When Will Cannabis Be Legal at the Federal Level?

Old school dealers always reduce customer complaints by weighing large quantities on the heavy side. A pound of weed will come in at 16 ounces with a few eights throw in for good measure (about 1.5% more weight). The guy moving the bag between buyer and seller often can’t resist the temptation to pinch a few nodges for personal use. When the buyer finally gets the bag and weighs it, it still comes out heavy and they’re a happy customer. Everyone wins.

Nowadays, buyers and sellers just do stuff out in the open and nobody cares, at least in states where cannabis is legal. And that list is growing. As of America’s last election, four more joined the list of states where medical or recreational use is kosher. Given there are now more donkeys than elephants in the house, we’re led to believe that legalization at a federal level is now inevitable. In order to better understand that thesis, we sat down with the lads at KEY Investment Partners to talk about their recent piece on “Cannabis and the 2020 Election: Everything You Need to Know.”

The Poor Performance of Cannabis Stocks

Cannabis remains illegal at a federal level. This means that by default, cannabis is illegal in any state. That’s changing though, as states are now passing laws to legalize cannabis for medical and recreational use. The fact that it remains illegal at a federal level makes it very difficult to conduct business in the burgeoning cannabis industry. For example, multi-state operators (MSOs) cannot conduct business across state lines. There’s a great deal of regulatory risk that you cannot control, and that’s the main reason why we’ve avoided dabbling in the cannabis investment thesis. In looking at the performance numbers, we haven’t been missing out on much.

As a proxy of the cannabis industry’s performance, we can turn to the largest cannabis ETF, ETFMG Alternative Harvest ETF (MJ), which has now amassed over $1.4 billion in assets under management (AUM). Per the ETF’s own marketing collateral, 5-year performance was a dismal -4% compared to a Nasdaq return of +209% over the same time frame. Here’s a look at the top-10 holdings for MJ today:

Perhaps now is a good time to think about investing in the cannabis sector. As we said before, we need some assurance that progress is being made towards cannabis becoming legal at a federal level.

It’s highly unlikely that legalization will occur as one discrete “flip of a light switch” event, but rather as a series of legislative reforms that will take several years in the best-case scenario to implement.

Credit: Key Investment Partners

One much-needed step towards legalization would be to repeal IRS code 280E.

Legalizing Cannabis at a Federal Level

The State of California was the first to legalize medical marijuana in 1996 with recreational use becoming legal in 2018. People with boots on the ground know that the whole medical thing was a “wink, wink” and any Californian with the tiniest amount of street cred had a medical marijuana card. It’s often said that medical use is always a precursor to recreational use, and California was the epitome of that belief. Despite a rather mature medical/recreational market, black market growers still command about 30% of the Californian cannabis market. Why is that?

We believe that at least part of the reason is related to strains like true skunk that you just won’t find in legal dispensaries. The more likely reason is related to economics. It’s far cheaper to grow and distribute cannabis when you don’t have to follow any rules.

At the moment, cannabis operators have to pay an increased cost for banking services because most banks don’t want to get anywhere near an illegal product. Legalizing cannabis will remove this added cost, but that’s small beans compared to other low hanging fruit, like taxes, which make up about 22% of the cost of a legally grown pound of bubonic chronic.

Back in 1981, cocaine trafficker and living legend Jeffrey Edmondson filed his tax return claiming deductions for the costs of his drugs, his packaging, and some of the mileage incurred on his 1980 Chevette while delivering amphetamines, cocaine, and ganja. The IRS objected, so he took them to tax court and won. The following year, Congress reversed the decision and instated IRS code 280E which blocks deductions of any kind for businesses involved with illegal drugs. Today, the effect on the tax rate for cannabis businesses is rather dramatic:

If the tax code can be changed, the cannabis industry would become a whole lot more profitable.

This is where the story starts to get a bit complicated. KEY Investment Partners thinks it’s “unlikely that a standalone law will be passed by Congress to fix 280E, as the issue presents a difficult spot for regulators.” Instead, they expect passage of either STATES or MORE would remove Section 280E.

SAFE, STATES, and MORE

KEY has identified three acts that can be passed which lead the cannabis industry closer to legalization.

• The SAFE Banking Act – federal protections for banks servicing cannabis
• The STATES Act – deferment of authority to individual states that chose to legalize
• The MORE Act – federal legalization & permittance of interstate commerce.

The SAFE Banking Act would protect banks servicing the cannabis industry, and it passed the House of Representatives in May 2019 before being blocked. Perhaps they’ll try again now, though this won’t solve the IRS code 280E problem. If either the STATES Act or MORE Act passes before SAFE Banking, the need for the SAFE Banking Act becomes irrelevant. Both STATES and MORE solve the 280E problem.

The STATES Act

The STATES Act would grant autonomy to individual states and permit them to decide whether to legalize cannabis. In doing so, the STATES Act would eliminate the 280E issue for cannabis businesses and open capital markets to US cannabis businesses. Further, STATES would also ensure federal bankruptcy protection for US plant-touching operations, which has been an overhang on debt-lenders to cannabis businesses given the uncertainty of their collateral base. STATES would not allow for interstate commerce. KEY expects this to pass in 2H’21 or 1H’22.

The MORE Act

The MORE Act would legalize cannabis at the federal level and permit interstate commerce by descheduling cannabis from The Controlled Substances Act entirely. Individual states and counties would still be permitted to decide whether to permit cannabis sales. This would lead to a patchwork framework of geographies permitting cannabis sales across the nation. KEY thinks this could pass as early as 2H’21

To summarize, there are any number of ways to skin the legal cannabis cat at a federal level.

KEY thinks that investors who are interested in cannabis and who have the appropriate risk appetite should act now.

Conclusion

While cannabis legalization at the federal level is likely inevitable, it’s more complex than we thought, taking any number of years for things to be ironed out. As new laws are enacted and regulations lifted, there will be unknown unknowns that need sorting out. Now that the hype has settled, it makes more sense to look for a potential winner in the cannabis space and put down some long term bets. In coming articles, we’ll look at how the big MSOs are faring and digest the recent merger announcement between Aphria and Tilray.

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