In brief

  • History is replete with manias and bubbles. But it is also full of examples of disruption and innovation. Which bucket will cannabis fall into?
  • Intellectual property and pricing power drive free cash flow. And free cash flow is ultimately what is material to asset prices long term — not investment stories.

The investment industry has always suffered from storytelling and chart chasing. Examples include the tulip mania of the 1600s, the South Sea Company bubble in the 1700s and more recently the hype surrounding cryptocurrencies. History has shown that if the story does not pan out and deliver promised outcomes (i.e., cash flows), there will be pain. 

However, not all stories disappoint. For instance, smartphones, cloud-computing and eCommerce are innovations that have benefited society enormously, unleashing prodigious cash flows and ultimately returns for investors. A new story the market has become increasingly focused on of late is cannabis. I am asked about it frequently, so I am making it the focus of this month’s letter.

Although only two countries have legalized the recreational use of cannabis — Uruguay became the first in 2013, followed by Canada in 2018 — over two dozen countries now permit medical consumption of the plant. In the United States, the situation is more complicated, but the trajectory is similar. While illegal at the federal level, beginning in the mid-1990s many states began legalizing, in some form, the medical use of marijuana. As shown below, 10 U.S. states permit both medical and recreational use.

Exhibit 1: Marijuana legalization status

The chart shows the states in which medical marijuana is broadly legalized, states in which marijuana is legalized for recreational use and states in which no broad laws for legalizing marijuana. In general the west coast has recreational legality, while the rest of the states are a mix of no legality and medical legality.

Source: As of 7 November 2018. Used with permission.

We will set aside the question of whether or not society should allow cannabis use, keeping our focus on investing. As potential investors, we would want to know the answers to certain key questions. How big could the profit pool from cannabis be? Could it eclipse beer, wine or spirits? Is there intellectual property that could provide a business with a competitive advantage and superior returns, as with alcohol and coffee? Will there be, for example, a Johnnie Walker or a Starbucks of cannabis?  The answers to these questions are not yet clear, although the equity market’s obvious euphoria in this space suggests otherwise. 

Today two-thirds of the population of the United States has access to medical marijuana and one-fifth has access to recreational marijuana1. So while the cannabis profit pool could be large if adoption rates grow, will there be free cash flow? That is hard to envision in a category where we see little product differentiation and no pricing power. For example, in early adopter states like Washington, cannabis prices have steadily declined. Why wouldn’t they do the same in Massachusetts or the next region or country that legalizes the plant?

Here is another way we are thinking about this: Households have budgets. People generally budget how much they can spend on vacations, holiday shopping and even lunch during the work week. If cannabis scales up, what might it take share from? As smartphones and tablets penetrated in the late 2000s, they cannibalized sales of personal computers. What existing product categories may be put at risk with the growth of the cannabis market? In our view, beer, wine or spirits could be candidates for cannibalization. We are looking at this issue closely and modeling a potential range of outcomes. 

To sum up, fundamentals such as intellectual property and pricing power drive free cash flow.  And free cash flow is ultimately what is material to asset prices long term — not stories. 


1 Bernstein, “Weekend Consumer Blast: Scoping the Size of the US Cannabis Market – Could It Be As Big As Wine?” November 2, 2018

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