When the curtain closes on 2018, chances are that one of the biggest news events of the year will be Canada's legalization of recreational cannabis. Following nine decades of prohibition, years of promises from Prime Minister Justin Trudeau, and many months of debate in Canada's Senate, the Cannabis Act, which went into effect on Oct. 17, 2018, allowed our neighbor to the north to become the first industrialized country in the world to green-light adult-use marijuana.
Although sales estimates vary wildly, as we'd expect to see from an industry that has little legal precedent around the globe, Wall Street is looking for somewhere in the neighborhood of $5 billion in added annual sales once the industry is fully up to speed. This rapid surge in sales, along with economies of scale working in the favor of large growers, should yield healthy operating margins and profits.
The big question that's being asked now is: When will the United States follow suit?
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Gallup's latest survey shows support for cannabis from two unlikely groups
Through this past weekend, 30 states had passed broad-based medical marijuana laws since 1996, with nine of those states also allowing for the use and sale of recreational weed.
What's more, a majority of the American public is now in favor of legalization, at least according to Gallup's newest survey. In a report released two weeks ago, Gallup found than an all-time high 66% of adult respondents favored marijuana being made legal. That's up from 64% in 2017, 60% in 2016, 50% in 2011, and just 25% in 1995. In other words, support for the cannabis movement has come a very long way in a short amount of time.
However, Gallup's October 2018 poll brought with it two notable surprises.
To begin with, for a second consecutive year, a majority of self-identified Republicans favored the idea of legalizing marijuana. Following the 51% who agreed in 2017, some 53% of Republicans were in favor in 2018. Mind you, a majority of Democrats and Independents have been in favor of legalizing pot, per Gallup's survey, since 2009 and 2010, respectively. Republicans, who currently control Congress, have had little incentive to change marijuana's scheduling in the U.S., despite polling figures that suggest American support favors legalization.
The other surprise is that, for the first time ever, a majority of older Americans (aged 55 and over) also favor legalization. Last year, 50% of seniors favored legalization. Now 59% of older Americans are in favor of waving the proverbial green flag. As has been the case for decades, support for legalization tends to decrease with age. Comparatively, 78% of 18- to 34-year-olds were in favor of legalization in Gallup's newest poll.
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Two reasons lawmakers will overlook this data and keep marijuana illegal
With virtually every poll, including Gallup's, showing overwhelming support for recreational and/or medical legalization, you might expect change to soon follow at the federal level. In that, I believe you'd be sorely mistaken.
Among the biggest impediments to legalization are lawmakers on Capitol Hill, including President Trump. Republicans generally have a more negative view of marijuana than Democrats or Independents, so they're far less likely to go along with the idea of legalization.
Additionally, President Trump has wavered on taking a side when it comes to recreational cannabis. During his campaign, he preferred a wait-and-see approach, with many of his political allies in the Senate and House of Representatives also having reservations about the long-term safety of the drug. In other words, there's still little incentive to put reform on the docket.
The other problem here is that legalization could actually cost the federal government money. The whole idea probably sounds preposterous given that cannabis could be taxed, but I assure you, it isn't.
The concern is that profitable cannabis-based businesses are currently subject to Section 280E of the U.S. tax code. In layman's terms, this tax section disallows businesses that sell a federally illicit substance from taking normal corporate income tax deductions, save for cost of goods sold. This can lead to an effective tax rate of as much as 70% to 90%. If marijuana were suddenly made legal, Section 280E would no longer apply to pot companies, thereby allowing them to take normal corporate deductions. In doing so, even with a reasonable excise tax, the federal government would lose revenue. That could be a tough pill for the federal government to swallow with the fiscal 2018 federal budget deficit hitting its highest level in six years.
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Investors should focus on larger legal markets
As much as Americans and investors might like to see the U.S. government change its tune on pot, it simply may not happen anytime soon. That means investors might be best off not paying too much attention to the U.S. cannabis market until such time as the federal government does change its mind.
If, however, you are willing to stomach the added risk of investing in U.S. pot stocks, then my suggestion would be to stick with larger markets that offer clear potential, even if the federal government doesn't cooperate.
For example, small-cap medical cannabis grower Liberty Health Sciences (LHSIF +0.00%) could provide healthy returns for investors despite being solely focused on Florida. Even though cannabis is only legal for medical purposes in Florida, it's a state with a notably older population that could benefit from medical marijuana/cannabidiol prescriptions.
Liberty Health Sciences holds one of just over a dozen permits to grow cannabis in the state and, when its newest production facility is complete, will boast the largest production capacity in the state. Already working with around 15% of the state's market share, Liberty Health Sciences could increase that to 20% to 25% once its new production comes online. And as icing on the cake, if Florida does move to legalize recreational weed by or before 2020, it would place Liberty Health at a competitive advantage given its production capability.
You'd also be wise to keep an eye on a player like Origin House (ORHOF +0.00%) (formerly CannaRoyalty). Origin House expects to derive the majority of its business from California, a market with the potential to generate $6 billion to $7 billion in peak annual sales. Within the Golden State, there are expected to be thousands of brands competing for shelf space in hundreds of licensed dispensaries. Yet there is only going to be a small handful of licensed distributors in the state. Origin House aims to control as much of this distribution market share as it can, leading to predictable cash flow and profitability.
The U.S. marijuana market has plenty of risk, but if investors stick to larger markets, they have an opportunity to succeed.
