Description

While the market is in a frenzy chasing the latest speculative bubble, there is a compelling deep value investment opportunity hiding in plain sight: US cannabis operators. The easiest way to express that thesis is to purchase MSOS, the AdvisorShares Pure US Cannabis ETF. This ETF was launched in the fall of 2020 and now has approximately $900mil of AUM and $17mil avg daily trading volume.

The current MSOS holdings can be seen here:  https://advisorshares.com/etfs/msos/. The holdings are largely comprised of plant-touching US multi-state operators (MSOs). The expense ratio of 0.74% is relatively modest, and the ETF provides a good diversification across the industry. Moreover, the ETF trades in the US and offers US investors a vehicle to get exposure to MSOs who are otherwise restricted from owning plant-touching US cannabis company securities. MSOS has obtained an opinion from counsel and been through a rigorous listing process to get the ETF listed in the US. The ETF doesn’t actually own any plant-touching cannabis companies directly. Rather, the ETF owns total return swaps on MSO securities. We would also recommend owning specific individual underlying securities directly, but MSOS is a good investment vehicle to capture the potential upside available in the US cannabis market today, especially for those who are restricted from owning plant-touching securities. Please refer to some of the previous VIC writeups of cannabis securities: VRNOF, AYRWF, TCNNF, GRAMF, LHS, NLCP, etc.

It’s very rare to have this combination of strong secular tailwinds and depressed valuations that we are seeing in the US cannabis industry. Usually, companies operating with a secular tailwind like this trade at far higher multiples.

For a good summary of the US cannabis opportunity, we would recommend reading the following recent blog posts:

https://toddharrison.substack.com/p/us-cannabis-in-the-crosshairs?justPublished=true

https://mindsetvalue.substack.com/p/the-cannabis-manifesto

Here are some charts and excerpts regarding the current opportunity in US cannabis:

https://twitter.com/cashflow_free/status/1455014694071189510/photo/1 

MSOS started trading in the fall of 2020 at $25/share. MSOS is at $27/share now. Meanwhile MSOs trade @ ~7.6x 2022 EV/EBITDA vs. 15.0x nine months ago.

Brief Summary of US Cannabis Market

There are numerous projections about how large the US cannabis market will be in the future. Legal cannabis sales hit $20bil in 2020, are on pace to top $26bil this year, and are projected to rise to $45.9bil in 2025 and $100bil eventually.

By comparison the US alcohol market is $250bil+ and the US tobacco market is $100bil+. One has to keep in mind that much of the cannabis use is still illicit use (e.g. in California, which legalized adult use in 2016, about 75-80% of cannabis use is illicit). A significant percentage of the growth in the US cannabis market is converting consumer demand that just already exists from the illicit market to the legal market. There are very few emerging industries in which the demand for your product is actually already pre-existing.

Cannabis is currently federally illegal. However, 36 states have legalized cannabis use for medical purposes and 18 states have legalized it for adult use (recreational use).  See a summary of the legalization status here:

https://en.wikipedia.org/wiki/Legality_of_cannabis_by_U.S._jurisdiction#:~:text=In%20the%20United%20States%2C%20the,Controlled%20Substances%20Act%20of%201970.&text=Commercial%20distribution%20of%20cannabis%20has,except%20the%20District%20of%20Columbia. 

The overwhelming trend is for more states to legalize cannabis, either medical or adult use, and more states to convert from medical use to adult use. Recent polls show 70% of Americans are in favor of some sort of legalization. The polling numbers have only been rising over the years. Legalization is a matter of when, not if. The legalization process has gained momentum worldwide as well with more countries adopting legalization measures: https://en.wikipedia.org/wiki/Legality_of_cannabis.

Investment Considerations

As is evident from the above, the MSOs are trading at a very low valuation relative to their own growth and to the secular growth rate of the industry. In the discussion below, we examine some of the key issues facing the MSOs and why we are bullish.

