Quant buys in cannabis

0:09Very happy to welcome two investing experts, our quant strategist, Emma Johnston. Welcome to the show, Emma. Great to have you. Thanks so much, Rena. Thrilled to be here. Today we are talking cannabis and what the quant system, what our quant system thinks of those stocks and the ETF. cannabis stocks have been somewhat in the news lately true to form in that sector saw a nice little rally off of proposed promised thought to be promised uh changes in regulation and scheduling how cannabis is considered will it be a schedule three quote unquote drug will it not TBD like always a lot of fits and starts in the cannabis sector a lot of ups and downs a lot to suss out a lot not to like frankly so Emma talk to us about how quant thinks of stocks and ETFs in general the metrics that it uses and then if you would start with MSOS the index ETF for cannabis and then we'll get further into particular names.

1:19Definitely. Yeah, it's a very exciting time, I think, for cannabis focused investors. The rare bipartisan support for the de-scheduling or lessening the schedule, I guess, for cannabis. So that is encouraging. And, you know, to your point, we can start with MSOS. That's the Advisor Shares Pure U.S. Cannabis ETF. In terms of cannabis ETFs, This is a fairly large. It's about 840 million in assets under management. And it's the only kind of pure play concentrated exposure to the U.S. cannabis market. What does that mean? It means quite a bit of risk from both a regulatory perspective and just the lack of maturity within the market.

2:04But that also means quite a bit of upside. And I think that when you're seeing the increased attention and focus on that ETF in the U.S.-based stocks, you're looking for that upside associated with legalization or a descheduling within the U.S. Now, you asked about quant and how we assess an ETF for a given stock. It's a little bit different. Obviously, an ETF quant grade would differ from a stock grade because they've got different characteristics. So in the quant space for ETFs, we evaluate them along momentum, pretty self-explanatory. How well has it been doing from a price perspective across the last four quarters?

2:51Expenses. So what is the expense ratio as well as the bid-ask spread for the ETF? Dividends doesn't really apply here. These companies are not large enough yet to even consider paying a dividend, but that is a huge consideration for many investors and other associated ETFs. And then risk, that's got quite a few metrics. Standard deviation, of course, annualized volatility turnover. And then if it's a passive ETF tracking error, so how well does it follow the index? That doesn't really apply here because it is an actively managed ETF, given all the regulatory uncertainty. And then liquidity, which is a huge, huge consideration for an ETF.

3:38That's, you know, how easily can you move in and out of this position? And are you getting a fair price for it? You know, I guess when we get into the single stocks a bit later, I'll focus on that. But what we're really seeing with MSOS is excellent momentum and really decent liquidity. And, you know, given I mentioned at the top, you know, it's got a sizable ETF AUM. I think it's about three times as large as the next largest cannabis focused ETF. And from an average daily dollar volume perspective and an average daily share volume perspective, really decent liquidity. So that is definitely one of the areas that's allowing MSOS to get into the strong buy category, or excuse me, the buy category.

4:31It is not a strong buy. And that, I think, flipped from, let's see. Yeah, it was a sell as recently as August 11th. But obviously, all that news around speculation around the descheduling of cannabis in the U.S. really helped propel the momentum for MSOS, which is, you know, that flagship U.S.-based cannabis ETF. Yes. In terms of the timeline, you mentioned that it switched from a sell to a buy for investors wondering quite justifiably what they should be thinking in terms of timelines and how to assess that and when to get in and when to get out and how much warning they'll have before a buy sign turns to a sell sign or the inverse of that.

5:13If you would explain that a little bit, I think that might help clarify things. Sure. I mean, I'll say at the start, you're kind of assuming a lot of risk when you're thinking about getting into, you know, a speculative cannabis position. So I hope that investors would know that and that that this type of sector equity allocation is not meant to be a core holding, you know, so, you know, intuitively, you'd be taking on a lot of risk. The the buy to sell, you know, a bit unpredictable, there is no we operate from, you know, and with single stocks we operate from a broad valuation framework. With ETFs here, we're looking at expenses.

