Lemons or Lemonade

Updated: Jul 18, 2019

Without proper information and context, cannabis investments are more likely to be sour, not sweet.

Recently, while researching game and behavioral theory to gain a greater insight into the imperfect and slightly irrational public markets for cannabis stocks, I came across George Akerlof’s essay “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” The thrust of the essay deals with information and knowledge differences among market participants which touches on one of my favorite subjects-assymetric information.

As I am wont to highlight, we at Merida are obsessed with asymmetric information: Where we find it, how we cultivate it, how we determine who else has it, and ultimately, how it informs and drives our investing thesis. In reading Akerlof’s “Lemons,” and his later collaboration with Joseph Stiglitz and Michael Spence on asymmetric information and its effect on markets, which won a Nobel Prize in 2001, Merida's aspiration to use the disequilibrium in cannabis information to sharpen our investment focus and knowledge took on more meaning.

Feel free to skip a few pages if asymmetric information is of little interest and you would rather get right into how it affects today’s cannabis markets specifically. Further below you'll also find several recommendations we have for rounding out a diligence process that is suited to today’s cannabis environment.

Akerlof’s work begins by noting that "this paper relates quality and uncertainty.” I envy his succinctness and I'm sure some of the Merida team wishes I was so pithy. While Akerlof’s words were not exactly the famous opening line, “Arma virumque cano,” reading it was a worthy of Virgil in its own right due to the Aenean task of synthesizing all of this raw information and turning it into the highly curated investments Merida makes.

Akerlof provoked thoughts about how Merida drills into our research of potential investments, and the work we do to find relevant information through investments we don’t make (called the “Research Graveyard” by one of the smartest guys I know). I began thinking not just of the broad fragmentation of information in the cannabis space and the widely varying quality of information available to investors. With more than 500 public companies for people to invest in the U.S. and Canada, and wide distribution of many private placements, the democratization of the cannabis investment landscape is upon us. That said, while access to this new abundance of information is important, understanding the quality of that information is paramount. The same can be said for deal flow; we hear from many retail investors who see deal flow from investment banks in today’s market yet have virtually no context for these opportunities. You don’t need to be Richard Feynman to know that the type of deal flow matters more than just the volume or look.

Merida has now diligenced hundreds of companies in depth; easily more than a thousand when factoring in the years we invested in cannabis before Merida existed. As of today we have invested in 29 companies. Call it 33 when including the limited licenses we won. Those experiences have taught us some lessons on quality and uncertainty.

We acknowledge that the excitement and energy we see relating to cannabis investing has never been higher, even if tempered by fear created in the past three months by choppy public markets. We interact with investors ranging from the Wall Streeter casually buying some pubco stock to the traditional PE fund manager who is now beginning to focus on CBD/Cannabis investments, and each one seems to have a genuine curiosity and passion to invest and to learn more. Far more often than not, we do not see the uncertainty or hesitation to invest in direct opportunities one would expect from a person who says they are beginning to learn more about the space.

Half the time people who admit to knowing very little about cannabis in general have already invested a million dollars or more in a cannabis company that was largely diligenced through a traditional lens, or simply recommended by contacts who supposedly know a great deal about investing in the space.

This brings me to the core point of this commentary. We seem to have arrived at a precarious point in the cannabis investment landscape specifically because of this lack of uncertainty. There are three likely scenarios taking shape that we can reasonably predict amongst a myriad of potential immediate futures. Each scenario has a potential positive and negative effect on the markets:

1. Individual investors, regardless of size or experience will need to either become dedicated cannabis investors, with a defined diligence process, or start to look much more favorably on investing in vehicles (like Merida) that flatten their learning curve and are likely to achieve higher risk-adjusted returns.

2. The surge of institutional investors now looking at the space will push public values down for the short term as they opt for private structured investments in public companies.

3. The investment landscape will continue trending towards greater transparency and accessibility, as investors become more familiar with the nuances of how companies report their earnings and have past quarters as comparisons.

There is a seeming schizophrenia driven by the varying quality (and quantity) of information available to participants. Many, we believe, may not realize how disadvantaged they actually are in their analyses. Regardless of the sophistication of an investor, it is not the lack of information driving the danger, as there is now an abundance (verified data and comps to get a decent sense of the MSO landscape is just one example). People tend to understand that much of what will drive value for many companies is not in the numbers alone. In cannabis, it’s the untold story which usually hurts an investor's chance at returns.