1. Near term issues and negative market technicals will abate over time.

1. US Cannabis is still largely a retail driven market.

1. Retail investors are currently chasing lots of other shiny objects in the investing/speculation world: GME, AMC, TSLA, SHIB INU, DOGE, NFTs, spacs, etc. Cannabis stocks had a strong run earlier in the year when there was newsflow about potential legalization. The US cannabis market peaked in Feb 2021 and has been trending down since then. MSOS is now trading at 50% of the Feb peak. The retail investors base has not really returned to cannabis stocks and may be using cannabis stocks as a source of funds to speculate in other assets since comprehensive cannabis reform is not going to pass anytime soon. Some hedge funds are stepping into the space while most institutions are still restricted. Eminence Capital recently made a basket of cannabis stocks one of their top 10 holdings.

2. Institutional ownership is very low. This is long term bullish.

1. The investor base is slowly becoming more institutional but still only 4% institutional. This is very bullish in the long run as these investors will have to buy in once either the SAFE Banking Act passes or regulatory restrictions are eased. We anticipate institutional ownership of these companies will exceed 50% as investors chase secular revenue and earnings growth in an otherwise slow-growth economy.

2. There are numerous reasons for the low institutional ownership, but as regulatory restrictions ease and the social stigma of cannabis dissipates, more institutional investors will buy in.

1. Cannabis is still federally illegal. The plant touching US MSOs trade on the Canadian Stock Exchange (CSE), which is the backwaters of the Canadian stock market, and trade OTC in the US. Many US institutional investors are severely restricted from owning US MSO securities. The limiting factors are custody agents like Pershing (will not custody plant-touching cannabis stocks), compliance departments, and social stigma associated with transacting in cannabis / something federally illegal. A number of US retail brokerages also limit trading of US MSOs securities. 

2. After 6+ years of cannabis companies trading in the US, most banks, brokerages and custody agents that wanted to have already implemented their bans on cannabis securities. It feels like it’s closer to the end when headlines like will plague sentiment in the sector: https://www.reuters.com/business/finance/exclusive-jpmorgan-restrict-trading-us-cannabis-stocks-letter-2021-11-02/ 

3. SAFE Banking Act is likely to pass in 2022. See below for a more detailed discussion of this legislation and the regulatory landscape. Passage of the SAFE Banking Act in 2022, which is likely to allow US MSOs to list in the US stock exchanges, would be a major positive catalyst for MSOS, as this legislation would allow institutional investors to finally be able to own US MSOs without the threat of regulatory crackdown. If the SAFE Banking Act doesn’t pass, there is still a chance that some other legislation or a more comprehensive cannabis bill may pass at some point. 

4. There is still a lot of social stigma associated with cannabis. For many years, the government waged a “War on Drugs” to demonize and stamp out cannabis use. In many consevative circles around the country (more so in older vs younger populations), this social stigma is still the prevailing attitude. Current polls indicate 70% of Americans believe cannabis should be legalized. We expect these attitudes to continue to change and bring about a change in social perception among investors.

3. IPO lockups expiring, but will be less of a factor by the end of 2022

1. Recently IPOed public stocks like VRNOF (lock up expiration on Aug 10 and more next year) and AAWH (lockup expiration on Oct 25 and more next year) are facing lockup expirations. On the negative side, the increased supply is pressuring prices. On the positive side, the increased unlocking of shares is greatly increasing liquidity, which will attract more institutional interest going forward. Interestingly, insiders and founders are generally not selling into the lockup expiration. In fact, VRNOF’s CEO/founder made some small purchases recently. 

4. Low liquidity, but improving

1. Liquidity in MSOs has improved tremendously in the last 12 months. A variety of factors have contributed to the improving liquidity: more institutions investing, much better IR by the companies to reach retail and institutional investors, more interest in the industry, more shares made available for trading, etc. 

2. With lockups expiring for recently public companies like VRNOF and AAWH, trading volumes have vastly improved. For example, VRNOF went from trading 20k-40k shares per day to now 300k+ shares per day after the lockup expiration in August.

