A Deep Dive into Value Investing in Cannabis and Hemp
A summary from Value After Hours S06 E29 Mindset Value's Aaron Edelheit on value investing in cannabis and hemp
In the world of value investing, finding industries with substantial growth potential, untapped opportunities, and significant barriers to entry is the ultimate goal. Over the past few years, the cannabis and hemp sectors have become prime candidates for such opportunities. As an investor deeply involved in these industries, I want to walk you through why cannabis and hemp are ripe for value investors and how you can begin evaluating these sectors to find potential gems.
1. Why Cannabis? The Unseen Value
At first glance, the cannabis industry might seem volatile, with numerous boom-and-bust cycles, as evidenced by the market peaks in 2020 and subsequent crashes. However, understanding the factors driving the industry’s future potential can help you see beyond the noise. Here’s why cannabis presents a unique value investing opportunity:
Federal Illegality: Cannabis remains federally illegal in the U.S., which means many institutional investors are hesitant or outright prohibited from investing in the sector. This creates a significant supply-demand imbalance in the capital markets, keeping valuations low. The result? A playground for individual investors who are willing to do the research and get in early.
Fragmented Market: Each U.S. state operates its own regulatory framework, with wildly varying rules about cultivation, distribution, and retail. Some states, like California, allow open competition, whereas others, such as Florida, maintain strict caps on licenses. As a result, each state's cannabis market behaves like a separate country, which creates inefficiencies and opportunities.
Regulatory Overhang: As soon as the U.S. federal government moves to decriminalize or reschedule cannabis, expect a flood of institutional capital, M&A activity, and market expansion. This presents the classic value investing setup: entering while the market is cheap and holding as legalization proceeds.
2. How to Evaluate Cannabis Companies
When analyzing cannabis companies, your goal is to identify those that have a competitive advantage, whether through operational efficiency, brand positioning, or strategic assets. Here are the key factors to consider:
2.1 Production Cost
Understanding the production cost structure of cannabis companies is crucial because cannabis is becoming increasingly commoditized. As prices drop due to competition, companies with the lowest cost per gram will survive and thrive. Here’s how to assess a company’s production efficiency:
Indoor vs. Outdoor Cultivation: Indoor cultivation often produces higher-quality cannabis but comes with significantly higher costs due to energy consumption and labor. On the other hand, outdoor and greenhouse cultivation offer lower costs but can result in less consistent quality. The sweet spot lies in companies utilizing advanced greenhouse techniques that harness natural sunlight while controlling variables like humidity and pests.
Technological Integration: Companies using precision agriculture technology (automated irrigation systems, climate control, CO2 recycling, etc.) often have lower operating costs. These technologies allow for efficient resource management, making them better equipped to handle price compression in competitive markets.
2.2 Licensing and Regulatory Capture
Some cannabis markets are “limited-license” states where only a few operators are allowed to grow and sell cannabis. Companies holding these licenses enjoy monopoly-like conditions, allowing them to charge higher prices for their products. However, be wary of overpaying for companies that rely solely on regulatory barriers for their business model—these advantages may erode over time as regulations evolve.
Conversely, in “unlimited-license” states like California, the barriers to entry are lower, creating fierce competition. In such environments, companies that can scale efficiently, maintain consistent quality, and operate with low costs will dominate the market.
2.3 Branding and Product Differentiation
Cannabis is more than just a commodity. Consumers are increasingly discerning, especially at the high end of the market. Just as people differentiate between Budweiser and craft beers, they are doing the same with cannabis strains. Look for companies that are building strong brands and consistently delivering high-quality products.
Brands that can deliver consistent quality while catering to niche preferences (e.g., organic, boutique strains) will hold a significant advantage. Consumers pay premium prices for specific cannabis genetics, and companies that can rapidly rotate strains to meet changing consumer tastes will remain competitive.
3. Case Study: Glass House Brands
A prime example of a company capitalizing on all these factors is Glass House Brands. Based in California, Glass House operates one of the largest cannabis greenhouses in the world—a 5.5-million-square-foot facility in Ventura County. Here’s why this company stands out:
Location Advantage: Located in an agricultural paradise, Glass House leverages natural sunlight while using advanced technology to control variables such as temperature, humidity, and pests. This allows them to produce high-quality cannabis at a significantly lower cost than most of their competitors, particularly those reliant on indoor cultivation.
