Analyst Dimitry Zaytsev shares his thoughts on the security options provide investors in a highly volatile market like cannabis. Zaytsev believes there’s very little institutional participation behind the space’s current rally and believes company’s like Tilray are being buoyed by retail momentum players. Zaytsev questions current valuations and sees a lot of execution risk in the Ontario cannabis market because of black market enterprises and the “head start” such operations have over LPs for recreational dollars. Zaytsev anticipates a sell-off soon with subsequent new lower highs and explains what it means for the industry. Zaytsev addresses the mining industry, highlighting junior miners as a potentially lucrative, low-risk investment option.
James West: Welcome back to Midas Letter Live. My guest this segment is Dmitry Zaytsev. He is an analyst, and he is joining us today to talk technical. Dmitry, welcome to the show.
Dmitry Zaytsev: Glad to be here, James.
James West: Dmitry, the reason we started talking in the first place because you had some interesting comments about the technical indicators as it pertains to the cannabis industry in particular, and given the extreme exuberance in the marketplace, which is unexplainable by anything fundamental except that excessive exuberance, there must be some technical indications. So why don’t we start with a bit about who you are and how you came to be an analyst?
Dmitry Zaytsev: Yeah. So a little bit about myself: I recently graduated, and I’ve had a bunch of different experiences I was very fortunate to have at various boutique investment banks and other shops. I worked at Kinross, the gold mining company. I’ve also had an opportunity to work at Stoic Advisory, and they’re an M&A shop that focuses specifically on the cannabis space. And I’ve personally been investing in the cannabis space since 2016, 2015, around that time, and so I’ve been very interested by the opportunities there.
And I mean, we can talk about technicals, but I’m also very interested in terms of the fundamentals of all these companies, and I’ve been following those very closely, as well as, you know, the equity, derivatives, options, all those kind of things.
James West: Okay, interesting. So if you started investing in cannabis in 2015, you must be almost ready to retire.
Dmitry Zaytsev: Yeah, I wish I had a little bit more money when I was a student, that would have been way better! But no, I mean, I’ve done well for myself. A lot of my friends have done very well for themselves, and it’s been a great opportunity riding these waves.
James West: So you have been intriguing me because you’re talking about buying puts and options, and I mean, I’ve just got to be straight up: I just don’t dabble in that space. I never have. I would go so far as to say my understanding of all of the implications inherent in the option chain is limited at best. So just for the audience, because I’m assuming there’s some people in my audience like me who don’t really fully understand what options are – I mean, there’s the options that you get that are stock options, but then there’s options, puts and calls, which is what you’re talking about, which is very different. So, tell me about those options, the derivatives, as you describe them.
Dmitry Zaytsev: Yeah, so I mean, it’s actually very simple once you get your head around it. An option is just a right to buy a security or sell a security at a certain price. And so there’s something called a Black Scholes model; we could get into it, but we won’t. but there’s five or six main inputs. The two that you really have to – or three, I guess, that you have to really worry about, are the price of the stock – the underlying – the implied volatility, and the time. So the time until expiry.
So the way I like to, I guess, analogize options, they’re very similar to an insurance policy. So when you’re selling an option on a naked basis, you’re selling an insurance policy to someone else, and someone else is buying that insurance policy. So in essence, from a trading perspective, if you’re buying options, you have a very leveraged return and your downside is very limited. And you know, in a highly volatile space like cannabis, right, that’s a very interesting strategy to have, right? A lot of upside, you know, capped downside.
James West: So that’s the main reason to trade options as opposed to buy stock, is to limit your cost for entry and also to know exactly where the limits to the downside can be?
Dmitry Zaytsev: Right. And it’s also the leverage, right? So options offer, depending on, you know, so many things, like in terms of what strike you’re buying, and how high, how far out it is, they offer different return profiles. So for example, if you buy, for example, with Canopy, an in-the-money call, so something at 20, which gives you the right to buy the stock at 20, it’s the leverage on that isn’t as high, right? Because you’re already in the money a certain amount, because the stock is already what, 60, 70? I lose track every day.
James West: So I can’t buy the right to sell a share of Canopy at $20 at some point in the future?
Dmitry Zaytsev: Yes. So you’re really betting – and your upside here is, as opposed to buying the actual $70 stock, right, you’re paying $50, roughly, for it. An so you’re getting the leverage there.
James West: And the risk is that the stock will be below $20 by the time I want to sell it?
