Cannabis and baking – a small-cap investment perspective - no puns intended

Cannabis and baking – a small-cap investment perspective (no, I’m not talking magic brownies or infused profiteroles)

Investment sentiment in the cannabis sector these past few months has been about as positive as Eeyore’s outlook on life, so not very. The media has been focused, by and large, on events that have strengthened and, to some extent, precipitated this negative sentiment. While some of the negative attention has been fair and self-induced, I believe that the sector has been overly punch-bagged. 

The cannabis industry continues to grow: in terms of patients and recreational consumers, in the number of countries legalizing cannabis (medical and/or recreational), and in terms of revenues. We are also seeing novel form factors and products being introduced, expanding the delivery choices people have to consume cannabis. At the same time, a rapidly growing body of scientific research has increased the credibility of cannabis as a legitimate medical therapy.

Using Canada - with approximately 1% of its population registered as medical patients - as a proxy for the global cannabis market, it is clear that the growth outlook for this sector is very strong indeed. Combined with the legalization of consumer use, this is the premise based on which the sector has attracted steep valuations. While markets have not developed as rapidly as many investors would have liked, and valuations have come down sharply, this premise still holds true.

How to stand out

With some 200 licensed cannabis companies in Canada, we are seeing many companies with strategies that look like scaled-down carbon copies of what the globally dominant companies are doing. In other words, we are faced with a fragmented but undifferentiated investment universe. This doesn’t help anyone, as one company disappointing or doing something it shouldn’t have can drag the entire sector down.

To see what should work, let’s look at baking as an analogy. If I were try and raise funds because I wanted to start a generic bread company, perhaps my wife would chip in a bag of flower for me to produce a couple of loaves (as I am a not a good baker, my execution would be poor and prevent me from establishing a decent brand). Beyond that, I doubt I would get much traction. The bread market is dominated by large companies with optimized industrial processes that have locked up the key distribution channels. They have a cost profile and brand strength that as a small, undifferentiated newcomer, I would not be able to compete with.

This is similar to the cannabis industry, where a number of larger global players have sucked much of the oxygen out of the room for smaller players. These large companies have invested heavily in infrastructure development, have broad product portfolios, secured medical, recreational and international distribution channels, and are heavily engaged in research to develop next generation products, technologies and services. This makes it very difficult for a smaller player to stand out, be noted and make headway in an increasingly fragmented market.

Back to the baking industry. If rather than being an also ran, my focus would be on commercializing a patented process that produces gluten free bread that tastes and toasts like normal bread, the story would be completely different. In this case, I would have a compelling, differentiated offering with a moat around it.

In my opinion, that is the space where smaller cannabis companies need to play. Either have early mover advantage in non-fragmented markets (e.g. some of the emerging cannabis markets), have exceptional brands, or develop unique products with some level of protection that target as yet unmet needs.

In my view, the small-cap cannabis space is not dead. Far from it. There is a growing number of well-led companies with strong management teams, differentiated strategies, exciting technologies and/or service offerings that demonstrate strong execution. I believe these companies are playing smart, going for the gaps in the market where the larger players are absent. Perhaps they will not be multi-billion dollar companies (some of them may), but their low valuations provide upside potential that at the very least should earn them another look. 

We are still in the very early days of the development of the cannabis industry. There will be hiccups, there will be pain (especially with tax loss selling season upon us), and some companies won’t be able to make it. However, there are so many avenues as yet unexplored, there are so many people who likely can benefit greatly from the developments in medical cannabis science, there are so many novel products that are yet to be developed and launched, that I believe this sector has a great future. We just need to be a little more discerning in assessing companies, both on the way up and on the way down. 

For companies, it is paramount that their messages are differentiated. Don't be part of the white noise, create a sound of your own and be noted.