When There's A Gold Rush, You Should Be Selling Picks & Shovels
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Many of you may have heard this old business maxim before, but if you haven't, it essentially means that the people who made the most money during the gold rushes in centuries' past were the people who sold picks, shovels, and mining equipment to the miners. Sure, every now and again a miner would strike it rich, finding a profitable ore vein or massive nugget of gold, but by and large the people who became prosperous from all the mining were the purveyors of the mining equipment themselves. This may seem counter-intuitive, but the business of selling equipment has a steady demand (return), which is much less volatile than the partially luck-based process of mining for gold, thus allowing the equipment sellers the ability to slowly compound their businesses over time and earn the real fortunes.
The cannabis space right now is very much akin to a 21st century gold rush. While growing weed is a much more systematic business than mining for gold, the ability for companies to "strike it rich" will be severely diminished given the low barriers to entry and sheer amount of competition in the space. Think of it like this: how much gold can you really mine if you are sharing the same creek with 50 other miners? You won't be the one pulling all the gold out of the ground. This is simply to say that ultimately I expect the % net income margins of most large weed businesses in the future will be in the mid to high single digit range - a fundamentally low margin business and not the type of enterprises that see their market caps really explode long term. In addition, similar to the alcoholic beverage industry, there will also always be a want for niche, small batch product, preventing too much in the way of consolidation. Like the gold rush, we want to be invested in the people selling the mining equipment.
However, in the 21st century, this equipment looks a lot different. Grow beds, Lighting, and hydroponic equipment will be the picks and shovels of tomorrow, and there are only a few public companies that sell them - GRWG and HYFM. In addition, I expect that these companies will continue to lead, given that they have the head start of being public & attracting investment from the capital markets - a key competitive advantage.
But these companies have hot stocks that are doing well. How can we remove risk from this trade and try to take advantage of some 21st century gold rush arbitrage? The answer: short the most bloated, worst Canadian weed producers. Why Canadian weed producers? Because they are behind the 8 ball when it comes to building out MSO operations in the United States, and the US is projected to account for over 90% of the total global market for weed and CBD products. In other words, right now they are trading at a VERY expensive valuation compared to what they will be able to make in the future. Take CGC for example, one of the two stocks I have selected for this trade:
Canopy Growth trades at C16B market cap and 40x EV/Sales despite reporting only C135M revenue and negative C886M EBITDA last quarter.
The company has no near-term path to break-even EBITDA and has already burned through 3.5B of the 5.0B cash from Constellation.
Who would want to be long this company at these prices? Going long CGC you are getting a company that owns 13% of the 3B canadian weed market, which in it's entirety is smaller than California alone (~4B). Why pay FORTY TIMES EV/SALES???
Cronos, the other Canadian weed stock I've selected as a hedge, is even worse.
So to recap: We want to look to go long the two companies that will be selling picks and shovels at healthy net income margins to the enormous U.S. market, while shorting the two most overvalued companies that operate in an extremely low margin, smaller Canadian market.
Hopefully both sides of this trade will generate alpha over time, but the reason this works as a hedge is that all four companies trade within the "weed" basket, allowing some of the correlation % to be offset.
Cheers!
-P
The cannabis space right now is very much akin to a 21st century gold rush. While growing weed is a much more systematic business than mining for gold, the ability for companies to "strike it rich" will be severely diminished given the low barriers to entry and sheer amount of competition in the space. Think of it like this: how much gold can you really mine if you are sharing the same creek with 50 other miners? You won't be the one pulling all the gold out of the ground. This is simply to say that ultimately I expect the % net income margins of most large weed businesses in the future will be in the mid to high single digit range - a fundamentally low margin business and not the type of enterprises that see their market caps really explode long term. In addition, similar to the alcoholic beverage industry, there will also always be a want for niche, small batch product, preventing too much in the way of consolidation. Like the gold rush, we want to be invested in the people selling the mining equipment.
However, in the 21st century, this equipment looks a lot different. Grow beds, Lighting, and hydroponic equipment will be the picks and shovels of tomorrow, and there are only a few public companies that sell them - GRWG and HYFM. In addition, I expect that these companies will continue to lead, given that they have the head start of being public & attracting investment from the capital markets - a key competitive advantage.
But these companies have hot stocks that are doing well. How can we remove risk from this trade and try to take advantage of some 21st century gold rush arbitrage? The answer: short the most bloated, worst Canadian weed producers. Why Canadian weed producers? Because they are behind the 8 ball when it comes to building out MSO operations in the United States, and the US is projected to account for over 90% of the total global market for weed and CBD products. In other words, right now they are trading at a VERY expensive valuation compared to what they will be able to make in the future. Take CGC for example, one of the two stocks I have selected for this trade:
Canopy Growth trades at C16B market cap and 40x EV/Sales despite reporting only C135M revenue and negative C886M EBITDA last quarter.
The company has no near-term path to break-even EBITDA and has already burned through 3.5B of the 5.0B cash from Constellation.
Who would want to be long this company at these prices? Going long CGC you are getting a company that owns 13% of the 3B canadian weed market, which in it's entirety is smaller than California alone (~4B). Why pay FORTY TIMES EV/SALES???
Cronos, the other Canadian weed stock I've selected as a hedge, is even worse.
So to recap: We want to look to go long the two companies that will be selling picks and shovels at healthy net income margins to the enormous U.S. market, while shorting the two most overvalued companies that operate in an extremely low margin, smaller Canadian market.
Hopefully both sides of this trade will generate alpha over time, but the reason this works as a hedge is that all four companies trade within the "weed" basket, allowing some of the correlation % to be offset.
Cheers!
-P
Nota
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