In this pre-recorded episode of the Market Foolery podcast, Chris Hill talks with Abi Malin from Motley Fool Hidden Gems about what she's watching out for in 2018. Tune in to find out why you might want to put Globus Medical (GMED 0.93%) on your watch list in 2018, a few of the most important risks to be aware of before buying in, and how it competes with the likes of Johnson & Johnson (JNJ 0.12%) and Medtronic (MDT 0.20%).

Then we talk about Stitch Fix (SFIX 3.07%): why the clothing company was one of the best-performing IPO's of 2017, why Stitch Fix's earnings report set off a few analyst alarm bells, and what those concerns mean for the company's long-term health.

A full transcript follows the video.

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This video was recorded on Dec. 29, 2017. 

Chris Hill: It's Friday, December 29th. Welcome to Market Foolery! I'm Chris Hill. Joining me in studio today from Hidden Gems, Abi Malin. Thanks for being here!

Abi Malin: Thanks for having me!

Hill: All week long, we're wrapping up 2017. Of course, this is the last trading day of 2017. Looking ahead to 2018 in terms of, whether it's an industry or company, what are you looking at? What are you watching?

Malin: I think one company I'm pretty excited to watch is Globus Medical. The ticker is GMED. I've been watching this since about March, and when I first started looking at it, they were doing a few things to upgrade their sales staff and sales team, they were having a little bit of recruitment issues, retention issues.

Hill: Medical device company?

Malin: Medical device company, yeah. They are a founder-led engineering-driven medical device company that, when we first started following them, they were specializing in spinal fusion products.

Hill: Ugh. Sorry, just spinal fusion, I just... anyway, go ahead.

Malin: That's actually part of why it's an interesting one to watch in the coming year. The company spends about 7% of sales on R&D [research and development]. This was mainly concentrated in two areas. The first is their Excelsius robot offering, and the second was innovating in their trauma-care sector. So neither of those actually had revenue lines for this past year, but both of them are growing. So I think this is going to be one to watch.

Hill: Market cap-wise, roughly how big is this company?

Malin: It is currently a $3.8 billion company.

Hill: $3.8 billion. When I hear medical device, the two companies that popped into mind for me are Johnson & Johnson, which is enormous and has a medical-device division, and I think about Medtronic. And either one of those companies.

Malin: I thought you were going to go with Zimmer Biomet or Stryker, one of those.

Hill: Oh, OK.

Malin: But either way.

Hill: But I don't look at this industry as closely as you do, so you know more of the names involved here. In the case of Johnson & Johnson and Medtronic, and possibly/probably for the two that you mentioned, so much larger than Globus Medical. Is part of your thesis with Globus Medical -- and maybe it's not among the top three or four reasons to be interested in this stock -- but is somewhere on the list the possibility that someone else buys them?

Malin: I wouldn't depend or expect that. I think something that's unique about this particular company is, they're really engineering-focused. When you look at the spinal space, there's two distinct paths. There's disruptive technologies and then there's innovative technologies. And they are much more in the disruptive side of things. They're looking at other places where other people aren't necessarily looking. So I wouldn't necessarily see them as a nice tuck-in acquisition.

Hill: Healthcare is so big, and I'm wondering if one of the ways investors can narrow their field of vision with respect to healthcare, whether it's medical-device companies or pharmaceutical companies, is to look for the companies that are specializing? To look for, "This is a medical-device company, but they're the only one that's really focused on X, or they're the dominant player in spinal fusion?"

Malin: I work on our small cap team here, and I work on Hidden Gems, and I think when we look in this space for medical exposure, that's something that's probably the best way you're going to get outsized returns in that particularly sized pool.

Hill: You mentioned the R&D spending. They're currently spending about 7% of their sales on research and development. As an investor, help me out here, should I be looking for that to be higher? Should I feel good about that? I'm not a shareholder, but in general, this is one of those industries where R&D is really crucial. And it's a fine line that companies have to walk, where they need to invest in R&D. But we've seen this with plenty of other companies, whether it's medical device, something else in healthcare, or just tech, general hardware tech, where we've seen companies come out with their quarterly earnings, R&D spending has spiked, and the stock takes a hit.

Malin: Yeah. Generally, for a company of their size in this field, at least by our thesis, we thought that was pretty high. I guess, when we had to think about this, and in the original thesis, it was, how likely is that going to come to fruition, or how positively will those potential new markets affect their total addressable markets, and things like that. So because those are two new spaces for them, both trauma and the robotics, it's a little bit unsure. But that's what makes it an interesting story to follow.

Hill: Alright. What's a stock that, maybe you don't own it, maybe it's not an active recommendation in the Hidden Gems service, but it's something that you have on your personal watch list?

Malin: I recently started looking at Stitch Fix. They IPO'd back in November. I think it's sort of at the almost perfect juxtaposition of, right after Blue Apron is doing so terribly, which is a similar subscription business, and also this retail space, which is getting no love this year. I think investors haven't really given it enough attention, maybe, as it deserves.

