Here's Why Cannabis Investors Shouldn't Ignore Cigarettes

Should cannabis investors be buying stocks in the tobacco realm? Is now a good time to invest in pot stocks? How long should investors hold their pot stocks? These are just a few of the questions we ask Meb Faber, CEO and CIO of Cambria Investment Management.

The Motley Fool sat down with Faber to talk about Cambria Cannabis ETF (TOKE 2.37%). The quant firm's low-cost cannabis fund seeks exposure to the broader marijuana industry with top holdings including Altria (MO -0.26%), Philip Morris (PM -0.94%), and British American Tobacco (BTI -0.76%).

Corinne Cardina: Hello there, Meb. How are you?

Meb Faber: What's up?

Cardina: Welcome to Fool Live. We're live.

Faber: Great to be here. Good morning.

Cardina: Good morning. So great to meet you. I was just telling our guests, we are so excited to welcome you, CEO and CIO of Cambria Investment Management. You all have an ETF called Cambria Cannabis ETF (TOKE 2.37%), and the ticker is TOKE, so that's pretty fun. I'm going to put that in the chat, so that our attendees can get that ticker, if they're interested. We're going to spend the next 15 minutes talking about this ETF and zooming out a little bit to the cannabis landscape. Then the second 15 minutes, I'm going to bring on a Fool.com contractor to dive into some pot stocks. But Meb, I would love to dive in to the sector, and talk about the strategy behind TOKE ETF. Can you tell us a little bit about the investment thesis?

Faber: Sure. Great to be here, guys. Let me give you a little background, it's foundational, because it's important, because I don't think thematic funds offer value. That's a weird way to start a podcast about a thematic fund from someone who manages one. We manage 12 ETFs, and for those who have followed us for long enough, would realize that we're mostly a quant shop. We've been around since before the last financial crisis, so over 10 years, and manage funds that represent all sorts of things, real estate, asset allocation, tactical, quantum value, everything else. We manage almost a billion dollars. What are we doing launching a cannabis thematic fund? When you think about thematic funds, in my opinion, there's only three reasons to ever consider one. Is there a factor that works particularly well suited to a certain sector or industry or theme? We say themes, it could be something like a sector or industry like cannabis, or something like emerging Africa, or companies in Nashville, or companies developing cancer drugs. Some are sensible and some don't really make much sense, they tend to be marketing oriented. So there's really three reasons to think about doing a thematic fund. First is factor-based. Is there a factor that applies specifically to a certain theme? A good example would be real estate, something like funds from operations. Or you apply factors across the sectors. I mean, one of the oldest strategies out there ever is a sector rotation strategy. People have been doing that for decades. Or something like old-school value.

One of our largest funds picks the 12 cheapest countries in the world stocks, so it's like a value rotation. Second, would be if someone wanted exposure to a theme based on what we call mean reversion. If you go back to our very first investment book, and most of our books are free on our website, if you go, you can download them, called the Ivy portfolio, we wrote about mean reversion. We took the French pharma data, which is free online, you guys can go download it for free, all the way back to the 1920s for any sector in the U.S. You could take it back to the 1920s when you bought sectors that were down 60, 70, 80, 90 percent, usually, they had good returns the next following three years. That's going to become relevant in a minute as we talk about cannabis as well. Lastly, is structural. Is there a structural reason why someone should be interested in a theme that has some sort of inefficiency? The classic example, somewhat tangentially related to cannabis and that's tobacco. I grew up partially in a town in North Carolina, where literally, my high school was named after a tobacco company. People could smoke in high school. Not inside, but you could still smoke in restaurants at that time. But tobacco, obviously, one of the most maligned sectors or industries on the planet. Every single ESG fund on the planet doesn't own tobacco stocks. Meanwhile, if you go back 1920, what is the single best performing industry in history? It's tobacco. There are these structural inefficiencies, so long-winded example of why we are getting to cannabis now. As a quant, I saw this setup where you had a few of these factors aligning. The first is, you had the structural inefficiency, so you couldn't own many cannabis companies. We had this fund filed for a really long time, and none of our service providers would let us launch it. If you remember the history of cannabis funds, the first one that came out actually wasn't a normal launch, it was a conversion of a Latin American real estate fund into a cannabis fund. So it was a bit of a work around. But we saw the scenario, and many people have talked about this, but we put some numbers to it. By the way, cut me off if I'm droning on too long.

Cardina: No. Great stuff.

Faber: Highly resembled is set up from almost a century ago, and of course, that's prohibition. It's pretty rare to have a market that has a built-in customer base, a customer base that's pretty adamant. It's not seen for many people, as a discretionary purchase as part of their life, but it's also a black market that's becoming opened up. So that's obviously what's happening with cannabis not just here, but all around the world. But if you go back to the 1930s, the fun part, is you can do quant studies on how did the alcohol companies perform in 1933 and the decade following? We ran through all these numbers and found out that sure enough, that had you invested in these companies post prohibition, you would have had excellent returns. I think it was 20% returns for straight-up decade. I didn't look at it past a decade because the catalyst was probably baked in at that point. What's interesting also, was that the performance, a lot of it came in the second half of the decade when all the pump and circumstance of probation lifting may have gotten baked into the stocks, but really once you had the maturation of the actual industry, as you saw a lot of the big returns. So we saw the possibility of a lot of these factors aligning when we eventually put together to fund. I'll wind down here. The problem with a lot of funds, as we all know, in not just thematics and cannabis, but everywhere is of course, fees. We write ad nauseam about fees, and Cambria is proud, all 12 of our funds are cheaper than their category averages and some of them they're cheapest fund in the entire category. That's the case of course, with cannabis fund where it's the cheapest fund, but that has a huge impact on long-term performance. I'll wind down. That was my basic intro on why we were attracted to this space.