5. Sales are trending soft in 3Q21 and analysts may need to take down estimates for 2021 and possibly 2022. With the COVID lockdowns and the stimulus checks since the beginning of the pandemic, it appears that consumer spending on cannabis experienced a temporary boost that will normalize in 2022 and beyond. Regardless of the temporary bump in the road, the long term growth trajectory is still intact. In the coming years, we expect more states to pass legalization programs, convert from medical use to adult use (usually causes a 2x - 3x sales increase), and launch their cannabis programs after legalization legislation has passed. We also expect the vast majority of the illicit market consumers to switch to the legal market over time. Compared to the illicit market, the legal market offers a product that is much safer and consistent with many more varieties of flavors and form factors, all in a more convenient and pleasant retail experience either at a physical location or by delivery. We don’t know how much of the sales weakness is currently priced in. If you’re worried about 3Q21 earnings, you could wait to see how the market reacts to upcoming earnings reports and buy in accordingly.

6. Tax loss selling as MSOS is down 50%+ from the highs in early 2021. This should abate soon.

2. Regulation is trending in the right direction. Federal legalization is a matter of when, not if.

1. Continued legalization by states. Currently 36 states permit medical use and 18 states permit adult-use. More states are continuing to adopt measures to legalize cannabis either medically or for adult-use. 

1. There are still large states in the country that have not adopted adult use. OH and PA are considering adult use. Most states that are adjacent to other states that have legalized adult use realize that they are losing jobs and tax revenue to other states by not adopting adult use in their own state because residents simply drive over the border to purchase their cannabis. TX and FL and both have medical use programs. FL’s program is very robust, while TX is just dipping its toes into the water. There’s a chance that FL goes adult use in 2022, but it's more likely in 2024. TX has recently relaxed regulation to permit higher THC content and increased the number of medical conditions for which cannabis use is allowed. Usually, when states convert from medical use to adult use, demand increases fairly quickly by 2x - 3x.

2. Legalization at the federal level is a matter of when, not if because 70%+ of Americans support some form of legalization of cannabis, and the support is only growing over time.

1. The key issue is what form will federal legalization take and what happens to the US cannabis market afterwards. There are obviously many combinations of how this could all play out, but we discuss a few possible scenarios below:

1. Scenario 1: SAFE Banking Act passes in 2022, and full federal legalization happens at some point down the road. We believe this is the most likely scenario. (https://www.congress.gov/bill/117th-congress/house-bill/1996) 

1. This legislation has been introduced multiple times already in Congress and has the support of Democrats and enough Republicans to pass. Currently, this legislation is attached to the NDAA in Congress. Most observers think the odds of passage this year are low but expect it to pass sometime in 2022 given the level of support in Congress. While this bill doesn’t legalize cannabis, it provides a good stepping stone to full legalization while addressing some of the big chokepoints in the industry. There’s increasing pressure on Senator Booker to support incremental legislation such as the SAFE Act rather than try to push through a comprehensive reform bill that doesn’t have sufficient support to pass. The SAFE Act would help achieve some of Booker’s social justice goals by providing greater access to capital and financial services for smaller operators in the industry.

2. This would be a great outcome for the large MSOs. While cannabis will still be illegal at the federal level, US cannabis operators get access to banking & financial services (credit card payments, loans, deposits, transfers, etc.), get listed on major US exchanges, and rid themselves of the huge section 280E tax burden. The US financial services industry is chomping at the bit to get access to the $1T+ in cannabis finance. These changes will greatly accelerate the business plan and consolidation opportunities for the large MSOs. 

3. All of the MSOs in the MSOS ETF would move their listing from the CSE to a major US exchange. Most MSOs are already compliant (or getting ready to comply) with US rules to switch immediately. Liquidity would vastly increase. The cost of debt capital would decrease to 4-6% for the large MSOs. Operating margins would increase 5-15% overnight from the elimination of 280E. Valuations would increase 2x-3x and likely exceed the multiples of the Canadian cannabis companies (US MSOs have a much bigger TAM and are much better operations vs Canadian companies). 

2. Scenario 2: Federal legalization in all forms is delayed for a number of years. We believe this is the second most likely scenario.

1. Federal legalization not occurring in the near term is bullish for the incumbent large US MSOs as they have the scale, talent, and access to capital to dominate the industry at the expense of the smaller players. Their domination will only continue in a scenario where the continued federal illegality hampers the smaller competitors in the market and accrues to the benefit of the scale players. While it would be great for the industry to have access to basic banking services instead of having to deal in cash, not have to pay exorbitant taxes because of 280E, and be able to raise capital at reasonable rates, the large MSOs are in a much better situation to continue to weather these challenges faced by the industry.