5:55So it's not that there's, you know, a specific entry point we're recommending. But we are saying based on the momentum, which is a very predictive factor, if you're to look at just kind of a breakdown across all these factors and how they inform a buyer, a sell rating, momentum is very predictive. And so, you know, it might be a good time now, of course, you know, we're not providing specific recommendations. But, you know, if there were to be an announcement related to the de-scheduling that was not in favor of this, that that momentum signal could flip. But I would say for the time being, it is a pretty positive indicator.

6:37In terms of things flipping, is it much quicker in the cannabis sector for all the reasons that we've discussed, the political discussion and the back and forth and the will they, won't they in terms of federal legalization and or rescheduling? Is it much harder to predict in the cannabis sector? In other words, if we were looking at an S &P ETF, it would be much different, I would assume. Yeah. I mean, and again, as I said, this is part of the appeal, right? If you are, And, you know, I'm not going to analogize this to crypto exactly because really different products, underlying products. But in terms of, you know, this regulatory limbo that both of these industries are living in, you can see that, you know, there's established infrastructure.

7:24there's quite a bit of money moving, but regulatory wins will shift that sentiment, which can have an impact on the momentum grade and can signal that it's no longer advantageous. I will say I've been referencing buy and sell signals. There's also a hold period, right? So if that momentum diminishes, it becomes less attractive, but everything else is looking okay, then there is a space for that to become a hold kind of wait and see. Again, I would probably speak to that more on a single stock basis because the way the ETF quant ratings are structured is a bit different. But yes, overall, you can expect quite a bit more volatility in this space.

8:09But again, high risk, high reward. So that's appealing to a certain type of investor. And speaking of risk, what would you say about the, there's a lot of talk about how MSOS is constructed and how they're approaching their model. What would you say about that as a caveat to investors to be focused on specifically with this ETF? Yeah, it's a great point. And I always encourage ETFs are, you know, they're really interesting financial technology in it. I think they require looking under the hood because there's so much variation in how an ETF can be destructive. As I mentioned earlier, there's active ETFs, there's passive ETFs.

8:46Um, there are leveraged ETFs. There are ETFs that invest directly in companies. And in the case of MSOS, you know, because of the regulatory structure in the U S MSOS can't directly own many U S cannabis stocks due to federal rules. Um, so it invests in swaps to allow it to get the same financial results as if it did, uh, again, kind of a complex structure, but the long and the short of it is that a counterparty, a broker, will help facilitate a swap so that MSOS can realize the same gains or losses that an individual stock would hold. There are some stocks it invests in directly that trade OTC over the counter.

9:28But this arrangement gives MOS investors access to S-cannabis companies while staying in compliance with federal law. Again, the advantage of this a pure play U.S.-based ETF allows for huge upside if and when that legalization should occur. So, you know, I would say that's the sector bet that this type of investor is taking. And, you know, there's been previous examples of that having huge payoffs. So, you know, that's really what's going on here. For those unaware, by the way, when we're talking about quant rankings and grades and how the quant team is quantifying this. If you're a premium subscriber on Seeking Alpha, you can see the various grades under the various metrics that they measure.

10:17I'm curious what makes it go from a sell to a hold to a buy to a strong buy. What are the variables that are afoot when those changes happen? Yeah. So, you know, in terms of an ETF, there's a few different things. There's the quant rating, which is really, it's intended to simplify all of the, you know, kind of the aggregate impact of all these separate variables that are informing the quant score. So once a quant score drops below a certain threshold, and I don't have the threshold in front of me, but, you know, for instance, the quant score of MSOS right now is 4.35. If that drops below, I think it's two something, then it becomes a hold.

11:05A sell is, I think, below two. Again, don't have the thresholds in front of me right now. And that quant score is informed by a combination of the ETF's momentum, expenses, dividends, risk, and liquidity. If you want to shift now to some of the single stocks, I could explain how we evaluate single stocks from a quant perspective and maybe talk a little bit about some cannabis stocks that are currently strong buys. Would that be helpful? Yeah, I think that's a great place to go into. You know, Winreen asked to have this conversation and thought it was a super interesting space and wanted to focus on U.S.-based cannabis stocks.

