Insider Monkey is in the business of identifying and following smart insiders, hedge fund managers and prominent investors. Our flagship investment strategy, which identifies the 30 best stock picks of the 100 best performing hedge funds, returned more than 77% since its inception nearly 4 years ago and outperformed the S&P 500 ETF (SPY) by 22.5 percentage points. It doesn’t make sense for us to pay a hedge fund manager management and incentive fees to invest in publicly traded stocks. There are only a handful of fund managers who deserve large fees and most of them operate in new industries and are hard to find early.
Today I am going to talk about one of these funds: Phyto Partners. Let me first talk about another fund manager who deserved large fees. I met this fund manager 8 years ago. His investment strategy was extremely simple. He bought privately held Facebook shares from former employees and investors who wanted to cash out. Facebook was valued at around $20 billion at that time and there were a lot of investors who were interested in Facebook but couldn’t do so because Facebook wasn’t a publicly traded company.
This fund manager was providing a service that wasn’t widely available at that time and he deserved every cent of the fees he collected from his investors.
Phyto Partners provides a similar service in the Cannabis industry. Even though recent polls suggest that 6 out of 10 Americans support legalizing recreational use of marijuana and even more numbers favor legalization of medical use, it will be years before we start seeing marijuana in grocery stores or smoke shops nationwide. Until then the federal government could decide to launch a crack down on the industry at any time in states that already legalized marijuana use. This poses an unknown risk that many investors are unwilling to accept.
Despite the legal challenges, investors embraced several marijuana stocks that trade over the counter or in major exchanges. Cronos Group (NASDAQ:CRON) is the only pure play marijuana stock that trades in a major US exchange. Its market cap is north of $1.5 billion. Canadian growers Canopy Growth Corporation (NASDAQOTH:TWMJF) (market cap of $5 billion), Aurora Cannabis Inc (ACBFF) (market cap of $4.5 billion), and Aphria Inc (TSX:APH) (market cap of $1.9 billion) are among other popular marijuana stocks among investors. Unfortunately, one of our favorite influential short sellers, hedge fund manager Anthony Bozza, thinks these stocks are hugely overvalued. Here is what he said in Lakewood Capital’s latest investor letter:
“Ever since recreational marijuana was legalized in Colorado in 2013, retail investors have been in a frenzy to try to play the impending cannabis boom, often being sucked into many stock promotions and scams along the way.
Despite a trend towards increased legalization of recreational marijuana at a state level, it is still illegal to sell pot under U.S. federal law, and consequently, investors have flocked to Canada based cannabis companies that operate safely outside of the purview of the U.S. government. Enthusiasm has been particularly acute in the past year as anticipation grows for Canada to legalize marijuana for recreational use in mid-2018. Heading into the final months of 2017, each of these public companies sported market capitalizations that were nearly impossible to rationalize, but nonetheless, the stocks saw their values more than triple in just a few short weeks around year end as focus turned to the legalization of recreational marijuana in California on January 1, 2018.
Despite the recent mania around the legalization of recreational pot in California, there is a little problem: none of these companies sell at all into California (or anywhere else in the U.S. for that matter), since that would, of course, be illegal. The fund is short both Canopy Growth, a C$7.5 billion market capitalization company, and Aurora Cannabis, a C$6.5 billion market capitalization company. I suppose it’s easy to understand the appeal of these stocks to the casual investor – strong regulatory momentum, constant press coverage, growing public acceptance, an absence of large incumbents and an enormous, rapidly expanding market opportunity. These attributes would serve as the foundation of an intriguing investment thesis if getting into this business wasn’t so simple.
Canopy Growth will lead you to believe it is building competitive advantages through its industry-leading capacity expansions or partnerships like the one it struck last year with Snoop Dogg and his “Leafs by Snoop” brand or by potentially one day selling cannabis-infused beverages through a relationship with beer, wine and spirits company Constellation Brands (which would be illegal in the U.S.). Aurora Cannabis might tell you they have an advantage as the only grower in the lowcost Alberta region nestled in the Canadian Rockies (but only if you ignore the fact that no one else grows there because of negative 10° Fahrenheit weather conditions or the frequency of hail storms that at a minute’s notice could destroy their entire greenhouse operations) or through their accomplished management team led by Alberta’s “youngest master electrician” and founder of one of Canada’s “Top 50 Fastest-Growing Companies” (which actually is just a tiny Alberta-based construction permit and inspection company called Superior Safety Codes).