2. Scale has many advantages, but one that is noteworthy for the cannabis industry is the byzantine and burdensome regulatory regime favors the large players with scale who can afford the resources to meet all the regulatory requirements. 

3. Large MSOs have a much easier time getting access to basic banking and financial services. Many smaller operators still have no, or very limited, access to basic banking services and have to deal with cash and armored vehicles to transport cash, greatly increasing expenses and operational risks.

4. Most of the smaller US operators are having difficulty raising capital. Those that can raise capital have to pay on the order of 15-25%+ interest rate for debt. Large MSOs are now raising debt capital at 8.5%. This has been trending down from the low teens a year ago. 

5. The large MSOs have been able to purchase small operators in the last 12-24 months at 3-4x EBITDA and will continue to consolidate the industry as the smaller players have difficulty operating in this kind of environment. Many small operators, especially retail dispensaries, have trouble turning a profit because of the onerous tax burden of 280E and the other challenges outlined above.

6. The large MSOs will be much more dominant in a few years and even more attractive as acquisition candidates for new entrants into the industry.

3. Scenario 3: Comprehensive cannabis legislation passes in the near term. We believe this scenario is possible but a low probability. The fears over interstate commerce / dormant commerce clause seem to be one of the top concerns among investors. While full federal legalization is an eventuality, there’s quite a bit of uncertainty what form it would take.

1. A comprehensive cannabis act was introduced in July 2021 by Senator Schumer with the full knowledge that it was not going to pass. See https://int.nyt.com/data/documenttools/the-cannabis-administration-and-opportunity-act/6ae57fc5bae6ada6/full.pdf 

2. Senator Booker from NJ has been vocal about blocking any incremental cannabis legislation such as the SAFE Banking Act and supporting only comprehensive reform legislation with a strong social equity component. There’s not enough support currently to pass comprehensive cannabis reform legislation, especially before the 2022 midterm elections. Most industry observers believe it will take a number of years before comprehensive cannabis legislation is passed.

3. The key question on investors' minds is whether the legislation will allow for unfettered interstate commerce pursuant to the dormant commerce clause of the US constitution. Interested investors can read further on this issue here: https://my.vanderbilt.edu/marijuanalaw/tag/dormant-commerce-clause/ and https://my.vanderbilt.edu/marijuanalaw/2021/08/new-article-on-the-hidden-problems-posed-by-federal-legalization-and-a-new-way-to-address-them/ (argues for temporary suspension of DCC to give the states time to adjust to federal legalization)

4. One possible outcome of federal legalization legislation is that regulation of cannabis is largely left to the states. The federal government will undoubtedly levy a tax on cannabis but could opt to rely on the existing regulatory framework of the states. In this scenario, the states would not allow (or only allowed a limited form of) interstate commerce, and the large incumbent MSOs would continue to dominate with their scale advantages. This would be very bullish for the MSOs. 

5. A second possible outcome of federal legalization legislation is a temporary suspension of interstate commerce followed by unfettered interstate commerce. The legislation could opt to suspend interstate commerce for a few years for the states to get ready for interstate commerce. This would give temporary advantage to the existing large MSOs and give them an opportunity to further cement their dominance and allow them to consolidate the industry. This would be near term bullish for the MSOs.

6. A third possible outcome of federal legalization is unfettered interstate commerce. The concern is unfettered interstate commerce would shift cannabis cultivation from the current cultivation sites scattered throughout the 36 states (a mix of indoor, greenhouse, and outdoor) to California, Oregon and Washington where the cost of cultivation is much lower. The price of wholesale flower in California is about $500-$1000/pound for outdoor grow (a rough approximation setting asides the nuances of whether it’s A bud, B bud, popcorn, kief, trim, indoor, greenhouse, light dep, outdoor, seasonality, etc.) while it’s $4000-$5000/pound for indoor grow in a number of the limited license states. Traditionally, most of the cannabis in the US was grown outdoors in California because California had the right climate to grow cannabis outdoors. California serves as the agriculture hub of the US for many vegetables and produce grown in the US, so it’s logical to assume that without regulatory restrictions cannabis would be mostly grown in California. The fear is that cheap cannabis from California (where outdoor cannabis can be grown profitably at $500-$1000/pound wholesale) sold throughout the US would decimate the cannabis industry in all the other states.