11:47So one of those is Verano Holdings, ticker symbol V-R-N-O-F. Again, this is a decently large multi-state operator with an AUM, or excuse me, a market cap of around 500 million. And it's a quant rated buy, also gained pretty significantly on this momentum. And if you take a look at it from a quant perspective, for those less familiar with quant, we evaluate based on three fundamental indicators. So that's valuation, growth, and profitability. And then we evaluate along other predictive factors that we call timeliness indicators. And those are momentum and revisions. Now, if you were to take a look at all of the, you know, publicly traded cannabis stocks, what you'd see, and it's intuitive if you think about it, right, they score poorly in terms of growth.

12:40And that is because a lot of these are operating in terms of, you know, they're in the negative in terms of earnings. And given the regulatory uncertainty in the States, it's really hard to provide a long-term growth outlook. But But DRNOF is kind of the exception to that rule. It's got an A-grade valuation. And if you're a premium subscriber, you'd be able to dig in to see all of the metrics that inform that A-valuation grade. It's over 15 metrics, some traditional, like price-to-earnings, some less traditional, like a PEG, that's a price-to-earnings growth. So it is this really comprehensive evaluation of the company's valuation framework.

13:23Now, you'll see the price to earnings is missing for Verano Holdings, and that's because it's not yet profitable. However, if you look at some other metrics, like it's price to book, it's trading at about an 80 % discount relative to the sector. This is the healthcare sector because Verano, you know, both recreational and medicinal cannabis use, so that's how it's classified. These are sector relative grades. also scores quite well in terms of growth, particularly its CapEx growth. It's 98 % versus the sector median of negative 6%. This really signals that the company is investing in the, you know, maybe facilities or tech required to grow the company.

14:12And then lastly, in terms of fundamentals, it's profitability. It's got a 25 % trailing 12-month EBITDA margin. That's about 160 % higher than the sector. And it's also got a decent amount of cash from operations. It's about 86 million. So again, part of the joy of premium, you can dig in, look at all these submetrics. And you can also, what I really like to do is take a look at the time series of the factor grades. So you can see how a company has evolved over time. Obviously, if their profitability grade is getting better over time, that's really encouraging. And that actually, I'm looking right now, that is the case with Verano.

14:54It had a C grade profitability back in July, and it is now a B minus. So yeah, when you see those improving metrics, always quite encouraging. And then of course, its momentum is great because we've seen the broader sector get a lift over the last month or so. So that combination of factors has contributed to a strong buy rate or excuse me, a strong buy quant rating. And that's one of the, like I said, one of those US based companies that could have huge legalization upside should we see that descheduling take place. And what other stocks would you add to this conversation that are buys or worthy of discussion from a quant perspective?

15:37Yeah, totally. So there's another US based one that's pretty interesting. It's called Vext Science, ticker V-E-X-T-F. That is headquartered in Arizona. It operates mainly through its subsidiaries, focusing on branded products and cultivation. So another vertically integrated company, quite a bit smaller though, market cap of around 60 million. Again, these companies are pretty small. They're new, but it's gained 24 % over the last month. And it really stands out in terms of its profitability. It's got an EBITDA margin that is 76 % above the sector, a decent levered free cash flow margin. And its forward EBITDA growth is 677 % above the sector.

16:27Again, really good valuation framework. Let me just hop in there. Yeah. And so from a valuation perspective, we're seeing a trailing 12-month price-to-book ratio that's 70 % discounted relative to the sector, a forward price-to-cash flow that's also about 70 % discounted to the sector. So really tantalizing combination of growth and value, as well as profitability. Love to see that really great profitability profile for a nascent industry, etc., in a space where a lot of companies have negative earnings. So yeah, those are two US-based ones I would highlight. When we think about cannabis stocks from a global perspective, Canada is kind of where it's at.

17:12It's legalized at the federal level. So you've taken a lot of that regulatory uncertainty out of the equation. And it's just a much more mature market, which for someone who's less risk averse, but still wants to make a play within the sector, that might be, you know, a better option. And there are two strong buy Canadian based companies. One is Tilray, and then SNDL were two other strong buys in that space. So, you know, like I said, they're not positioned to capture that legalization upside, as well as the US-based ones would. But if you saw a huge momentum in the sector, I wouldn't be surprised to see a lift for those companies as people kind of just get excited about the space.