Dmitry Zaytsev: Yeah. So it’s – the risk/reward for that kind of trade is very, is exactly the same to Canopy, until it gets below 20. So the leverage – if Canopy goes to $20, right, your risk with the option is it goes to zero at that point. With Canopy you still have the $20 left of your $70 purchase price. I mean, I don’t think it’s actually going to go to that, just because, although the valuation is very stretched, they have $10 billion of cash, and I think on a per-share basis that’s something like, you know, $15 to $25, somewhere in that ballpark, depending on how much they deploy.
James West: Right. No kidding. Okay, so tell me about what are some of the trades that you’ve been making and having the best experience with in the last couple of weeks, for example.
Dmitry Zaytsev: So definitely – so I mean, I can talk about last couple of months and last couple of weeks.
James West: Well, tell me about your favourite success.
Dmitry Zaytsev: I mean, when it comes to how volatile this space has been, you really want to be buying a lot more options than you’re selling, right? Because you’re letting someone else insure the volatility of the cannabis space, in essence. So I mean, I’ve had some calls that I’ve been running since the deal was announced, but I mean, even I was surprised by how far the move has been so far, and I honestly think we’re very toppy today, for example.
James West: Sure. Tilray at $83. Where’s the fundamental sense behind that?
Dmitry Zaytsev: So I mean, listen: 80 to 90-plus percent of the people that buy this are retail; no matter what anyone tells you on Reddit, there’s very little institutional participation, and I’ve looked at it, right? The only institutions that are there are strategics, like Constellation investing directly into Canopy, or like funds that need to replicate the TSX. Anyone else that’s in there, they’re usually momentum players. And so they’re going to get out as soon as the momentum turns, which, kind of like today. Maybe that today that they’d be getting out.
So in terms of the options plays, right now, I’ve gotten a lot more bearish, right, and you know, I loaded up on some more puts today, for example, this morning. So it’s about bet sizing. It’s about keeping, you know, not deploying all of your capital; just small, bite-sized amounts that have asymmetric risk/rewards.
James West: Sure. So then let’s talk about macro-fundamentally; I mean, there’s a couple of value catalysts that are obvious on the horizon – legalization of cannabis in Canada October 17th. There are some that are not visible on the horizon yet, we know they’re there: de-prohibition in the United States, legalization incrementally in Europe and the rest of the world. What do you see happening in the next 12, 24 months to the cannabis sector generally?
Dmitry Zaytsev: Yeah, I think like you said earlier, the valuations are extremely stretched. So when I was investing back in 2016, 2017, you know, we built models with my friends and myself individually, on Canopy and Aphria, and you know, the dollar per share price we were getting was like $20, $30 type ranges for Canopy.
James West: In the future?
Dmitry Zaytsev: In the future, that’s the target price. Back in the day, I remember when it went to $17, we were like, this is nuts – back in the day. But so the fundamentals mean, you mentioned Tilray earlier in the show, and I mean, that’s a story where there’s no Canadian listing, it’s just been listed on the NASDAQ, and these are just the micro-market fundamentals of it. And there’s a really small float. A lot of people want to get short for fundamental reasons and they get killed, because the US retail investors just keep piling in.
On a macro level, I mean, I’m very challenged at these valuations right now, because if you look at the Canadian market, you know, it’s projected to maybe be $8 billion by 2020. How much of that is going to be black market demand, right? How much of that is going to be homegrown, right? And then think about what that is: that’s 800,000 kilos. How much of that is going to get taken off by homegrow, but then consider the capacity. The capacity, the fully funded capacity for a lot of these names, I think if you were to aggregate it, it’s somewhere close to 2 million tons, or 2,000 thousand kilos.
So it’s a really significant amount, and there’s just, I find, a lot of execution risk for a lot of these names. I see a lot of execution risk in Ontario. For example, you’re going to have cannabis legal October 17th, right, and if I want to smoke, do you think I’m going to wait for the OCS to give me a two-day delivery? I’m going to go to the guys that are going to be operating, still illegally, right, with no enforcement action, and I’m going to buy from them if I want to have a good night out or whatever.
So you’re actually giving the black market an eight-month head start. And Doug Ford has also mentioned that he will allow those guys to apply for a license, actually. So it’s actually, the black market is winning.
James West: But only if they stop selling now.
Dmitry Zaytsev: Yeah, only if they stop selling. We’ll see…I don’t know, right? I mean, there’s been a lot of threats before in terms of how illegal these cannabis operations have been, but I guarantee you’re going to have to some stories, if there’s no crackdown October 17th in Ontario, you’re going to have stories like, you know, ‘black market getting the full benefit of Federal legalization, they’re getting off to a head start’ ‘record sales, but not from the big LPs’. And so the way I see a lot of these valuations playing out, it’s like, you’d have to assume like almost 100 percent market share for a lot of these guys for it to make sense.