1. Undoubtedly, unfettered interstate commerce will disrupt the cultivation and supply chains existing in most of the states today. In this scenario, the limited license states will eventually look more like the competitive states (CA, WA, OR, CO, or MI). However, even in the competitive states, there’s room for both indoor and outdoor grown products, with the indoor grown products commanding a premium. So not all of the cultivation in the limited license states will be displaced as the cost of indoor cultivation is roughly comparable across all geographies at around $500-$600 per pound. Good operators in these competitive states are running profitable businesses, albeit at lower margins than operators in the limited license states. 

2. Even in the event of unfettered interstate commerce on day 1 of federal legalization, it will take some time for interstate trade to be fully implemented. Upon enactment of federal legalization, the legislation will be challenged throughout the country. It will take years before the appeals are exhausted and the legality finally adjudicated. It’s not hard to imagine that states will try to adopt rules and regulations that make interstate commerce cumbersome or not cost competitive. States are heavily incentivized to protect local jobs and tax revenue, which they are relying on (to fund priorities such as education and social justice initiatives).

7. Let’s consider what the incentives are around federal legalization.

1. The parties with the strongest interests in the outcome of any kind of federal legalization legislation in Congress are the vested interests in the cannabis industry - the MSOs, other existing licensees, and the states collecting cannabis tax revenues and enjoying booming employment in the sector.

2. Why would these vested interests want to hollow out their cultivation, manufacturing, and distribution operations and send it to California (and Washington and Oregon)? Do representatives in Congress want to send their state’s tax revenues and jobs to California to the detriment of their own state’s thriving cannabis industry? We’re talking about many billions of dollars of tax revenue and hundreds of thousands of jobs. No state can afford to lose the tax revenue and these high paying jobs. Do Schumer and Booker really want to hobble their own state’s cannabis industry before it barely gets off the ground?

3. How would it achieve social justice objectives? A portion of the cannabis tax revenues support social justice initiatives in the various states. How would it look if all of those programs got drastically curtailed because their Congressional representative voted for unfettered interstate commerce and killed their state’s cannabis industry and tax base?

4. Doesn’t the federal government want a piece of the cannabis tax revenue? Why disrupt the existing revenue stream in many states with unfettered interstate commerce if they are going to get a piece of the action? 

5. The states that have enacted cannabis legalization continue to regulate the industry very stringently given the benefits but also the potential public health and safety issues. The regulations provide consumer protection, safeguard the public, and create a system to levy taxes. For example, California uses a tracking system called METRC to trace every bit of cannabis throughout the value chain from seed to sale. There are strict limits of when, where, how much and to whom cannabis can be sold. Will federal legalization just sweep all these regulations, and the attendant concerns, away? Will the states suddenly be okay with cannabis being imported from elsewhere and distributed and sold in their state without their strict oversight?

6. In sum, regardless of what happens with federal legalization and interstate commerce, we believe that by owning MSOS at these prices we are well positioned to capture the upside in the likely bullish scenarios and face limited downside in a bearish scenario because there will be bids from potential acquirers at these depressed prices.

8. When full federal legalization passes and regardless of whatever form it takes, we believe the large MSOs will be purchased by large alcohol, tobacco, CPG, food, healthcare and other companies looking to enter the US cannabis market. To be sure, they can all collectively wait around to see what happens as interstate commerce gets implemented. But why wait to enter the biggest consumer product opportunity in a generation, especially when everyone else will be jumping in?

9. It’s easier for new entrants to buy rather than to build, especially if the valuations are as low as they currently are. There are only a limited number of MSOs with scale. Potential acquirers will likely need to purchase more than one MSO to build a true national footprint. There are many buyers for these assets and a limited number of assets. Most of these buyers are facing slow growth in their incumbent markets and would jump at the chance to enter an industry with these growth characteristics. They all realize that speed to market is critical so it makes much more sense to buy than build since all of their competitors will be jockeying for a piece of the pie as well. 

