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  • Marijuana's days as a Schedule 1 drug may be numbered.
  • Reclassification of cannabis clears the way for profit-friendly changes in accounting and financing.
  • Significant sales and profit growth could entice institutional investors who are currently prohibited from owning marijuana stocks to buy.

Doug Kass is increasingly optimistic about the marijuana industry. Previously, we wrote about how his rising bullishness was rooted in the likelihood of marijuana support shifting from states to the Federal level, where it remains classified as a Schedule 1 narcotic.

Today, Kass doubled down (dare I say, tripled?) on enthusiasm for cannabis companies. In a posting on his Daily Diary on Real Money Pro entitled “The Biden Pivot - Cannabis Equities May Be Poised to Triple by 2025,” he wrote:

“President Biden's Thursday announcement to take the first step towards decriminalizing cannabis, materially de-risks cannabis stocks, sets the stage for institutional investment, and suggests that we have entered a secular bull market for cannabis equities.”

D.C. shows support for cannabis

On October 6, the White House issued a “Statement from President Biden on Marijuana Reform.” 

In it, Biden said, “First, I am announcing a pardon of all prior Federal offenses of simple possession of marijuana. I have directed the Attorney General to develop an administrative process for the issuance of certificates of pardon to eligible individuals.”

He followed that up with a call out to states to follow suit, and perhaps most importantly to marijuana stock investors, instructed his Secretary of Health and Human Services to review marijuana’s Schedule 1 status “expeditiously.”

If a review of its scheduling results in a more favorable status, it could be a big win for marijuana stocks.

Back to Kass: 

“A rescheduling beneath Schedule II or removal from CSA [Controlled Substances Act] would result in a marked reduction in tax rates (with 280e tax provisions - non-deductibility of normal operating expenses) being eliminated (see chart below) and a lower cost of capital - leading to a vast improvement in profitability, cash flows and valuations.”

CHART-DFC-101022

Because marijuana is a Schedule 1 drug, marijuana companies are subject to the 280e provision, which prevents drug traffickers from deducting business expenses. As a result, the tax hit faced by marijuana growers and retailers is substantially higher than non-marijuana companies. How much more? Estimates are that effective tax rates for marijuana stocks could eclipse 70% or more, but they’d be less than half that amount under standard accounting rules.

The industry’s profitability could also benefit substantially from reclassification’s impact on access to traditional banking services.

Currently, most banks shun marijuana companies as customers because of the risks associated with complying with federal regulations, such as money laundering laws. This risk is why marijuana dispensaries don’t accept credit cards, creating a barrier to sales.

However, suppose favorable attitudes in D.C. result in the SAFE Banking Act finally becoming law, removing the risk of federal compliance in states where marijuana is legal. Banks will likely battle fiercely to service these highly-profitable companies in that case.

Changes to marijuana laws also clear the way for mutual funds and other institutional investors to own marijuana stocks in portfolios. Currently, marijuana stocks can’t list on the major market exchanges. That’s a hurdle for “big money” because mandates often prevent them from owning stocks listed elsewhere.

Back to Kass:

“Institutional investors have been essentially barred from investing in the space as the major Exchanges can not list cannabis stocks. Custody issues have only exacerbated and complicated this predicament. So, with most cannabis stocks held almost entirely by retail accounts (in a sense, cannabis is the most under-owned market sector extant), liquidity has been limited, and heightened volatility has been an ongoing and distinguishing feature of cannabis trading activity.”

It would likely provide a big tailwind if institutional investors could finally buy these stocks. According to Statista, the total global net assets of U.S. mutual funds registered is roughly $27 trillion, so even if they take small starter positions, it could represent a significant amount of buying. Furthermore, the tailwind shouldn’t be fleeting because it takes time to accumulate these positions.

Admittedly, institutional interest depends upon how these companies execute. Of course, some will do better than others, but stocks tend to follow sales and earnings growth over time, and I suspect that will be true in this industry, too. If so, many portfolio managers will likely want to own these stocks because of sales growth and, potentially, the bottom-line numbers associated with its reclassification.

Kass writes, “Despite near unbearable regulatory, economic, and market headwinds, retail cannabis sales have still tripled to nearly $27.5 billion since 2018. By the end of this decade, recreational cannabis sales could triple again.”

According to the institutional number crunchers at Cowen, the addressable market for cannabis companies in the U.S. could exceed $46 billion in 2026. A combination of ongoing sales growth and improving earnings stemming from more favorable treatment in Washington, D.C., leads Kass to conclude: “I know of no individual market sector that possesses as favorable a multi-year reward vs. risk ratio as cannabis.”

The Smart Play

Marijuana stocks have been terrible performers for a while, partly because Main Street investors have grown skeptical that Federal laws will change for the better. For perspective, the Advisorshares Pure U.S. Cannabis ETF  (MSOS)  invests in multi-state operators. Since peaking in February 2021, the MSOS has lost about 80% of its value, and that includes a 34% gain following President Biden’s announcement last Thursday.

Nevertheless, this is an intriguing idea. Over the past eighteen months, a lot of excess has been wrung out of this industry, so it could be setting up for better days ahead. However, that still hinges largely upon rescheduling and the passage of the SAFE Act, neither of which is guaranteed. As a result, approach these stocks cautiously, risking no more than you’re willing to lose.

What pot stocks should you buy if you’re OK with the risk? Currently, multi-state operators must operate grow facilities in the same states as retail stores because of existing laws, forcing them to have redundant expenses. If regulations ease, these U.S.-centric companies should benefit from economies of scale, making them particularly intriguing. 

However, picking specific winners or losers is challenging because many companies operate in this space. Since each has pros and cons, consider buying the MSOS ETF to gain broad exposure to a basket of large players. Its three biggest holdings are Green Thumb  (GTBIF) , Curaleaf  (CURLF) , and Trulieve  (TCNNF) , and its expense ratio is a reasonable 0.73%. 

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