18:03Do you want to talk briefly about what looks better and what looks less good on those two names? Yeah, let me pull up my... I actually created a cannabis portfolio by... I downloaded the holdings of MSOS and then looked at also, just so folks are aware, on the left-hand nav, if you look at comparisons way at the bottom near our stock screeners and ETF screeners, we do have a cannabis comparison screen. So I uploaded all these tickers into the portfolio tool so I can have a look. So let's look at Tilray. Tilray, B plus valuation, C minus growth, C profitability, A momentum, B, EPS revisions. Looks like SNDL scoring more highly across both growth and profitability, but they both have really similar quant strong buy ratings.

18:57So I'd say it really depends on their given niches, which I'm less than familiar with right now, but one could easily find that out if they're a premium subscriber by taking a look at our virtual analyst reports. so you can find out a good bit about the company description and the unique value for the company. It looks like S &DL is pretty well diversified in its operations. Operates also within other lifestyle brands like Liquor, really, really good profitability metrics, No Debt, robust retail network, et cetera. So marginal difference, but I'd say between Tilray and S &DL, S &DL scores a bit more highly from a quant perspective.

19:40And for those observers that have been around cannabis for a while, you are well-versed in this caveat. For those who are newer to the industry and wondering if they should be getting in, please be aware that there are many risks afoot. As Emma mentioned, there's also the 280E issue in terms of what cannabis companies are taxed with and whether that's going to be a thing of the past when it comes to the rescheduling federal legalization conversation. Also, management plays a big part. There's a lot of variables and intangibles, especially, I think, in this sector specifically. I'm also curious, and you may not have a strong opinion on this, but looking around at the MSOs, which are the multi-state operators, those are the bigger companies with a bigger spread, more tentacles in more states.

20:35Also a question as legalization develops, what kind of upside those MSOs do have. According to QUOT, many of them are holds. Green Thumb, I would say, is at the top of the list in terms of people's favorites of the bigger cannabis stocks and the consistency that it's shown and its strong balance sheet that it's consistently shown. if you look at the factor grades of Green Thumb, they're pretty good grades. But then when you look at growth, it's a failing grade. Revisions are not good. What would you say if you want to, let's say, use Green Thumb as an example? Because that seems to be everybody's favorite stock.

21:15And I know you're not a cannabis expert. You're a quant expert. You're an ETF expert. But what would you say are the things that even for a stock like Green Thumb or a True Leave that people might be more excited about. What are kind of the challenges that you see from a quant perspective and why those are holds and not buys? Yeah, I think when you dig into the growth grade for green time, I'm looking at it right now, what seems to be dragging down its growth grade would be its EPS for long-term growth. So, you know, it's quite a bit below the sector median. it's negative 36 % versus 10 % for the sector.

21:57You know, what that tells me is it's, this might be a longer term play, like this might be something people have to wait and see for it to pay off. You know, given its size relative to other, other companies, it could be preparing for some acquisition targets. I'm not sure. Like, like you mentioned, I'm not an expert, but that is really what's impacting it from a growth perspective. And then from a revisions perspective, look, these companies, they're relatively small compared to a lot of publicly traded companies, and it's a very nascent industry. So they don't get a ton of coverage, analyst coverage.

22:38But this actually, what I'm seeing is seven downward EPS revisions versus one upwards. that's eight eight analysts are covering this that's actually a decent amount and so you know the earnings expectations in the near term um and projected you know throughout you know the next five or so years people aren't expecting much so i would say the combination of those two things suggests that uh this is going to like i said maybe be a longer term wait and see type of investment Yes, yes. A lot to beware of when looking at this space. But might I also add in a question for you? When it comes to valuations these days, a lot of talk about how it's so hard to properly value a stock, be it in cannabis, be it in tech.

23:31so many overlapping sectors, so many promises not yet realized, hard to suss out where it exactly is going to land. When you're looking at valuations from a quant perspective, is there something that you especially keep in mind these days in particular? I will say the benefit of quant is it's a really comprehensive framework. And I know some folks aren't going to like to hear this because, you know, I think people are looking for a price target or a suggested entry point. But you really want to look at evaluation framework holistically. And these submetrics are, we can't necessarily share what's everything that's in the secret sauce, but these are weighted according to their predictiveness.