Regulatory Positioning: Glass House has a unique advantage due to Ventura County’s strict rules, which limit new greenhouse development. This creates a significant barrier for future competitors, ensuring that Glass House’s facility remains one of the most efficient in the state.
Expansion Strategy: Despite the price volatility in the cannabis market, Glass House has been expanding capacity methodically, renting out excess greenhouse space for tomatoes and cucumbers until cannabis prices stabilize. This measured approach shows that the company understands the importance of not flooding the market while maintaining profitability.
4. The Rise of Hemp: Beyond Cannabis Flower
While cannabis is often the focus of media and investor attention, hemp presents a quieter yet equally lucrative opportunity. Specifically, hemp-derived products like low-dose edibles and beverages are set to replace a significant portion of the alcohol market. Here’s why:
Legal Loopholes: In 2018, the U.S. passed the Farm Bill, which legalized hemp and its derivatives as long as they contain less than 0.3% THC. This opened the door to a new class of products: hemp-derived cannabinoids, including Delta-9 THC, which offer the same psychoactive effects as cannabis but are legal across state lines.
Hemp Beverages: Hemp-infused beverages are emerging as a popular alternative to alcohol, particularly in states where recreational cannabis remains illegal. These drinks offer relaxation without the hangover, appealing to a health-conscious consumer base. As more states legalize these products, hemp beverages could capture a significant share of the $260 billion U.S. alcohol market.
4.1 How to Invest in Hemp Beverages
When evaluating hemp beverage companies, look for:
Distribution Network: The key to success in the beverage industry is distribution. Companies that can plug into existing beverage distribution channels (e.g., grocery stores, bars, liquor stores) will be able to scale rapidly.
Branding: Similar to cannabis, branding plays a crucial role in hemp beverages. Consumers gravitate toward brands they trust, especially when it comes to health-related products.
Partnerships: Companies partnering with major beverage distributors or licensed producers will have a significant competitive advantage. Look for businesses that are not just innovating but are also building the infrastructure for rapid growth.
5. Case Study: Grown Rogue – Crafting a Niche in Cannabis
While large-scale cannabis producers like Glass House capture attention with their massive operations, smaller craft cultivators such as Grown Rogue are proving that there’s plenty of opportunity at the other end of the spectrum. Grown Rogue is a prime example of a company leveraging the unique dynamics of cannabis cultivation to create a highly profitable niche. Here’s how Grown Rogue stands out in the competitive cannabis market:
5.1 Craft Cultivation at Scale
Unlike larger companies that focus on producing massive amounts of cannabis at low cost, Grown Rogue specializes in craft cultivation, emphasizing quality and consistency over sheer volume. Their approach is to focus on producing smaller batches of high-quality cannabis that caters to a discerning customer base, particularly at the premium end of the market.
Controlled Production: Grown Rogue operates 50,000-square-foot (4,645 square meters) cultivation facilities, much smaller than the mega-greenhouses of their competitors. This deliberate limitation allows them to focus on producing consistent, high-quality cannabis with unique genetics that appeal to cannabis connoisseurs.
Genetic Rotation: One of the most interesting aspects of Grown Rogue’s business model is their ability to quickly rotate cannabis genetics, introducing new strains to keep consumers engaged. Cannabis consumers, especially at the high end, seek variety and are drawn to unique strains with distinct effects and flavors. Grown Rogue has positioned itself to meet this demand by constantly experimenting with new strains while maintaining consistent quality.
5.2 Hyper-Efficient Operations
Operating in highly competitive states like Oregon and Michigan, Grown Rogue has developed a business model that allows it to remain profitable even in the most challenging market environments. Oregon, for instance, is known for having some of the lowest cannabis prices in the U.S., yet Grown Rogue has managed to thrive by implementing extreme operational efficiency.
Cost Control: Grown Rogue focuses on optimizing every aspect of their operations. From the placement of air conditioning units to how they build their cultivation facilities, every decision is made to minimize costs. This attention to detail allows them to produce cannabis at a lower price point without sacrificing quality.