1. The buy or build calculations will be made based on a number of considerations such as speed to market, know-how, talent acquisition, brands, ability to build infrastructure, and regulatory barriers.  We highlight a few here that are pertinent to the US cannabis industry: 

1. Scarcity of talent. It’s gotten a bit better over the years, but it’s notoriously difficult to hire good talent for the cannabis industry, so having an established executive team and several layers of management and operational talent in a company is a real asset that’s not easy to replicate.

2. Limited licenses. Not only has it been difficult to obtain one of the limited number of cannabis licenses but it has also been quite challenging to build out infrastructure (retail, manufacturing, distribution, cultivation, delivery).  Operators have to obtain licenses at the state and the local level. Some local counties and municipalities don’t want any cannabis operations in their jurisdiction or have stringent permitting requirements that severely limit the number of operations (such as locations must be 500’ from schools, religious establishments, etc). In competitive states like California and Michigan, for example, some municipalities have granted a very limited number of cannabis licenses and have said they will not grant any more in the future -- incumbents that already have licenses and facilities built out in these territories have protected oligopolies. The rush to acquire existing retail licenses and locations in Florida has been driven by the same concern that new entrants in the future may not be able to find any new locations to build out retail stores.

3. Existing know-how. Despite the common refrain that cannabis “grows like a weed,” it’s actually not that easy to grow high quality cannabis. Many of the operators, even some of the large MSOs, have experienced major crop failures. One anecdote we heard in Massachusetts was a large MSO had 14 crop failures while they were trying to get their operations up and running in the state. We also know that Liberty Health Sciences (a public company acquired by Ayr Wellness) almost went bankrupt because they could not grow sufficient cannabis (due to low yields and crop failures) in Florida to supply their dispensaries.

4. Relationships with existing state regulators. It’s hard to believe the existing state regulators will just go away once federal legalization takes place. The existing state regulations are onerous and complex. Some require interpretation by regulators. Having a good relationship with regulators is very helpful in operating the business.The large MSOs have existing relationships with the state regulators (who are generally a small group of people in the state and local jurisdictions). These relationships have value.

10. There are two ways to hedge against the risk of interstate commerce.

1. The best hedge is to go long Glass House (GLASF or GHBWF). Glass House owns 5.5mil sq ft of cultivation under glass in southern California. They have the potential to produce near indoor quality cannabis at production costs comparable to outdoor grow (production cost of $150/pound, which is just about the lowest in the industry). A facility of this scale and quality is a very scarce asset in the US. If interstate commerce opens up and allows Glass House to sell all over the US, they instantly become a very coveted asset for every player in the industry. https://ir.glasshousebrands.com/news-events/investor-presentation/ 

2. The less preferred way is to short IIPR. There have been 2 writeups on VIC to short IIPR. The cannabis cultivation real estate facilities held by IIPR throughout the US essentially become far less valuable in an unfettered interstate commerce scenario. Investors have to wait as the individual leases to these facilities roll off over time before impairments start to hit cash flows. However, investors may reprice IIPR ahead of the impairments. We recommend you read those and decide for yourself. https://www.valueinvestorsclub.com/idea/INNOVATIVE_INDUSTRIAL_PPTYS/7596062975 

https://www.valueinvestorsclub.com/idea/INNOVATIVE_INDUSTRIAL_PPTYS/9545139574 

11. Another concern we’ve heard among investors is how competition from existing deliveries and e-commerce companies will affect the industry after federal legalization. No doubt Amazon, Postmates, Uber, and other delivery platforms will seek to enter the market. It remains to be seen what the regulations will be around e-commerce and deliveries at the federal, state and local levels. Cannabis operates in a heavily regulated legal regime with things like age verification requirements, physical delivery rather than delivery by mail, limited dosage per consumer, etc., so a lightly regulated delivery model seems unlikely. One can look at online sales of alcohol to imagine one possible scenario. Online penetration of alcohol is growing but still in the mid single digit percentage range (with a big bump from COVID which may subside as people return to normal). Amazon and the other large delivery platforms do not dominate the alcohol industry sales. During the pandemic lockdowns, the MSOs were able to pivot to provide curbside pickup and delivery under the existing regulatory framework so they are a step ahead of any new entrant to the industry. We are monitoring the evolving regulatory landscape to see how this plays out.

