A large debate that has grown in investing circles during recent decades is the ability for professional investors to provide “alpha” rather than simply “beta.” That they are adding value rather than just collecting the value provided by the broad market or a specific sector. Legitimate market sectors draw investors and those investors are being asked to prove their value not only versus the broad market but versus the particular sector or strategy group they are involved in.
So, if an emerging industry is going to attract professional investors, it will be asked to measure its performance versus a benchmark. The Marijuana Index, which is owned by MJIC, tracks the performance of the legal marijuana industry. This includes companies that directly handle legal marijuana, such as marijuana producers, processors, distributors and retailers. It also includes companies that don’t directly handle plant product, but cater to those who do, as well as to consumers. These “ancillary” businesses operate in a wide range of industries such as consumption devices, product packaging, information technology, equipment, business services and more, says Dan Nicholls, vice president at The Marijuana Index. “Our definition of marijuana includes all forms and applications of the marijuana, cannabis and hemp plant, including cannabinoids such as CBD or THC,” says Nicholls, adding that it does not, however, include activities related to synthetic cannabinoids.
MJIC breaks down the Marijuana Index into three indexes: The North American Index, American Index and Canadian Index (see “One plant, 3 indexes,” below). Currently there are 23 stocks in the overall index, 13 American and 10 Canadian (see “The roster,” below). MJIC recently reconfigured the index based on specific criteria. “The start of this year we revamped the index, putting in place strict eligibility criteria,” Nicholls says.
“The first rule is that companies must have a 50% focus on marijuana,” he says. “Big names like Scott’s Miracle Grow (SMG) have invested a couple million in the space, but they are a $10 billion company. If companies aren’t focused on marijuana, they aren’t eligible for the index.”
SMG’s size means its performance will not reflect the performance of the industry. Those that are focused on the marijuana complex must have verifiable metrics. Nicholls says, “They also must be included on one of the main exchanges — NYSE or Nasdaq — or the over-the-counter (OTC) QB or OTC QX. Companies on the OTC Pink are not eligible because they aren’t required to report audited financials.”
Deciding the level of involvement in the industry was a key metric. “People use the index as a reflection of the industry (how is the marijuana industry doing?); if we are including companies that only have a small involvement, they are not going to trade that close to the marijuana industry. We want our index to be a benchmark for the industry, so companies that aren’t majority focused on the industry just aren’t eligible,” he says. “The index is meant to represent the top companies. It is based on quantitative criteria. These are the top trading companies in the sector. That cuts out a lot of companies. The broad universe of marijuana related stocks number roughly 200.
“The main criteria is our trading criteria, which is a weighted average of a company’s market cap, share price and trading volume,” Nicholls says. “On average, companies must have at least $20,000 of daily trading values (dollars not shares), they must have at least a $10 million market cap and a 10¢ share price. We look over each quarter and do a weighted average or see what companies qualify.”
A problem in such an emerging sector is that growth comes in various waves that can turn things upside down in a short period. This occurred to an earlier version of the index when the recreational use of marijuana became legal in Colorado and Washington State. “It was a massive bubble, companies went up thousands of percent,” Nicholls says. Some companies went from penny stocks to billion dollar companies in a month, but it all came crashing down in March 2014 (see “The higher they rise…” below).
“We are kind of seeing something similar right now but on a smaller scale,” Nicholls says. “It is the result of the same thing. The marijuana sector has decent liquidity but it is still a small industry. The states that have legalized — Colorado, Washington, Oregon (we spoke to Nicholls before Nov. 8) — are small states, so there is a wide swath of Americans that don’t have exposure to it.”
The indexes are equal weighted and rebalanced quarterly. “Our old index was market-cap weighted, if you look at top 10 companies GW Pharma is larger than all other companies combined (see Top heavy,” below), Nicholls says. “It is the only billion dollar company that is solely focused on marijuana, not on THC products but CBD products (non-psychoactive component). They are so big that it would be impossible to be market cap. We wanted equally weighting so it would be distributed well.”
The index would simply be a referendum on GW Pharma, and it would also complicate MJIC’s long-rage goal of creating investable products from the indexes because they would be narrow based, and not eligible to be a pure futures product.