Numbers, while very important, are a bit like photographs. You can observe them but unless you know what came before or comes after, the images themselves may be misleading. A perfectly posed and serene photo can hide the fact that two seconds after the snap, the subject of the photograph was attacked by a swarm of bees. Reading an early-stage company’s numbers in cannabis is no different. If investors lack the understanding to contextualize what they can gather, or perceive where the asymmetry of information is, they are potentially walking into a buzzsaw. That is bad for the long-term health of the industry.

For now, there is an energetic base of retail investors buying stocks daily, institutions biding their time and large operating companies looking to buy their way into the cannabis industry. We also have to take into account the aforementioned investors that tell us that they are still gathering intel and in the early stages of developing a deeper understanding of the space, while already having made significant direct investments. Sometimes we hear that from people who have already invested millions. Multiply that times a few thousand people and you are talking about the deployment of hundreds of millions of dollars. That can get to the danger level of Staff Sergeant Barnes -- with a foxhole shovel during a napalm attack -- pretty quick.

In Akerlof’s model, car sellers held a pronounced information advantage, assessing the true value of their cars far better than potential buyers. Akerlof noted that this distinct information asymmetry nearly destroyed the U.S. used car market in the 1970s. While we are not ringing that type of alarm bell, we do note that cannabis investing is unique precisely because the energy and excitement of a new industry unfolding is helping mask the risks inherent with being on the downside of an asymmetric information skew. If that excitement turns into resentment or a buyers strike, the market will get even more volatile and companies who need capital will be in dire straits.

Akerlof’s thesis is that “lemons” are more likely to get traded, as sellers try to game the system and make a profit. Sounds a bit like the early public cannabis markets in 2014 and 2015, during which penny stocks that had some direct, completely tangential or manufactured connection to cannabis skyrocketed and then raised capital at these artificial levels, leaving investors holding the bag. That led to a skepticism and fear in 2016 which helped fuel the boom in real companies leading us to today’s market. At times, it appears that while the asymmetry in information has grown amongst the haves and have nots, uncertainty has somehow fallen to new levels as yet unseen in the cannabis industry.

It could be that more companies are making their research available or coming to market with more materials that attempt to educate potential investors while soliciting them. Whatever the reason, we find it a bit disconcerting when we encounter smart, cautious investors who have been active for a year or less and seem to be 100% confident in their ability to have scenario-analyzed an investment in all its complexity. The difficulty and effort we put into diligencing opportunities, or negotiating a lead term sheet, can make us feel like a contestant in a Russian face-slapping contest. We face our own uncertainty by relentlessly pursuing every angle and every shred of information available on a company. It is hard to comprehend a gainfully employed person doing a fraction of the work we do pre-investment. We also ask a limitless amount of questions so we can come through the process like Vasily Kamotsky rather than the guys he left looking like Oberyn Martell after his bout with the Mountain.

Akerlof noted that if enough buyers get hurt by paying for “lemons,” it can lead to a correlated spiral which can force the market to cease functioning. I am skipping the discussion of utility function and the risk-variance effects of uncertainty but you Econ majors can probably figure out the real risk here for the cannabis market. If investors cannot discern good companies from bad companies because they feel like they are on the wrong side of the asymmetric information, then it is likely that large financings will fail to materialize or significantly slow. We have seen some of that occurring already, as diligence periods become prolonged as bankers feel the need to conduct more traditional and in-depth due diligence on more granular aspects of an issuer’s business.

We also have seen early investors recently burnt in newer issues, completely receding from the market or becoming much more skeptical around their investments. We have also heard from several banks that Canadian investors have largely stayed on the sidelines recently with respect to offerings for US MSOs after plowing into early pubcos.

Capital is becoming increasingly scarce for less deserving or unproven companies for many reasons, two of which stand out: (1) early, knowledgeable investors have fatigue from financing transactions with diminishing results as the perceived scarcity value premium has decreased; and more importantly, (2) newer investors have not materialized quickly enough as the perception that cannabis investing is “easy” money has declined. We have also seen that interest has cooled amongst newer investors as they realize that potential transactions lack early investors who can be credibly followed into a financing. Exuberance can overcome some level of uncertainty but not to the level of financing that the cannabis industry needs to continue advancing at its torrid growth pace.