12. As a side note, we believe the chance of cheap imported cannabis flooding the US market from Columbia or other countries is fairly low in the near term. While cannabis can be grown at a fraction of the cost in Columbia (see CLVR), we believe the US doesn’t have a strong incentive to allow cheap foreign imports that would significantly harm the US cannabis industry given how much tax revenue and jobs the industry provides.

3. One thing that’s unusual about the MSOs is that they are still mostly founder led (Verano, Green Thumb, Trulieve, Curaleaf, Ayr Wellness, Ascend Wellness, Glass House, etc.). These founders own large stakes and have mostly not sold their shares (and even made some open market purchases). It’s extremely rare to see an entire industry with so many founder-led public companies. These founders see the generational opportunity in front of them and are not looking to sell at these depressed prices.

Risks

We’d like to touch on a few risks not addressed above.

1. MSOS holds total return swaps and not underlying securities of MSOs. 

1. The main counterparty to the total return swaps is Cowen, a $1bil publicly traded investment bank (COWN). 

2. Bank of NY Mellon is acting as custodian with segregated accounts for the swap. BNY is generally more conservative than most custodians.

3. SEC approved the ETF under the ’40 Act and generates a 1099, not a K-1.

2. Substitution by cheaper synthetically produced cannabinoids.

1. There are a number of companies using biosynthesis platforms to try to produce various cannabinoids. These platforms, in theory, could produce all 140+ of the identified cannabinoids in the plant as well as an infinite number of derivatives. The technology platforms are: bacteria (e coli), yeast, algae, chemical synthesis, and a combination of the above. So far, we are aware of no company that is working on producing THC, which is the key psychoactive cannabinoid in the cannabis plant, because it’s federally illegal. It’s unclear what federal legalization will allow or disallow in terms of biosynthetic production of THC (or other cannabinoids). These platform companies have the theoretical ability to produce THC with some amount of R&D work. The real gating issue with all of these platforms is whether they can produce THC and other cannabinoids at scale and at a price point that is cost competitive with the cannabis plant. Each biosynthesis platform has its own set of positives and negatives, and each cannabinoid has its own unique set of challenges.

2. While some portion of the market may eventually be captured by synthetically produced cannabinoids, we believe the cannabis plant will not be completely replaced by synthetically produced products. It will take some time before these platforms are able to reach scale and bring down the cost of production. The more likely scenario is that synthetically produced cannabinoids will be incorporated into cannabis products to enhance their health and wellness appeal (i.e., good for sleep, good for appetite, good for dieting, etc.).

3. The jury is still out on how this will all play out. A way to hedge some of this risk is going long synthetic biology plays: INM, CANSF, AMRS, DNA. We like INM, which has multiple synthetic biology platforms and is already able to produce some cannabinoids (CBC) at kilogram scale. 

3. Substitution by other psychoactive products

1. Currently some psychoactive derivatives from the hemp plant (which is the same plant as the cannabis plant but with a lower THC content) such as Delta 8 are being sold as a substitute for cannabis. These sellers are operating in a regulatory gray area and will eventually be shut down. 

2. In Nov 2020, Oregon, which already legalized adult use of cannabis, decriminalized other psychoactive substances. Other jurisdictions have followed. Attitudes are changing with respect to all of these substances. It’s too early to tell what if any substitutes could gain market shares from cannabis. As we see from tobacco and alcohol, there’s plenty of room for different types of consumer products to prosper. Cannabis in particular has a health and wellness component that alcohol and tobacco do not. This is not something to worry about in the near term but something to keep on the radar. One way to hedge this risk is by going long PSIL, which is an ETF comprised of psychedelic companies, but we are not currently hedging this risk.

Catalyst

• SAFE Banking Act passage in 2022 or other federal cannabis legislation

• More institutional interest in US cannabis

• More states legalize cannabis for medical use and adult use.

• Rotation out of meme stocks into value stocks

• Industry consolidation

• Continued revenue and earnings growth by the US MSOs.