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Although cannabis remains illegal in the U.S. federally, there are now 23 states where adult-use cannabis has been legalized. Ohio and Pennsylvania are the next states expected to allow adult-use cannabis, while Florida could do so in two to three years, one analyst says.Robert Layman/The Associated Press

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Potential reforms to cannabis laws in the U.S. are raising high hopes for a strong rally in marijuana stocks.

Pot stocks have been beaten up amid false starts for reform in the U.S., where cannabis is illegal federally, but some North American fund managers are cautiously optimistic about two recent developments.

“We feel very strongly that the biggest opportunity is the U.S.,” says Dan Ahrens, chief operating officer and portfolio manager at Bethesda, Md.-based AdvisorShares Investments LLC.

Given their depressed valuations, U.S. cannabis stocks can be a buying opportunity “with the caveat that they are extremely volatile in the short term,” says Mr. Ahrens, who runs the actively managed AdvisorShares Pure U.S. Cannabis ETF MSOS-A and AdvisorShares Pure Cannabis ETF YOLO-A.

“I don’t want to sound too bullish about stocks that have been down dramatically for the past two-and-a-half years,” he says. “We admittedly are extremely dependent on what happens with federal reform.”

On Aug. 29, the U.S. Department of Health and Human Services (HHS) sent a letter to the Drug Enforcement Administration (DEA) recommending cannabis be reclassified as a lower-risk Schedule III drug from Schedule I, which includes heroin and LSD.

The review of marijuana rescheduling, which U.S. President Joe Biden requested a year ago, is now in the hands of the DEA. Given precedent, it has typically come up with a proposed rule in about 90 to 100 days.

“We feel strongly that things have been co-ordinated behind the scenes – that the HHS wouldn’t put that letter out unless it was already co-ordinated that the DEA was going to approve it,” Mr. Ahrens says.

DEA approval is expected to be accompanied by a memo from U.S. Attorney General Merrick Garland that would “provide guidance for protecting states’ rights in saying that states that choose to have legal cannabis are not contrary to federal law,” he adds.

The second development for marijuana reform occurred in late September when the U.S. Senate banking committee advanced the bipartisan Secure and Fair Enforcement (SAFER) Banking Act to allow cannabis firms access to banking services.

If passed by the full Senate, that bill would go to the House of Representatives. An earlier version of this legislation had passed the House seven times but failed to secure Senate approval.

Still, the reclassification of marijuana is expected to have a bigger impact than the banking bill as it would also allow cannabis companies to write off business expenses – a move that would boost cash flow and profits.

“Rescheduling … we think adds many multiples onto these companies’ stock prices,” Mr. Ahrens says.

Nawan Butt, portfolio manager with Toronto-based Purpose Investments Inc., agrees that rescheduling is key and “would probably be the biggest news in cannabis since its legalization in Canada.”

“It takes away the handicap that the industry has, which is weighing down growth as well as profitability,” says Mr. Butt, who co-manages Purpose Marijuana Opportunities Fund MJJ-NE.

“It means that companies can report significantly higher profits.”

There’s some euphoria built into U.S. cannabis stocks after the HHS recommendation, “but we think a positive development after some 90 days would be another nice lift,” he adds.

Given precedent, it’s unlikely the DEA would go against the recommendation of the HHS, he says. “Our guess is that the final decision could land roughly within the second quarter of next year.”

Still, it’s wise to be cautious on timing, Mr. Butt says. “Going into the 2024 U.S. election cycle, it’s possible these elements of reform can get caught up with political posturing.”

But U.S. cannabis is still a “very bullish space” based on the growth opportunity, he says. “If we look at the total addressable market, we have gone from 18 states where there is legalized adult-use cannabis to 23 states in the past four years.”

Ohio and Pennsylvania are the next states expected to allow adult-use cannabis, while Florida could do so in two to three years, he adds. “For medical cannabis, I believe there are 38 states that have legalized it.”

U.S. cannabis companies should do well when institutional investors can step into these stocks, which can now only be listed in Canada, and drive these names multifold higher, he says.

“I believe there’s a lot of upside left for Canadian investors in this space. There will be a time to get out, but that time will come when large U.S. institutional investors bid for their stocks.”

Mr. Butt’s fund is now 90 per cent invested in U.S. cannabis names with the rest in Europe. He has almost no exposure to the struggling Canadian cannabis market.

“It was too much money applied to an industry too fast, and really got out of hand,” he says. “Canada was producing anywhere between three to five times its own consumption capacity.”

Among his favourite tier-one U.S. names, which are profitable firms with a strong balance sheet, have the ability to raise capital and a growing U.S. footprint, he likes Verano Holdings Corp. VRNO-CN, Green Thumb Industries Inc. GTII-CN and Trulieve Cannabis Corp. TRUL-CN.

In his tier-two group, which are companies with a smaller footprint but are becoming profitable and have a debt load that’s not too onerous, he favours Terrascend Corp. TSND-T, MariMed Inc. MRMD-CN and Cannabist Co. Holdings Inc. CBST-NE.

Among his tier-three names, he likes Cansortium Inc. TIUM-U-CN and Vext Science Inc. VEXT-CN. These firms have a strong footprint and are growing toward profitability, but may have too much debt, difficulty raising equity or whose shares don’t trade often, he says.

Bruce Campbell, founder and portfolio manager with Kelowna, B.C.-based StoneCastle Investment Management Inc., is also upbeat on the potential for U.S. cannabis stocks but remains cautious.

“We have taken small positions in U.S. companies,” says Mr. Campbell, who manages Purpose Canadian Equity Growth Fund.

If the SAFER Banking Act does not get passed again and nothing happens at the DEA, or if it takes a year for a decision, “cannabis stocks can drift and go sideways, or down,” he says.

The last and biggest false start to cannabis reform occurred last December when it looked likely that the marijuana banking bill would pass, and most stocks fell by 25 to 80 per cent when it didn’t, he adds.

That was tragic, he says, because the bill is also for the safety of employees as cannabis retailers can’t accept credit cards. “They have this pile of cash in their facilities and can get robbed.”

His Canadian equity fund now owns Green Thumb Industries and Verano Holdings. If cannabis reform were to get the green light, “we would be taking positions in companies like Curaleaf Holdings Inc. CURA-CN, Cresco Labs Inc. CL-CN and Trulieve Cannabis,” Mr. Campbell adds.

“We want to have a little exposure because we think the upside is pretty good,” he says. “But if we are wrong, it’s more like 50 per cent downside versus 10 per cent downside for a non-cannabis stock.”

Mr. Campbell is unsure the SAFER Banking Act will get approved even though President Biden and Vice President Kamala Harris campaigned on cannabis reform in the 2020 election.

“It’s a political game down there,” he says. “You have to weigh that risk and return.”

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