Why is the potential effect of these aspects so important? Think of the bold, and paradigm-shifting Acreage/Canopy tie-up as an example. Capital efficiency is obviously a virtue if you need a few hundred million for all of your capital-intensive build outs, particularly in tight capital markets. Access to other expertise and IP are obvious virtues. We could go point by point, but it’s likely that the two companies identified aspects of their respective businesses, and the future of the industry, which motivated them to enter into the transaction that are only known by the closest insiders. That’s where the rubber meets the road.

Merida’s team thinks it has a fairly good handle on the pros and cons of the transaction but have also looked horizontally for context, which we have found in other transactions and information available to us. That is a time-consuming and difficult exercise for any investor (sophisticated or otherwise) simply looking for cannabis exposure and higher than average market yields, especially if you don’t currently have a position in either company. It's an important transaction, and worth noting in many ways. You can read our original Canopy/Constellation analysis (broadly distributed by New Cannabis Ventures) to get a sense of where we looked for analytical advantage while dissecting companies and the transaction. Short summary-we predicted Canopy would be the first company to do something like this nearly a year ago.

The priority of reasons that created the transaction notwithstanding, there is a wide variety of situations in which the dynamic of asymmetric information Akerlof identified can push companies into pricing, or transactions that affect shareholder value in ways that are both non-obvious and crucial to understanding where to find value in this fragmented landscape.

Asymmetric information can affect shareholder expectations. It can drive stock price gains or losses. If it hurts stock prices or affects the pricing of private transactions, those comps could lead to further decreases in valuations which could cool M&A activity. The list of potential effects is limitless. In each scenario, the real beneficiary is the holder of asymmetric information or the person who can identify that they are disadvantaged. That takes some insight and self-awareness that can be difficult to summon when a company is pressing and FOMO is knocking on your door like Jack Torrance at the Overlook Hotel.

A solid analog for where we are in cannabis is the early automotive industry: A hyper-local industry in the sense of its legality and rule-making, with a developing supply chain that largely fell outside traditional industry understanding at the time. Demand for cars was nearly insatiable but the understanding of the changes that the industry could have on society, driving, or how to regulate cars was rudimentary at best. Like the entropy that prevails in different cannabis verticals, a 1915 road could have new automobiles driving next to horse drawn carriages, a train-like tram splitting the avenue, horseback riders, bicycle riders and pedestrians. The differing speeds and technologies created a toxic mix of old-world-meeting-new-world and rules around driving were just developing to meet these challenges. Almost sounds like the FDA review on CBD or California trying to institute a new legal regime while Michigan just mandated lab testing recently. Or the current mix of outdoor grows, indoor grows, new extraction technologies, and false claims of CBD purity, or in the case of recent product testing in CA, if CBD is even present!

On a percentage basis, the most dangerous era on America’s roads was the 1910-1920 early automotive era. Detroit, due in particular to local manufacturing and blue-collar interest in cars, had huge numbers of cars on the road but virtually no rules around driving. The resulting injuries and fatalities from cars, horses and buggies, streetcars, and pedestrians in particular was alarming. In 1916, a full quarter of Detroit’s police force was dedicated to managing traffic. Technology, in the form of traffic lights, stop signs, and other innovations that emerged in the next few years changed that quickly.

In 1917, Detroit had 65,000 cars and 7,171 accidents, 168 of them fatal. 75% of those accidents involved pedestrians. For context, there were 288 million cars on the road in 2016 and there were 3 million injuries, which makes driving in 1917 Detroit ten times more dangerous than today, when people are constantly distracted by their iPhones.

That’s a good analogy for today’s cannabis information superhighway. Professionals who live and breathe the financial information of cannabis, understand the various operating markets, Canadian Stock Exchange disclosure rules, and multi-state complexity are sure to have an advantage over someone casually buying a stock because they heard it’s the best product in Cathedral City or Los Angeles.

In New York, which was where ~30% of the nation’s cars were in the early automotive era, injuries and deaths were far lower due to the fact that many cars were driven by professional drivers or chauffeurs. By focusing on driving alone, these chauffeurs became proficient at their craft. Detroit’s ownership was much more skewed to the masses, rather than wealthy chauffeur driven cars, and safety issues were an ongoing menace to operators and pedestrians alike.