Lean Structure: Unlike many cannabis companies that have bloated corporate structures, Grown Rogue keeps their team lean. Most employees are directly involved in cultivation, with minimal staff dedicated to administrative roles. This focus on a hands-on approach ensures that the bulk of their resources go toward producing the highest quality flower.
Free Cash Flow Positive: Grown Rogue has achieved what many cannabis companies in competitive markets struggle to do: they are free cash flow positive even when cannabis prices are at their lowest. In Oregon, where prices dropped to record lows, Grown Rogue’s efficient model allowed them to continue generating profits, demonstrating the resilience of their business strategy.
5.3 Geographical Expansion: Scaling the Craft Model
What makes Grown Rogue particularly compelling is their approach to scaling. Rather than building massive facilities in a single location, they focus on replicating their 50,000-square-foot (4,645 square meters) cultivation model in different states. This allows them to bring their craft cannabis expertise to new markets without overextending their resources.
Michigan Success: Grown Rogue entered the Michigan market, where cannabis prices collapsed by 70%. Despite this, they have continued to expand their operations and now produce over $6 million annually in EBITDA from the state. Their ability to remain profitable in such a difficult market speaks volumes about their operational strength.
Expansion into New Jersey: Next on Grown Rogue’s radar is New Jersey, a state where cannabis prices remain high, hovering around $3,500 per pound compared to $600 in Oregon. With their efficient model already proven, Grown Rogue is poised to capture significant market share in this new, high-priced market. By replicating their craft-focused approach in different states, Grown Rogue can take advantage of varying market conditions while maintaining their commitment to quality.
5.4 Fast Fashion Meets Cannabis
One of the unique dynamics in cannabis is that it behaves somewhat like the fashion industry—especially at the high end. Consumers want the latest trends, whether it’s a new genetic strain with a catchy name or a particular effect they’ve never experienced before. Grown Rogue has capitalized on this "fast fashion" element by constantly rotating their cannabis genetics to meet changing consumer preferences.
Strain Variety: The cannabis market is driven by innovation in genetics. Strains with names like "Gary Payton" or "Cheetah Piss" appeal to consumers not just for their effects but for the novelty and exclusivity they represent. Grown Rogue’s ability to quickly bring new strains to market gives them a distinct advantage in the craft segment, where consumers are willing to pay a premium for something unique.
Small Batch Focus: Grown Rogue’s limited production capacity allows them to cater to high-end users who prefer small-batch cannabis. This mirrors the craft beer industry, where consumers often seek out unique, locally produced beers over mass-market options. In the same way, cannabis consumers in states like Oregon and Michigan are drawn to Grown Rogue’s craft-grown cannabis.
5.5 Why Grown Rogue is a Value Investor’s Dream
For value investors, Grown Rogue represents a textbook example of a company that is thriving by doing things differently. Here’s why Grown Rogue should be on your radar:
Contrarian Play: While many cannabis investors focus on large-scale producers or flashy brands, Grown Rogue is quietly carving out a niche in the craft cannabis market. Their ability to operate profitably in the most competitive markets suggests they have a defensible business model that will only grow stronger as they expand into higher-margin states.
Efficient Use of Capital: Grown Rogue’s focus on cost control and operational efficiency means they are well-positioned to weather any downturns in cannabis pricing. In contrast to many cannabis companies that burn through cash, Grown Rogue is already free cash flow positive, even in challenging markets.
Growth Potential: With plans to replicate their model in states like New Jersey, Grown Rogue offers significant upside potential. As more states legalize cannabis, the company’s proven ability to operate efficiently in competitive environments will allow them to scale without compromising their craft cultivation ethos.
6. Conclusion: Cannabis and Hemp as Long-Term Value Plays
The cannabis and hemp industries are poised for substantial growth over the next decade, with the potential to replace alcohol and prescription medications while delivering significant returns for patient investors. By focusing on companies with strong operational efficiencies, regulatory positioning, and branding potential, you can tap into the next major wave of value investing.
If you’re willing to do the research and understand the complexities of the cannabis supply chain, this market offers substantial upside, akin to the early days of the tech industry or the California Gold Rush.