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Brad here. One of the hot topics in the past year or so has been marijuana investing. Stocks have soared—and crashed. So, how can we know what to do if we want to invest? Peter Roberto, an investment research analyst on Commonwealth’s Investment Management and Research team, went back to history for some guidance. This perspective is a great way to think about this problem, and many others. Over to you, Peter.
As Thanksgiving rapidly approaches, we have much to look forward to, including quality time with family, gluttonous meals, and perhaps kicking back with the vice of your choice. For those in many states, that vice may be marijuana, newly legalized.
Of course, investors are also interested, driving pot stocks to ridiculous highs and, more recently, to new lows. The good news is we have a new vice industry in which to make money. The bad news? Its legality is still open to question. How can we, as investors, figure out this situation? As it happens, something like this has happened before when alcohol was relegalized after Prohibition. Today, we’ll take a look back at the trends that emerged following Prohibition, as well as the similarities and differences that this time period shares with what we see in today’s cannabis marketplace.
The role of state legislation
Prohibition emerged out of the Progressive Era (1890s–1920s) as supporters pushed to ban the sale of alcohol, which was alleged to be a source of crime and violence. Prior to this time, individual states legislated their own enforcement on the sale of alcohol. For example, Maine implemented its own laws on the sale of alcohol in the 1860s. This approach is similar to that of today, with state legislation determining the enforcement of the sale of marijuana.
When the U.S. entered World War I, these same supporters argued that the barley used for brewing beer could be used to feed the soldiers. These progressives included Wisconsin’s John Strange, who stated:
“We have German enemies in this country, too. And the worst of all our German enemies, the most treacherous, the most menacing, are Pabst, Schlitz, Blatz and Miller.”
This push led to a temporary Wartime Prohibition Act, which was put into place in November 1918. In January 1919, the Eighteenth Amendment was ratified, and the production, importation, transportation, and sale of alcohol were banned on January 17, 1920. (Its use for religious or medicinal purposes was still allowed per the Volstead Act.)
State versus federal control
This ban led to a flourishing black market and a rise of speakeasies through the 1920s. The support for Prohibition waned in the 1920s, as opposition cited the ban as infringing on personal liberty, taking away from tax revenues, and supporting bootlegging and organized crime. Sound familiar? The complaints led to easing of the restrictions on alcohol. Similar to the 2018 farm bill, which classified hemp as marijuana with less than 0.3 percent THC, the March 1933 Cullen-Harrison Act allowed for the sale of alcohol at a lower content level with a legal cap at 3.2 percent alcohol by volume. This act was shortly followed by the ratification of the Twenty-First Amendment on December 5, 1933, repealing federal Prohibition. Individual states and counties maintained their ability to legislate their region as dry. We are now at a similar place with respect to marijuana, with individual states and municipalities controlling legalization despite federal law.
Will we see the same trends now?
Right now, the marijuana industry is in the expansion phase. Since September 2018, one month before the legalization of marijuana in Canada, we have seen the number of licenses move from 120 for marijuana to 246 at the end of October. The Canadian hemp industry is even more fragmented, with 1,226 total licenses and registries. Production of dried cannabis has also risen sharply in Canada since 2018, rising from 18,481 kilograms in October 2018 to 60,872 kilograms at the end of August 2019. In addition, capacity for unfinished inventory rose from 96,822 kilograms to 328,187 kilograms over the same period. The same market fragmentation can be found here in the U.S., as California alone has issued more than 4,000 cultivation licenses this year (although most are smaller operations). Can all of these companies survive and thrive?
Back to beer for a lesson
During Prohibition, the number of breweries was roughly cut in half, and consumption from these remaining breweries fell dramatically. In the years after repeal, the remaining breweries ramped up production dramatically, and per-capital consumption gradually rebounded to the 20.1 gallons per capital level of 1910. This is just above the 19.5 gallons per capital consumed in the U.S. in 2017 (according to Kirin Holdings). Once beer was legalized, total demand was fairly stable—which we can probably expect for pot as well, after the initial rush. All of the marijuana companies that are now starting up will likely have to fight over a market that may be smaller than they expect.
As a result of relatively stable demand, there was a wave of consolidation in the alcohol industry after Prohibition. Those companies that could provide supply at the lowest cost or that had well-established brands survived. Others (e.g., Falstaff and Olympia) faltered. We also saw consolidation of companies through M&A. For example, while some of you may remember Schlitz and Blatz, others likely do not. These two brands have since been acquired by Blue Ribbon Intermediate Holdings (Pabst) and Molson Coors (Miller), respectively. In 2008, Anheuser-Busch, MillerCoors, Constellation, Heineken, and Pabst accounted for roughly 90 percent of the market share in the U.S. A stable market leads to concentration—another lesson for would-be investors in marijuana.
This dynamic looks to be well known by the management of today’s marijuana companies, and we are already seeing similar consolidation. According to Viridian Capital Advisors, 271 deals were executed in 2018 and 291 (so far) in 2019. Most of these deals occurred in the cultivation and retail space. Due to this issue, there is likely much consolidation to be had within this space through either M&A or failed business ventures. The vast majority of the companies simply won’t survive.
The lesson for investors
Due to relative market fragmentation, stable demand, and a ramp up in production, we prefer a diversified approach to the marijuana space, as it is extremely difficult to know which of these cultivators will be a Molson Coors, and not a Schlitz or a Falstaff. If you choose to invest, you may want to do so widely. We simply can’t know at this point which of these companies, if any at all, will emerge.