While this may sound self-serving, well run funds are like those early chauffeurs in NY, who focused on driving and could take in all of the various pieces of new information which reduce risk and continue investing in high reward opportunities. Is a horse-drawn carriage coming? Don’t rev the engine and spook a horse which could lead to an out of control reaction. Streetcar coming? Slow down to avoid passengers disembarking. It sounds simple, but comparing the statistics to Detroit, where automotive technology was meeting the masses in an unstructured manner, makes our point. New York also had the nation’s first traffic court which would judge driver conduct and help enforce safety and parking laws. A perfect example of enforcement helping reduce risk if the statistics in those early days can be trusted.

Rules and education helped make Detroit safer over time, but those early years were incredibly dangerous for both drivers (many of whom were 15-18 years old) and pedestrians. The 1917 statistics around pedestrian injuries and fatalities brings to mind the “innocent investor” who is getting whipsawed in market volatility. It is interesting to note that Detroit very quickly led the country forward with speeding laws, stoplights, stop signs, police directed traffic and other regulatory innovations that made the city and industry safer. That took time and so will the construct by which cannabis information becomes normalized.

As stated above, the goal of this commentary was to first highlight the ways asymmetric information is impacting the cannabis investment market at a high level, and how it is possible to navigate the investment landscape as it shifts to a broader base of institutional investors who are far more focused on informational certainty. We also want to highlight a few areas where we often see investors overlook critical information and help give a few guardrails that might be able to help investors better contextualize investments under consideration.

Lest you think we are pontificating, Merida itself constantly identifies information within our investment process that is incomplete, in order to decide if we can move forward with an unknown and if so, to track areas of our investment that are undefined. Cannabis has such an entrepreneurial velocity at this time that it is impossible to be certain about every aspect of a business. If you follow a few simple guidelines, it is possible to limit negative shocks to some degree and some unknowns can become quite valuable.

We wrote nearly two years ago, in a commentary ironically called “Information is Power” that the competitiveness of cannabis could lead to technological advancement in agriculture, medicine or related areas, much like battle-tested technologies translate from the military to the civilian world. Radar, canned food, penicillin, microwaves (as in the oven) and GPS are just a small snippet of advancements that innovated on the battlefield first before becoming broadly adopted in the civilian world. While we were not predicting nicotine cessation products would be such an area, it is nonetheless a welcome development related to two our our portfolio companies, Vireo and Vapor Dosing Technologies. The next one could be an antibiotic for resistant bacteria made from cannabis or a less predictable area that cannabis significantly affects due to the innovative spirit driven from the competition of our space.

As promised upfront, here is a short list of guardrails that non-professional investors can use to refine their own diligence and avoid the downside of the asymmetric information skew.

Ask more than factual or strategic diligence questions. Devise questions that probe at a company’s broader understanding of their market or positioning, the challenges they may encounter, or how they see their company evolving in different scenarios.

Invest in companies that have identified pain points and have strategized how to address natural growth friction.

Look for management teams that have analogous experience directly related to their core opportunity. We wrote about this in an early commentary in 2017 and it has proven to be one of our best risk mitigation strategies. Management teams that have previously encountered challenges similar to their current businesses tend to react faster, with actions that are well-defined to solve challenges without having to radically shift resources unless absolute necessary. Resume investing (i.e. investing in a previously successful executive) in a pivoting executive can be troublesome for a variety of reasons, so be cautious if that is the case.

If investing in a science-driven company, spend time to understand analogs that can reveal timing of revenue, competitive landscape, capital needs, etc. You don’t have to be an extraction chemist to successfully invest in an extraction business, but you should understand the contours of challenges those companies may face in order to properly orient your thinking to a risk / reward analysis.

Valuation is important, but companies that will be paradigmatically changed by a strong capital partner can grow past any reasonable valuation. This is a factor that takes a fair amount of time to flesh out, but if you can predict what capital efficiency can do to a company, then it is easier to work at a higher entry valuation.

Make a list of why you invest (and didn’t invest) in companies so that you can judge the future against a company’s past reality. Merida has revisited its “research graveyard” for several actionable opportunities since we launched in late-2016. Facts on the ground changed from our initial analysis, and we were able to review and recalibrate our thinking because we had extensive institutional knowledge on the companies. In all three cases, the opportunities look like significant winners, even when considering our later, and higher-valued entry points.

Paul Samuelson, the Nobel laureate from the Massachusetts Institute of Technology, recalled that John Maynard Keynes once was challenged for altering his position on some economic issue. “When my information changes,” he remembered that Keynes had said, “I change my mind. What do you do?”

Good luck in your cannabis investing.


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