24:19That's not available to the user, but you can kind of see how these submetrics roll up into an overall grade. Some matter more than others. So I will actually, I would encourage investors to look at something, a valuation framework from a more comprehensive perspective, because as you mentioned, there are so many intangible qualities that can impact a stock. And so your simple price to book or price to earnings, those conventional metrics, they can't be seen as standalone factors. They have to be looked looked at within the bigger framework. And that's really the advantage of quant. I mean, we're taking thousands of data points and distilling it down to an instant characterization, and that's really the service we provide.

25:01And if you look at the track rating of quant ratings, they do beat the market over the long term. So that's my two cents. That's a lot more than two cents, Emma, and I appreciate it. Curious, as we're closing out this show, first of all, really appreciate your time and energy and insight and information today. Going to leave all the links that we discussed, the Canna Comparison portfolio to all the factor grades, a lot of the links that are going to help you out for those not in the know yet. We're going to leave them in our show notes. And for those reading along in the transcript, perhaps on Seeking Alpha, we're going to have that.

25:35We're also double posting this to the Cannabis Investing Podcast. For those of you that don't know that I have hosted in the past, it's not very current because there is not much new information afoot. And to the point at hand, also not a lot of capital in the industry being changing hands right now. A really slow time, but also some promises and some excitement at hand. I'm curious, Emma, if you would add anything else to the conversation in terms of being aware that it's a burgeoning industry. Anything else to keep in mind? And then also curious what, if anything, you find the most exciting sector to be looking at right now, perhaps?

26:26Oh, wow. I put you on the spot. I know. It's a really weird time in the market. I mean, like you read, I just, my inbox is littered with thousands of newsletters and it's just, you know, we characterize this as the everything rally right now because you're seeing just, you know, these small cap AI stocks, you know, rocketing off and you're also seeing gold and silver taking off. So we've got a lot on the horizon and I'm not going to plug a specific sector, but if I can add that we will be covering specific stocks that might benefit from a rate cut next week. My eyes are on what the Fed's going to do.

27:11If it's a 25 bps cut, if it's a 50 bps cut, how that's going to impact small caps. I think I'm really focused on small caps at the moment. So that would be where my interest is. I mean, really interesting time for the U.S. Look, like politics aside, we have no idea what's going to happen. And like I said at the top of this discussion, this is something that has bipartisan support. So whether you think Congress is ineffectual or not, there's huge consensus around this. And we don't know the pace at which things are going to develop. We don't know what's going to take priority from a legislative perspective.

27:46but seems like there's some momentum here. So like, let's keep reading, let's keep watching and let's keep looking at our quant grades. Yeah, absolutely. And not being overly dissuaded. It definitely is a sector that can dissuade you and leave you dispirited, especially for those that have invested a lot of their capital already. But yes, there is still, you know, I think the last episode we had on the Cannabis Investing Podcast was with Jesse Redmond and the headline was, have cannabis investors been early or wrong or both. And I think probably both, but I think the end line is there. It's just a matter of timing.

28:24And nobody knows that answer, of course. Emma, where can listeners, investors find your writing on Seeking Alpha and perhaps in general? So I contribute to the quant team. I appear with Steve Kress frequently on webinars of all varieties. And I also help co-host AlphaPix webinars. If you are an AlphaPix subscriber, you would be familiar with me there. I've also in the past contributed to the country investor. It marries my love of international affairs with ETFs. So I haven't contributed there in a bit, but all things QAMP, I usually have my hands on. So keep a lookout. Appreciate it, Emma. So also look for those Fed takes next week from Emma's team.

29:08We'll also have a couple episodes on investing experts to digest the all-important Fed meeting coming next week. Emma, thanks for the deep dive in cannabis today. Really appreciate it. Hope to talk to you soon. Thank you so much, Rina. Take care.

29:23Emma Johnston:Just a reminder, anything you hear on this podcast should not be considered investment advice. This is for entertainment purposes only, and you should seek advice from a licensed professional before investing. If you enjoyed the episode, leave a rating or review on your favorite podcasting app, and we'll see you soon with a new episode. Thank you.