Wow, this tweet is timely.

I was literally finishing up an example of using discounted cash flows in valuing assets, and I stopped by Twitter while the post page was loading. The Tweet is from an analyst at CB1 Capital, a firm specializing in legal cannabis investments. TheCannalysts have known CB1 for years, having hosted 2 AMA’s with their principals, and Loren DeFalco appeared personally as one of Cyto’s panelists at the first of our business conferences.

I consider them colleagues, and I agree with much of what CB1 has to say. But……I diverge strongly with Todd Harrison specifically on the level of risk inherent in investing in the legal cannabis sector. CB1 Capital sees cannabis as a once-in-a-lifetime moment for investors, that the potential revenue and income that’s gonna come from legal cannabis is going to be really something else.

I agree with much of that. Where I disagree is where that income ultimately going to land, and which companies going to be the largest recipient of it.

Assets (a company’s share price) can be valued by math and models – there’s several ways to do it. One is using a cost of capital. Returns on assets need to be greater than the cost of capital needed to acquire and operate them. That premium suggests how much profit potential is there, and I discount that profit as perpetuity.

Another is using discounted cash-flow (or DCF), which is used in many, many applications. All expected future cashflows from operations are laid out and present valued to today. The cost of capital method is a little more abstract, the DCF method more robust. I’ve greatly oversimplified these – but – that’s the gist of it.

Both methods will give you a theoretical ‘asset value’ to compare with a company’s share price. Some people trade on this, for others, it informs investment decisions.

CB1 (and that analyst) have been bullish on the whole DCF ‘thing’. Like, really bullish. The forward cashflows they see are massive, and I’d agree there will be big ones.

My disagreement isn’t that I prefer one valuation method over the other (I use both extensively). Nope, I disagree with CB1’s assessment of risk underlying those cashflows. These stem from regulatory risk (3-Tier & Commerce Clause activation), and the specific examples that ‘legacy’ markets (Washington, Oregon, Colorado and California) provide.

Legal cannabis in those legacy markets is extremely competitive, and not entirely profitable. Business failures and startups in cannabis look pretty much like ‘normal’ retail there, with the primary difference being enhanced regulatory oversight. Supply and demand dynamics are in full swing, and ‘excess’ profit is confined to inter-market preferences (recent increases in demand for extracts in CO for example). A company predicting consumer trends accurately is going to have a couple of good quarters until competition responds. Private company participation is large, and sector consolidation challenging at this point.

In mature industries, demand growth is confined to changes in market share, or, the slow moving (and biggest) driver: population growth.

MSO valuations have been rocking for 2 reasons: anticipated regulatory change, and the expected (untapped) demand that’ll come as the product normalizes. When compared to traditional business models, MSO valuations are on another planet right now. Many will tell you that ‘doesn’t matter’ – the DCF’s say it’s going to be so big….no matter which way you turn, you’ll be staring at the sun. To a risk guy (me), that’s just bullshit.

I wrote a piece on basis differentials the other day on our Reddit channel, and I was immediately challenged about the ‘when’ – as in ‘when will inter-state start?‘ Not that inter-state commerce wasn’t going to happen – only the when. It doesn’t matter that much to me, because the ‘when’ blows up a DCF assumption anyhow. My challenger bet that inter-state imports probably won’t happen until 2025. Ok.

Here’s a simple example of a change in DCF if interstate imports are permitted in 2025. East Coast cannabis wholesales currently at about $7,000/lb, West Coast dope at about $2,000/lb and is generally of higher quality. Assume a single company is selling wholesale. Scenario 1 – no imports. Scenario 2 sees inter-state imports beginning in 4 years (2025). What happens to DCF?

Please forgive how crude this is (I didn’t discount it either), but notice the change in ‘cashflow’ between the 2 scenarios.

Those expected cashflows are more than halved in this example. And it doesn’t contemplate extrapolating across multiple states, different timeframes, 3-Tier insertion (at State or Federal levels). Or incoming competition. Etc. Etc.

And that’s the issue I have with the strong level of bullishness I see in folks relying on DCF to support their optimism. The future is unpredictable. A regulatory meteor strike will crush basis differentials, or nullify a company’s previous point of strength overnight. The range of potential outcomes is far more diffuse than what the bullishness is suggesting. Applying a probability curve implies sophistication….but to me it all remains a leap into chaos theory <nb: if one really wants to roll with the metaphysics of probability here……the Butterfly Effect suggests an expansion of probable outcomes is possible from a deterministic system. If one accepts that as possible, then one must logically accept that a contraction of probable outcomes could also occur, no? That’s the bull case in a nutshell>.

Today has largely been a down day in MSOs – which is what prompted that Tweet I referred to at the top. The sentiment that ‘close your eyes… it’ll all be alright soon enough‘. I can’t think of a worse mindset to have – as either investor or trader – than to have unwavering commitment within an environment of uncertainty. (Don’t get me wrong, I like the poster and have known him for years. We’ve had some passionate discussions around this topic, and above all, he strikes me as a smart, solid guy. It’s also his personal account).

I’ve seen this sentiment everywhere. In comments on the stock boards (buy the dip!), and I’ve seen it in the cognitive dissonance of folks trying to mansplain NY State regulations (from a place of ignorance) to others with questions about it. The psychology of some of the folks I’ve seen out there is amazing. I’m not exactly breaking new ground here by saying volatility is a 2-way street, although it appears to be surprising to many that it is. Not recognizing that is a brutal notion to take into an investment (or trade).

I think legal cannabis is gonna be a helluva market, a consumer staple of ‘sin’ products and health and wellness goods, and hopefully, medical applications. If anyone is telling you at this point who that wealth is going to specifically accrue to – they’re simply guessing.

MSO’s right now present one of the best entry points for financial exposure to legal cannabis in the US. It’s also incredibly risky – and reminding you of that is all this post is intended to do. From an analytical standpoint, a macro approach to the sector would be the least risky path (ETF). A riskier one would be to pick the best one or two operational companies out there (although with $TRUL, you’d be taking on massive regional risk in FLA. What’s to stop FLA flipping to recreational, and doing the same as NY? What happens to $TRUL’s DCF then?).

The most risky would be to buy 4 or 5 names based on popularity/volatility.

Keep emotions out of it, keep potential losses to amounts you can tolerate, and above all: we invest and trade to make money. If you want to be assured what the future will bring, joining a religion is a far better bet.

GoBlue and I have been talking lately about some of the parallels we are seeing between the US and Canada in legalization. We’ve been here since 2017 analyzing and documenting the sector. And there’s more in common beginning to emerge than anyone else is talking about.

I’ll surface some of these another day….but I’ll offer one up right now. It’s in plain sight, and has been happily sitting there, just doing its’ thing. It’s just like Canada…except in that it’s probably about 3 years ahead of where Canada is right now.

It’s Oregon.

The preceding is the opinion of the author, and is in no way intended to be a recommendation to buy or sell any security or derivative. A position in $TER was opened and closed on 2 successive days last week. The author holds no position in $TRUL.