Moving on up
Most of the stocks in the indexes, especially the U.S. index, are listed on OTC exchanges. MJIC doesn’t include companies listed on OTC pink sheets because they do not require the companies to fully report their financials. It is a problem and an impediment to the long-range goal of creating an exchange-traded fund and futures contract on the indexes. “A few companies have tried to become listed. The most notable is Mass Roots (MSRT), which is a tech platform; a social app for cannabis,” Nicholls says. “They are on OTC QB. They tried to uplist to Nasdaq but Nasdaq rejected them because they are cannabis related.”
This is a big problem in getting more institutional interest. Liquidity in the OTC markets is not as strong and there are some investors who just won’t trade there.
Now that marijuana is legal for a much larger group of people thanks to recent resolutions, the next big step is rescheduling. “Marijuana is a ‘Schedule 1’ substance, which means that technically the Federal government sees no medical use for marijuana, which is ironic because 25 states have passed medical marijuana laws,” Nicholls says. “Our Federal ‘Schedule 1’ is outdated. Until the Federal government reschedules it to a lower schedule or de-schedules it altogether, it is going to be difficult for U.S. cannabis companies, especially companies that are touching the plant.”
That is why more of the companies in the U.S. index are ancillary companies not directly involved in the growth, sale and distribution side.
The Federal law makes it difficult for companies to build banking relationships and uplist to larger exchanges. “A lot of banks won’t take marijuana customers so there is a lot of risk that these companies are handling millions of dollars of cash but can’t use a bank, Nicholls says. “Banks have so much money and so much cash flow that it doesn’t make sense to take on a few marijuana customers if it is going to bring on a substantial amount of risk. If they change the schedule it would no longer be illegal for banks and the risk would be much lower.”
Now that Proposition 64 in California has passed, things may open up. Marijuana has been legal for medicinal use in California for 20 years so the adult market would quickly mature. Canadian companies may be the largest beneficiaries because In Canada marijuana is Federally legal for medical purposes. “The Canadian Index has 10 companies that actually sell and grow marijuana,” Nicholls says. And Canadian Prime Minister has already announced the recreational use would be legal next year.
The current growers in Canada are the forerunners. Canada technically doesn’t allow dispensaries, so these growers ship product to customers. It is a unique distribution model. In the United States there are middle men.
Ch... Ch... Ch... Changes
With several additional states legalizing for both medicinal and adult use after the result of various ballot resolutions on Nov. 8, further growth and disruption is expected.
“As time goes by we are going to have to increase the standards (to qualify for the index) because the standards we set right now are pretty low,” Nicholls says. “Once those Federal laws change and those big companies enter, we could see a very large change in terms of the constituents of the index. The $10 million minimum can move to $100 million. We are aware that there is a lot of room for growth that would mean a lot of changes in the index.”
The big companies Nicholls mentioned are already showing interest. The Emerald Triangle is a three county area of Northern California that has the perfect environment for growing marijuana where a majority of the marijuana sold in the United States comes from. Nicholls says there is evidence that Tobacco companies are buying land up in the Emerald Triangle, quietly from holding companies. Sounds like some of those big companies are getting prepared to get into the space.
“The interesting thing about marijuana is that it is much more than a recreational plant. Most people think of the stigma of people getting high, but when you look at the plant and its uses, there is the recreational market, and then there is the medical side that has so much potential in the coming decades. It could replace a lot of the pharmaceutical industry and the third leg is the hemp side,” Nicholls says. “The hemp side could potentially be bigger than both the rec and medical side. Hemp can be used for textiles, clothing, cars, for wires. It is one of the most useful [plants] in the world. When you look at where the marijuana industry will be in five or 10 years, it is more than just companies producing weed for people to get high.”
Nicholls says when you look at those elements plus all the ancillary companies that are supporting this, the potential growth is staggering. “There will be thousands of companies and they will be big companies.”
MJIC has split up the industry in 11 sectors and anticipates creating additional indexes that will eventually be investable. “There could be indices for biotech, for pharma, there could be an index for hemp companies, consulting companies, agriculture technologies; there are a lot of different sub sectors in the space. Each of those sectors could have an index. Over time we’ll slowly add indices based on what people are looking for.”
Of course this all depends on a change in the Federal legal status, but momentum appears to be on the side of the industry and when it grows, MJIZ will be prepared to provide the benchmarks.