Diversification is known as the only ‘free lunch’ on Wall Street. While risk and return typically walk arm in arm, portfolio diversification allows for risk reduction without a corresponding decline in expected return. Diversification into a non-correlated asset class can further dampen volatility while boosting expected portfolio return. The cannabis industry is experiencing a blistering ~27% CAGR and a sound investment strategy can help one approach the intersection of high return with minimized risk.
Constructing an adequately diversified portfolio is no easy task in our constantly evolving and relatively undefined cannabis world. Determining appropriate sector allocation while hedging against inevitable commodity margin compression is as important as understanding legislative impact at the county level. Risk-adjusted sub-sector growth forecasting is simply the first step to producing cannabis alpha.
Diversification is one of two general techniques for reducing investment risk
The other is hedging
A well-diversified cannabis portfolio would have broad sector exposure with tactical tilts into sub-sectors with the highest expected growth rates. The investable cannabis market can be divided into the following broad sectors:
Retail and Distribution – Limited licenses and E-commerce
Primarily comprised of dispensaries and E-commerce platforms; we favor dispensaries in limited license scenarios with high barriers to entry. We see tremendous untapped potential at the intersection of e-commerce and cannabis.
Consumer – Branding and Intellectual Property
Cannabis becomes commoditized over time. Brands that provide the best consumer experience will create oligopolies that command the lion’s share of their respective sub-sectors. Accessories with little IP protection and low barriers to entry are highly competitive with immense margin pressure.
Therapeutics – Long-term Health Benefits
Research continues to uncover ways in which the cannabis plant can heal the human body, mind and spirit. This gives therapeutics the potential to be the largest sector in cannabis. When we combine this with the impact on big pharma along with decades old patent expiration issues, we can perhaps look to this sector for the largest exits.
Business Solutions – Top and Bottom Line Impact
Scalable, legal and necessary. This nascent industry relies on solutions from many other sectors to sustain its rapid rate of growth. Look for software that reduces the cost of business or increases the likelihood of it. Traction is key here.
Production – Cost Reduction and Yields Enhancement
Margin compression is the most substantial risk we see to cannabis production. Technology that can reduce cost or enhance yield with scalability can help hedge against commodity prices eventually normalizing to more typical agricultural margins.
While there are many sub-sectors in our industry, a fully diversified cannabis portfolio would at least include exposure to these sectors with outsized positions in protected markets with high barriers to entry. Acquisition viability will carry a premium for successful brands and companies in the cross-hairs of big corporations. These institutions, barred from participating due to federal regulation, are waiting for the proverbial mall doors to open.
Major financial institutions are already doing their cannabis homework behind the scenes. It is simply a matter of time before armies of analysts and algorithms begin to suggest that this non-correlated asset class can boost expected portfolio return for their wealthiest clients. How will your cannabis portfolio be positioned?