management president and chief executive Charles Taerk, which is the sub-adviser of the Ninepoint Alternative Health Fund (NAHF-NEO).

“Not all cannabis companies are created equal and we would urge investors to look at the U.S. market,” he says, given its sheer market size.

Legal cannabis sales reached US$17.5-billion in the U.S. last year, up 46 per cent from US$12.1-billion in 2019, according to Colorado-based research firm BDSA. It forecasts U.S. sales to reach US$41.3-billion in 2026. Meantime, the report says legal cannabis sales in Canada totalled an estimated $2.6-billion in 2020 and are forecast to grow to nearly $6.4-billion by 2026.

The Ninepoint fund, launched in May with a management fee of 1.25 per cent, takes an active approach and features a mix of U.S. and Canada cannabis companies and others in the “alternative or wellness” space such as pharmaceutical, vitamin and supplement companies.

Canadians looking to invest in the growing space should allocate about 5 to 10 per cent of their holdings to it, depending on their risk tolerance, Mr. Taerk says.

“Much like you have an allocation to technology or the work-from-home stocks, it would be comparable to that type of weighting to give you allocation to a sector that we see growing significantly over the next 10 years,” he says.

Kristoffer Inton, an equity strategist with Morningstar in Chicago who covers the cannabis industry, recommends investors look to ETFs with exposure to U.S. multi-state operators.

Of the nine largest cannabis ETFs traded in the U.S., only two meet his criteria; the AdvisorShares Pure US Cannabis (MSOS-N) and the AdvisorShares Pure Cannabis ETF (YOLO-N). Both are actively managed. MSOS carries a MER of 0.74 per cent and focuses exclusively on the U.S. market while YOLO has a 0.75 per cent MER and offers a 61.4 per cent exposure to the U.S. market with the rest in other international markets.

Most cannabis ETFs are different, Mr. Inton adds, and recommends investors pay close attention to their holdings.

“Some limit themselves only to the Canadian companies,” he says. “That doesn’t give you as good an exposure to the U.S. market.”