The whole beverage and international story, I’m not too sold on that either, because I’ve spoken to some of the extractor guys, and you can extract from stems and leaves of cannabis. Like, you don’t need the actual flower. So –
James West: For CBDs, true. For THC, you definitely need the flower.
Dmitry Zaytsev: Right, right, but I mean, it’s still – the question is, how much more of incremental demand do you think that’s going to add? And that’s really the question. And I guess the way I would look at it is, think of alcohol sales, which are, around, I think $10 billion or something like that in Canada. And how much do you think this will offset those sales, or supplement them? Maybe it’s going to be $1 billion or $2 billion or $5 billion market, which I think is very aggressive, 5 billion, that’s, you know, displacing half of alcohol beverage sales.
James West: So you see black market cannabis as a significant factor in the overestimate, or the excessive exuberance, projected by LPs in Canada in their projections?
Dmitry Zaytsev: Yeah, I think that’s definitely a big play. But I mean, even without the black market and homegrow, even if the market was larger, there’s way too much capacity online, and I think there’s only going to be a few winners. I think Bruce Linton said it really well when he said there’s going to be a disintegration, not consolidation. I really like that line.
James West: So from what you’re telling me, there’s a great opportunity to short the hell out of a lot o these guys coming up.
Dmitry Zaytsev: Yeah.
J.W. So is that how you will approach the market, call it, post-2019?
Dmitry Zaytsev: Yeah. So the way I’m approaching it right now is, this crazy mood, so I’m just buying options, you know swinging it however I can. But in terms of, what I’m really waiting for is, let’s say there’s going to be a sell-off. This is what I think, actually, this is my world view right now: there’s a sell-off for the next week or two, and we’re going to have an attempt to get back up, and the second it doesn’t get above this high that we just had, it will create a lower high, and that’s the point where I and everybody else, I guarantee you, in the industry, and in the US hedge funds, all those guys, are going to be layering on their shorts at that point.
James West: Okay. So as a well-rounded Canadian investor then, cannabis is, at some point the bloom is going to come off the rose. And so you’ve also got some experience in mining through Kinross, so do you keep a sort of one foot in the mining space, the resource sector?
Dmitry Zaytsev: I like to be in a lot of spaces. I mean, commodities is something I’ve looked at a lot, you know, and it’s more so that Kinross drew me because I’m so interested in commodities. But yeah, I’m definitely looking at what’s happening in the precious metals market with enthusiasm. It’s very interesting, some of the opportunities that are coming along right now. I’d also just, just to go back on our earlier discussion really quickly, people forget that a lot of these companies, they need a lot of capital as well. So it takes time to raise capital; it’s not just, you know, you call GMP and tomorrow you have a raise. It takes weeks to set this all up, and you know, that’s definitely going to add much more supply to the market of shares. And that’s going to be another reason, another thing that a lot of people are going to be watching, I think.
James West: Okay. Well then, so are you contemplating, like for example, junior miners is one of our sort of near and dear sectors on the show. So I’m curious as to your level of experience and interest in junior miners, and do you follow discovery plays, for example?
Dmitry Zaytsev: Yeah, so I mean, I haven’t been following as much the discovery plays right now, and just, it’s a very simple reason: I mean, it’s not the market for it right now. The market for discovery plays is when gold is slowly ramping up, and you get to a lot of these marginal producers. Because you know the way it works, right? The MPV at 10 percent, right? And a lot of them are very marginal producers. So you have that operating leverage where, let’s say, oh, they were making this great return at 1,400 if the project went through, but at 1,500, it’s like double. So you start seeing that, and that’s where I would get interested.
I also think, you know, the junior miners are very similar to an option. So you have very low risk, right? It’s just what you’ve invested. But if gold keeps going and there’s a mania, you can make multiples, especially if, as you’ve kind of told me, you’re interested in private placements and things like that, there’s warrants attached to those. So there’s lots of very interesting ways to play.
During the kind of cycle we’re having right now, where capital is extremely hard to raise for a lot of these companies, they’re going to sweeten the deal as with the warrants and with, you know, various clauses. So, definitely interesting.
James West: Great. Dmitry, well, we’re going to leave it there for now. I appreciate your participation. We’ll come back to you in due course and get some specific option strategies. Thanks for joining us today.
Dmitry Zaytsev: Absolutely. My pleasure.
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