You'll Never Guess Who's Betting Against Canadian Cannabis Stocks

Curaleaf Holdings (NASDAQOTH: CURLF) is the largest multistate operator focused on tightly regulated marijuana markets along the East Coast. Curaleaf's executive chairman, Boris Jordan, also runs Measure 8, a venture fund that recently stirred up some controversy with a questionable acquisition.

In the near future, Measure 8 wants to launch a hedge fund that will bet on U.S. marijuana stocks and against Canadian cannabis producers at the same time. Here are some reasons this strategy makes sense, and some reasons it doesn't.

Why shorting Canadian producers makes sense

The sales explosion that adult-use marijuana legalization was supposed to ignite is a dud. According to Statistics Canada, inventories rose in February compared with January while sales declined, and it's not hard to see why. Health Canada insists on putting public safety ahead of the industry's needs.

Plain-packaging rules will make it extremely difficult to build a recognizable brand. Health Canada also intends to limit the amount of THC that can go into edibles and beverages to a level too low to affect around 6% of the country that uses cannabis daily.

Perhaps the biggest reason to bet against Canadian producers is the oncoming glut of licensed cannabis. The 10 largest pot growers could soon be able to produce 3.3 million kilograms annually, and there are over a hundred smaller producers flooding an overall market that wasn't exactly starved for cannabis in the first place.

If we annualize total sales from the first two months of 2019, it looks like Canada will only need around 539,000 kilograms of licensed cannabis this year. If this figure doesn't start rising again, Aurora Cannabis (NYSE: ACB) will soon be able to supply the entire Canadian market for licensed marijuana while running at half capacity.

Canopy Growth (NYSE: CGC) will soon be able to grow enough licensed cannabis to supply the entire country as well, but it's unlikely to see a great deal of sales growth while sharing the Canadian market with Aurora and dozens of smaller producers.

Even though Canopy and Aurora are losing money now, their combined market value at the moment is a stunning $24.7 billion. Once more investors realize how difficult it will be for these businesses to simply break even, their stock prices will tank.

Why buying U.S. cannabis businesses makes sense

In the U.S., annual legal marijuana sales climbed to $10.4 billion in 2018, and there's still plenty of room to grow. In 2017, annual demand for recreational cannabis, state-legal or otherwise, was estimated at $50 billion to $55 billion.

In 2017, just 4,869 Canadians were charged with cannabis-related offenses, which was 53% less than in 2013. In stark contrast, police in the U.S. are still arresting people vigorously. In 2017, the FBI counted about 659,000 marijuana-related arrests across the country. It varies by state, and by prosecutor, but a lot of those people end up with a criminal record that permanently shrinks their career options.

It also helps that the federal government is completely hands-off from a regulatory standpoint, for now. As a result, some companies selling cannabis in the U.S. are actually making money.

For example, Florida-based Trulieve Cannabis (NASDAQOTH: TCNNF) reported a $75.2 million operating profit last year. During the same period, Aurora's operations lost $60.5 million and Canopy Growth's lost a stunning $339 million.

Why following the lead of Measure 8 is a terrible idea

There are no limits to a short-seller's suffering when stocks rise unexpectedly. Canopy Growth, Aurora Cannabis, and many of their giant Canadian peers will never run all of their greenhouses at full capacity, but markets can behave irrationally a lot longer than you can remain solvent.

Federal legalization might seem like the best possible development in the U.S. market for legal cannabis, but it's far more likely to cause a disaster. A lower likelihood of going to jail for cannabis-related offenses tends to embolden illicit markets the way it has in Canada and in most members of the European Union.

In California cities, licensed cannabis shops that follow all the rules at great expense are struggling to compete with unlicensed delivery services and storefronts that are added to the Weedmaps app faster than they disappear.

Rescheduling cannabis would also bring marijuana within the purview of the Food and Drug Administration. There's a chance that THC-containing cannabis products that can turn your mind upside down will get the same leeway from the FDA that it offers to CBD supplements that aren't the least bit psychoactive. But that isn't a bet anybody should be willing to take.

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Cory Renauer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.