Cardina: Excellent. For some of us who have been watching the marijuana market for a while, we've seen some of these cycles of hype and disappointment, generally focused around some catalyst, whether it's Canada opening up their recreational market, Canada opening up an additional recreational market. In the U.S., it's been really piecemeal. I'd love to hear why you think now it's a great time to start investing in cannabis and maybe that can speak to some of our viewers who have not yet taken the plunge into this space, but maybe interested in doing so.

Faber: I tend to be a little bit more sober is probably the wrong word, right adjective. But when approaching ideas like these thematics. Back when we could do events in person I used to go to the Cannabis Conference in Las Vegas, and they had an institutional investing day. I went a few years ago when cannabis was in its upward trajectory of all the stock's going to the moon and sudden on the institutional invest and gain. This was before the fund was launched and looked around and the things that I heard reminded me so much of the late 90s, Internet ideas. People were getting up and giving presentations and saying you cannot value cannabis stocks based on any metrics evaluation. They started coming up with all other reasons why you could only stocks with value and fundamentals was never one and obviously a red flag. I think people were drinking beers and vaping and smoking in the conference. It is about 10:00 AM. With any gold rush, you have people that are attractive from all sides when they see the money flowing. You have big conglomerates, you have people that are a little bit shady, and then of course, companies from all locations and domiciles ready to get in on it. We launched this fund. I actually went on Bloomberg and you can find the video and a very similar question was asked and this would have been, I guess, last summer. This feels like the longest decade ever, this one year. I think it was last summer. 2020 is almost over. We still have two months left. I don't know how that's possible. We still have some more time left in this year. What else could they throw at us? Aliens, I don't know.

Cardina: Don't jinx us.

Faber: Nice aliens though, you never know. I went on TV and they asked me some more question. I said, "Actually, look, I'm not going to stand here and be this unabashed bull." I think many of these companies are pre-earnings. Some of these companies are pre-revenue and the valuations seemed to be pretty expensive. My approach to this is one where it's a decade long approach. It's not next quarter, next month, next year. The way that I think about it is, I want exposure to this theme. It's going to be probably in no other part of the world do I recommend this. A very tiny portion of the portfolio, but the market go down, instead if it goes down 50%, I'll buy more, if it goes down 50% from there, so 75% down, I'll buy more and if it goes down 50% from there, I'll buy more and sure enough, you've largely had that last year where these companies have gotten pummeled. But we might be seeing light at the end of the tunnel. You have these cycles like you mentioned, they tend to wash out a lot of the bad. You have the companies and the created disruption of the free markets that allow many of the sustainable business models to survive. My long-term both thesis also, you mentioned a lot of the catalyst and I think that will happen. Of course, we're talking about them. You may put them under the category of expected. The one that I would've thought might have happened prior to election was that I thought both parties would have tried to outlook each other and get some banking legislation passed. I think the eventual opening up is an inevitable, but I think we all know that. That's just a question of when, not if. Hopefully, things seem to all be moving in the positive direction. You have that second factor I mentioned, which is the mean reversion now. I think a lot of the cannabis indices were down 60, 80 percent. Picked it off, this year one point. That's usually a pretty good setup. This goes back to an old investing joke and says, what do you call a market that's down 90%? There was a market that was down 80% and then went down by half. The problem is just being down 70, 80, 90 percent doesn't mean that it can't go down more and there's still a lot of risk. But long-term perspective usually means that there is some opportunity.

Cardina: Excellent. Last question before we have to let you go, we talked a little bit about timeline and you said investors should be ready to hang onto this for at least a decade to see the positive accumulation, but are there any other characteristics of investors that you think this ETF would be a good fit for, people who are looking more for growth or for value. Any thoughts there?

Faber: All the different cannabis funds have different flavors and that's fine. Some people want exposure to the multi-state operators. Some people always has a tilt toward a little bit about tobacco. Do you know there's not a single tobacco fund in existence in the U.S.? Which I find to be very surprising. I think there's a lot of opportunity, those stocks, most they've been cut in half since 2017 too. Some of those on the barbell exposures sporting 5-10 percent yields. Yields in a world where I hear treasuries are less than one. Real quick about time horizon. I often talk to clients. We have over 60,000 investors and I talk to clients and they'll ask me something to talk about one of our funds and then would say, "Meb, I'll buy your fund, it's not doing well. I've held over six months. I'm going to give it a few more months. We'll see how it goes." I say, "Oh, no, it can get way worse than that." They laugh awkwardly and they're like, "Well, how long should I give it?" I used to say 10 years. They would laugh even more awkwardly thinking I'm joking. Now, I actually say 20 years. Let me explain why. If you're going to do an active approach, move away from the market cap weighted index, which is free, essentially free in 2020, it's about five basis points, to get a World Index. The new better be pretty weird and different, and have a long-term time horizon, and real quick, why? There's no more universally held belief and all of investing then stocks outperformed bonds. I don't know a single person that doesn't believe that. However, you asked most people how long would you be willing to give an asset underperforming? Most people said two to three years, and that's institutions too, by the way. Stocks at one point this year in March versus the long bond in the U.S. had gone 40 years of similar performance. That is insane if you think about most people were expecting, oh, no, I need my returns, I need them now. You thinking about something as crazy as cannabis, which is an extremely concentrated sector that's pretty small and then most people are thinking about next week, next month, forget about it. You guys have me back on in 2030. We'll do this again. It'll probably be on holograms or teleporting somewhere. But we'll talk about how cannabis has done then. Long-term perspective, put in the lockbox and put it away for a decade.

Cardina: Awesome. Well, thank you so much, Meb. Good luck with your new ETF and we will keep in touch.

Faber: See you guys soon, bye bye.