In April, the Canadian government announced a plan to legalize marijuana for recreational purposes. David Mau, Portfolio Manager, TD Asset Management, talks to Sara D’Elia about the emerging marijuana market, investment opportunities and shares his top pick.
Well there's a couple of reasons behind the government's push to legalize recreational marijuana. And the first one is safety. They want to do their best to keep it away from children and teenagers. So that's a really big reason. And the second one is, right now, there's a lot of profits being made in this space from criminal organizations. And the government wants to remove those profits from the black market.
Assuming the government is able to weigh the costs and benefits and they do move forward with legalization, what do you expect it to look like?
So based on what we know right now, the full legalization of the recreational market will come into place sometime before July 1, 2018, so a year from now. And the government has laid out some broad rules. But basically, what they're going to do is let the provinces, each individual province determine exactly how they want their retail distribution model to look like, what the pricing is going to be. The one thing that the federal government has set is the minimum age to buy marijuana is going to be 18.
One of the things I found most interesting when you and I were chatting was around the potential of branding and what that could look like, comparing really it to either tobacco sales or alcohol sales. Could you shed some light on that?
Yeah, so the government really doesn't want to allow these companies that do a lot of marketing or advertising, just because they don't want to promote the use of marijuana. And they especially don't want companies to make marijuana attractive to young people. But you know, there have been already branding efforts in place. We can think of a couple of good examples. For instance, Canopy Growth Corp, which is the largest company in the sector right now, partnered last year with one of the famous rappers, Snoop Dogg, to promote his brand of marijuana. It's called Leafs by Snoop.
You've also had some interesting statistics away from branding. But comparing it to alcohol sales, specifically as it relates to beer, can you share that story as well?
Sure. So in Canada it's estimated that the size of the beer market is kind of somewhere between $9 and $10 billion. Now the estimated size of the marijuana market is somewhere around $7 billion. So what's really interesting is that past studies have shown that in instances where marijuana consumption has gone up, beer sales have gone down. So there is a bit of a substitution effect there.
So I really like that we're getting into some of the numbers here and the potential investment thesis. How big is the market today, and how big do you think it could grow to be?
So most estimates right now have the market in Canada pegged at about $6 to $7 billion. Now the consulting firm Deloitte also published a study last year, and their estimate is that the direct sales of marijuana in Canada is somewhere between $5 and $9 billion.
Now you brought a chart with you, which I'm going to bring up on the screen here, showing how only three of 21 companies in Bloomberg's Global Cannabis Index had positive earnings. When I saw that I thought, we've seen the stock prices explode. How are only three of those companies profitable?
So right now the only legal way to sell marijuana is into the medical market. So all of the companies that have revenues and earnings right now are medical marijuana companies. But the reason the stock prices have moved up so much in the last year or so is people are betting on the future recreational opportunities. So people are buying these companies ahead of the actual legalization.
So it's not about what they earn today. It's about what they could earn in the future.
So do you think the valuations we're seeing today are fair?
So that's a good question. I think it's a bit early to tell. But if you do believe that the market will evolve the way that it's expected to, I think there's definitely the potential for these companies to grow into their current valuations.
Do you think we'll still see them at margins of around 40% or do you think those might start to decline?
I think the EBITDA margins for these companies will stay roughly consistent, somewhere between 30% and 40% for the time being. It's going to depend on how quickly the demand switches from the illegal market over to the new legalized regime.
This is a growing market. And there was no pun intended there. It's actually just a relatively new market. So one of the things investors are trying to differentiate is separating the winners from the losers. And oftentimes with this particular sector is people draw correlations to the era saying, there can only be one Google or one Facebook. So who will that be in this space? So I have to ask you, who is your top pick?
So right now my topic is Canopy Growth Corp. They are the biggest producer right now in Canada. They also have the largest market cap. They're actually part of the TSX Index, which they were added to earlier this year. And the reason I like Canopy is because they currently have the most production capacity. And they also have probably the biggest brand awareness at the moment.
For an investor potentially putting money to work in the cannabis space, what should they consider before buying these stocks?
So I think the first thing that people need to think about is, what their time frame is when it comes to buying these stocks. If you're buying it for the short term, maybe next three to six months, I think it's going to be very, very volatile, just because there's still so many unknowns and the news will come out in drips and drabs. And that will potentially have meaningful impact to the stock price.
Now if you're buying it with a three to five year view, I think it's a lot safer just because in three to five years, the market will be at a much more mature stage than where we are now. So there will be a lot more visibility of certainty into the sales and the earnings.
Thank you very much.