But, what these companies certainly won’t tell you is that the number of licensed producers in Canada has doubled in the past year and is growing rapidly by the week, it costs just a few thousand dollars to obtain a cultivation license, the industry has collectively raised an astonishing C$2.1 billion in recent quarters and leading producers announced plans for a greater than ten-fold increase in their capacity over the next eighteen months.
Remarkably, we estimate that Canopy Growth’s current production capacity can be recreated for less than C$150 million, and Aurora’s current production capacity can be recreated for less than C$100 million, just a small fraction of their current enterprise values. The industry’s stock valuations have become so extreme that one co-founder of a leading Canadian producer told us he would not “touch [these stocks] with a ten-foot pole” and that he thought they were “way overbought” even before the recent run-up in the stock prices. Simply, we believe it is not a matter of if, but when these stock prices collapse… otherwise we should all be moving to Canada and growing pot. After all, a $100 million production facility should be good for at least $5 billion of market capitalization in the current environment. This cannot and will not last.”
I share Anthony Bozza’s sentiment towards marijuana stocks. Investors rightly sense that the marijuana industry is going to be huge but they really don’t know how to take advantage of this impending boom. For the time being they are flocking into publicly traded over the counter stocks and we believe this has created an over valuation bubble in these stocks. This isn’t the smart or sensible way to invest in marijuana stocks unless you are a short-term trader who can sell his holdings to a patsy who will be holding the bag when these stocks return to more reasonable valuations or collapse completely.
So, what is the right way of investing in marijuana stocks? I believe Phyto Partners has the right idea. Last week I spoke with Phyto’s Managing Partner Larry Schnurmacher who makes equity and debt investments in privately held, early stage companies that provide business services and solutions to the licensed operators in the cannabis industry. Phyto is basically investing in companies that are selling pickaxes during a gold rush. This is the first right thing Schnurmacher is doing right. Phyto’s portfolio companies will benefit from the overall growth of the marijuana industry but they won’t have to predict the winners and losers correctly to be successful.
“We see numerous ancillary businesses that will be necessary and critical to facilitate the growth of the industry. Testing labs and equipment, customer relationship management, business intelligence, data analytics, grow technology, extraction equipment and services, packaging, are all areas that we believe offer tremendous opportunity for innovation and development and will undoubtedly be high growth areas as all licensed operators will require supportive business products and services to execute their plans,” the fund says on its website describing the types of companies it is investing in.
Phyto looks for companies with $5 to $15 million in total valuation and looking to raise $500K to $3 million. This means by investing early, they pay reasonable prices whereas small investors are tripping over each to invest in publicly traded stocks at bubble prices. This is the second right thing Schnurmacher is doing.
Phyto’s first fund closed and is currently invested in 10 companies. While some of these companies will fail, some will become the cannabis unicorns of the industry. The key to investing in an emerging industry is diversification. This is the third right thing Schnurmacher is doing right. 6 of the 10 portfolio companies have successfully raised additional growth capital at 2 times to 6 times Phyto’s original cost. Leaflink, Baker, and FlowHub are among Phyto’s most successful investments to date and Phyto has participated in their follow on rounds.
LeafLink, an online marketplace that connects marijuana producers and distributers with dispensaries, just raised $10 million in November at a $50 million valuation. Baker, an online pre-order and loyalty rewards solution for the cannabis industry, raised $8 million at a $37 million valuation. Flowhub, which we previously covered here, was valued at $17 million in October when they sold convertible notes.
Last week Phyto Partners launched its second venture fund. The $100 million fund will follow the same recipe as the first fund. It will invest in the right companies at the right prices and spread its bets across multiple companies to diversify away risk. “Phyto focuses its capital on companies that can easily scale, require low capex, and have reasonable valuations. Most importantly, we only invest in companies with viable exit strategies. Our ultimate goal is to monetize our investments for our partners,” Schnurmacher said about the fund’s approach.
Phyto Partners charges an annual management fee of 2%. The General Partner receives a performance fee of 20% only when the investor capital is returned and only if the fund exceeds an average annual return threshold of 8%. I believe investing with the insiders of the industry and paying reasonable performance fee only when minimum performance thresholds are met is a better option for investors than investing in publicly traded marijuana stocks like Canopy Growth Corporation (NASDAQOTH:TWMJF) and Aurora Cannabis Inc (ACBFF) that are targeted by a renowned short seller for having lofty valuations.
Learn more about Phyto Partners at https://www.PhytoPartners.com.