A combination of factors, including the escalating trade war with China and concern that the fiscal stimulus efforts that drove economic growth will fizzle out by the end of 2019, are producing speculation among economists and investors that another recession could be around the corner.
Meanwhile, the steady march toward legalization has fueled remarkable growth in the cannabis sector over the last several years. While the outlook on cannabis remains bullish, many wonder how this emerging sector will respond to a major economic downturn.
Will the steady stream of retail capital, venture capital and private equity funds spurring cannabis industry growth dry up and bring expansion to a shuddering halt? Or will the cannabis industry – and individual cannabis private and public companies – demonstrate the historical counter-cyclical behavior we’ve come to expect from ”vice” industries, such as alcohol and tobacco?
Assessing the Likelihood of a Recession
The experts can argue about the severity and the timing, but – on the heels of an extraordinary 10-plus years of economic growth and stability – most agree that it is at least wise to prepare for a significant slowdown. Portfolio adjustments are probably in order, as prepared investors will start considering bonds, dividends, stability and commingled accounts.
It is also time to start thinking about defensive stocks – and add cannabis and cannabis-related equities to those considerations. If you have an option to invest through private markets, those opportunities may hold a key to more value, albeit with slightly less transparency to the public market.
How Have Alcohol and Tobacco Performed?
Clearly, the cannabis industry has never encountered a recession and as such, we can’t revisit history and cite earlier performance, milestones to watch or other informative data.
We can, however, note that the industry would enter a recession with what arguably appears to be very strong fundamentals. According to one report:
- Global consumer cannabis spending is expected to surge 38% in 2019 to $16.9 billion, up from an estimated $12.2 billion in 2018, $9.5 billion in 2017, and $6.9 billion in 2016.
- Compound annual sales growth between 2017 and 2022 is expected to average 26.7%, with $31.3 billion in global marijuana sales expected in 2022.
Additionally, the industry got an important kicker in 2018, when passage of the U.S. Farm Bill made the cultivation of industrial hemp legal nationwide.
It can also be insightful to go back and review the performance of comparable industries, in this case we will examine “vice” industries, specifically alcohol and tobacco. All have track records that provide at least some degree of visibility of what we might expect from cannabis.
The alcohol/tobacco example that followed the recent Great Recession is particularly informative. Consider (information compiled by financial information company Sageworks):
- In 2008, the first full year of the Great Recession, alcohol sales increased 9% and the average unemployment rate was 5.8%.
- In the 12-month period June 1, 2010-May 31, 2011, alcoholic beverage sales grew 10% in the U.S. and the unemployment rate hit 9.6%.
Takeaway: Consumers cut back on a great number of things when the economy turned, but drinking was not one of them.
Lessons (And Non-Lessons) Learned from Individual Stocks
Are there lessons to be learned by the performances of some of the individual stocks during and immediately following the Great Recession?
Yes and no.
Anheuser-Busch Inbev (NYSE: BUD) delivered a 39.4% return in 2008, which was nearly 80% better than the S&P 500. Revenue, however, climbed just 5%. The strong performance was not based on financial performance but, rather Anheuser-Busch’s acquisition by Inbev.
Lesson: Undervalued companies with market share will get noticed.
Shares of Altria(NYSE:MO), the parent company of Marlboro among other brands, gained 28% between December 2007 and December 2010. In the middle of that period (2009), the National Institutes of Health (NIH) put out a paper stating that smokers actually increased their cigarette intake during a period of economic difficulty.
Lesson: Price increases can offset weak sales. Brand power has value. Dividends are important in downturns.
Molson Coors (NYSE:TAP) is an interesting example, as the company’s “average-Joe” brand was overwhelmed by craft beers in the Great Recession. Example: the share price of The Boston Beer Co. Inc. (NYSE:SAM) advanced 80%. The issue has since been rectified, with numerous acquisitions, including Blue Moon, Leinenkugel, Hop Valley and Revolver. (Sidebar: Molson Coors, like Constellation (NYSE:STZ) before it with its acquisition of Canopy Growth (NYSE:CGC), also has a deal with cannabis company Hexo (NYSE:HEXO) to develop non-alcoholic cannabis-infused drinks in Canada.
Lesson: Consumers seek out “stress relievers” during stressful times. People with a little extra disposable income will consume products at the higher end of the pecking order.
Diageo (NYSE:DEO) is a global juggernaut, with a huge portfolio of brands, including Johnnie Walker, Smirnoff, Captain Morgan, Ketel One, and Guinness beer. The company continued to be highly profitable during the Great Recession, dropped a bit the next year and then more than recovered in 2011. Their dividend payout ratio is just over 50%.
Lesson: Brand power stays strong during a downturn.
There are a number of intangible differences across the cannabis industry that also need to be considered in any analysis:
- Illicit Market, Red Ink? – One major difference between cannabis and alcohol/tobacco is that in a recession the cannabis industry would still have to deal with the competitive pressures and potential price cutting of the illicit market. As an economic downturn puts pressure on consumers’ wallets, we could see a resurgence in illicit market offerings, cutting into legal profits.
- Strong Medical Tailwind – The cannabis industry really is two distinct sectors: adult-use and medical, and the differences are profound. As stated in the Cannabis Private Investment Review, the adult-use market is broader and has long-term growth potential, but the medical market has a number of strong characteristics. For example, U.S. public opinion is overwhelmingly in favor of medical cannabis; ample models of successful regulatory programs; the progress of medical cannabis at the pharmacological level, and the FDA’s 2018 approval of the first CBD-based medicine, are clearing the path for further de-scheduling of cannabis compounds.
- Mature Support Sectors In Place – The opportunity for cannabis investors extends beyond the well-known cultivation, manufacturing and distribution brands. Companies focused on research and development, accessory products, services, publishing and software all have carved out positions as well. In a recession, certain sectors may decline, but the diverse array of companies representing the cannabis industry could produce a mixed bag of winners and losers, evening out the industry’s performance as a whole, or even floating poor-performing sectors.
- Lawyers. Bankers. Politicians – Right now, the future of cannabis as a legal and regulated industry appears more promising than at any previous point as industry growth is being stimulated on several fronts. Doctors are beginning to embrace the medicinal value of cannabis and they are incorporating it into their practices. This is also supported by new efforts to enhance research and development throughout the US and internationally. Lawyers are pushing for legalization in jurisdiction after jurisdiction. Investment bankers and Venture Capital and Private Equity firms are stimulating a flow of needed capital. And even politicians are seeing that legalization is in their best interests.
Finally, there are some market watchers who believe the bull case for cannabis in a recession has almost nothing to do with the burgeoning industry being counter-cyclical, recession-proof or recession-resistant. Instead, they assert, the strong performance will be driven by economics, politics, balancing budgets and generating tax revenues.
Scenario: The prohibition remains at the federal level once the next recession hits. The economic downturn acts as a major catalyst for cannabis legalization at the state and federal levels in the U.S. and abroad. Legislatures will feel pressured to take action – and no jurisdiction will want to be left at the starting line as the others race toward to finish line, creating a possible “domino-effect” scenario.
“Recession-proof” is language that doesn’t belong in investment analysis. However, there is ample reason – based upon fundamentals, the track record of similar sectors and other investment considerations – to conclude that selective cannabis companies and public company stocks could, in fact, be “counter-cyclical” or “recession-resistant.” Accordingly, they should be seriously evaluated as investors consider adjusting their portfolio for a possible economic slowdown.