Hill: Tim Hanson and I talked about Stitch Fix last week, because they came out with their first earnings report. To me, this is an impressive young company, in no small part for how the business was managed leading up to the initial public offering. But they come out with their first report, and their margins are getting hit. I think that's why -- that and the fact that the stock had a pretty nice run in its very short tenure as a public company.

Malin: Yeah. I agree. Katrina Lake is their current founder and CEO. I think she's really impressive. They only raised about $42.5 million before going public, which, for being cash flow positive since 2014, you have to give her credit there. I think she's done a really excellent job. But I don't disagree, necessarily, with the current concerns about -- previously, Stitch fix has focused a lot on growing subscriber counts through word of mouth, and they haven't spent much, if anything at all, on marketing. So they've talked about, that has to tick up in coming years. They can't rely as much on word of mouth. So it's sort of a challenge to continue to grow subscribers, but also, keep your customer acquisition costs in check. I think that's definitely a relevant and worthwhile, worth-watching concern. But I think this is a business that, if they can actually get the economics right on this, I think it could be really interesting. But again, I agree with most investors. Their S-1, I don't know if you've looked at it at all?

Hill: Let's assume for the sake of this conversation that no, I didn't spend one second looking at their S-1.

Malin: OK, assuming that you didn't look at it, there's a high lack of clarity. Those metrics were so vague, it was really hard to get a picture.

Hill: Was it like when Groupon was getting ready to go public, and they invented metrics that no one had ever heard of and threw them in their S-1?

Malin: Stitch Fix gives a box of five items. And it's either auto scheduled or on-demand delivery. Clients keep what they like and send the rest back. Shipping is prepaid both ways, and if you keep everything, you get a 25% discount for keeping all five items. If you keep nothing, you pay a $20 styling fee. They don't exactly explicitly break out how many items each client keeps, on average, but they track how that number has trended over time, which is a little strange to me. Just things like that, where it's hard to estimate future cash flows when you really don't know what's happening.

Hill: And let's not put this completely on the shoulders of the people at Stitch Fix. We've seen over time that companies will share the metrics that they want to share, and when it is no longer to their advantage to share those metrics, they will stop sharing them. That's just kind of how that goes. Although it's interesting you mentioned Blue Apron at the start. I do think, despite what you just said about the lack of clarity in the S-1, that Stitch Fix has benefited, and rightfully so in my opinion, from the environment that it is up against. By that, I mean, by comparison to other recent IPOs, Stitch Fix grew their business in a more impressive way than Blue Apron did. Anyway, I think all things being equal, when you're looking at the rookie class of 2017 of IPOs, they come out easily in the top half, and probably in the top 20% or so.

Malin: Yeah. I guess my reason for keeping it on my radar, but not necessarily jumping in right away, part of their big competitive advantage is around their data and these data points. So they say, on average, they collect about 85 data points per client. And for each item of clothing they actually measure, aside from normal things like brand, color, size, pattern, silhouette, material, things like that, they actually do very specific measurements. They talked about, from the collar to the first button is so many inches, or the arm opening is X inches. And then, if I was a client, they track my spending habits, as well as people who I can be similarly grouped as. So if someone like me kept an item, they assume that increases my probability of keeping that item. I think there could be something there, that data is actually working. But without these explicit metrics behind it, it's a little bit hard to assume that that works.

Hill: Have you used the service before?

Malin: I haven't, no.

Hill: One of the things Tim Hanson mentioned was, and it's something you just touched on, the data they collect and the algorithm that presumably gets smarter over time, and on the flip side, you have the personal stylist, the actual human being that you're matched up with at the start. And those are people who are paid on an hourly basis. At some point, if Stitch Fix is really going to turn on the profit machine, don't they have to make a switch? I'm not saying get rid of the human beings, but at some point, wouldn't it make sense for them to say, "We're going to move these people to a salaried position, and we're not going to give them the incentive of, take as long as they possibly can to fill orders. We want to get more customers in, and we want our human-being stylists to work as efficiently as possible so we can get more items sold, so the algorithms get even smarter." It really seems like that's one of, if not the biggest, question they need to answer in 2018.

Malin: Actually, that would make me less interested, if they moved in that direction.

Hill: Really?

Malin: Yeah. I think when you start depending solely on algorithms, at that point, it's becoming an e-commerce game. And how are they going to compete with Amazon? I just don't see that as a place they could potentially win. I think they do probably have more data, but I think that human factor -- when you order a box, you get a handwritten note from your stylist, you can request certain things, you can request anything as broad as, like, clothes for work, to as specific as sweaters with tassels. So I think you need that sort of human interaction to keep it feeling personalized, diversified, and really a special experience. I think that would actually be a detractor for me as an investor.

Hill: Thanks for being here, I really appreciate it!

Malin: Thanks for having me!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you next time!