Could cancer diagnostics really be the next biggest thing in healthcare? Special guest Simon Erickson dives into this burgeoning field and shares the top stocks every investor should keep an eye on: Illumina (NASDAQ:ILMN), Roche (NASDAQOTH:RHHBY), and Guardant Health(NASDAQ:GH)

A full transcript follows the video.

This video was recorded on Oct. 22, 2018.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today is Wednesday, October 24th, and we're talking Healthcare. I'm your host, Shannon Jones. I am privileged and honored to have a very special guest joining us today, one of my favorite Fools. Many of our listeners who are members may know him very well. I'm pleased to welcome Simon Erickson, the lead advisor of Motley Fool Explorer. Simon, so glad to have you on the show today!

Simon Erickson: Hi, Shannon! The privilege and honor is actually mine! Thank you very much for having me!

Jones: No, trust me, it's all on this end. I'm super excited to have you on the show for this topic. I know it's something you've been extremely passionate about over the last few years, I know we've talked about this on and off for a while. One of the things that I love about healthcare, and more importantly, the fusion of healthcare and technology, it's always interesting when Silicon Valley enters the mix. They have what I think and what you think is probably one of the biggest bets in healthcare right now. Simon, what can you tell us about Silicon Valley's latest big bet in healthcare?

Erickson: Gosh, this is such an exciting time to be in the healthcare industry, as you know better than anyone. People maybe sometimes think of healthcare as this slow-moving dinosaur industry that hasn't really progressed in decades, but that's really not the case. This is an incredible time to be an investor in the healthcare industry because things are moving so quickly. What you're referring to as far as Silicon Valley is concerned is largely in the space of genomics, specifically in cancer treatment. We're in a day and age now where you're actually able to see a patient at a genetic level. We're able to see a patient's DNA. Of course, DNA is the building blocks of what makes us unique as an individual. When you're able to see more and more information about a patient, you can also personalize those treatment options that you have. For doctors, that provides much better outcomes. It's going to be a very good time not only to be in the healthcare industry, but also to be an investor in healthcare.

Jones: Absolutely. When you take the innovative approaches in healthcare and marry that with some of these high, high unmet need areas, and there's no hotter space right now in healthcare than oncology and cancer. According to the World Health Organization, cancer is the second leading cause of death globally, and is responsible for an estimated 9.6 million deaths in this year so far. That's, of course, one aspect. There's also the economic impact of cancer, as well. They also reported in 2010, it was estimated that the U.S. healthcare spend was $1.16 trillion USD. Simon, diving into this space is super exciting not just for patients, but also from an economic perspective, as well.

Erickson: Absolutely. Shannon, you nailed it. The first part of this is more academic. For 20 years, it was trying to figure out the correlations between specific genes and diseases or conditions that would arise from this blueprint that is each individual. That was all pretty interesting. They've now identified more than 2,000 different hereditary traits. Some of those are height or hair color, but some are other things, like insomnia or other behavioral conditions. Of course, the most valuable and interesting for the medical community, as you mentioned, is cancer, oncology, this field of people that have very serious conditions.

The reason that it's so interesting for everyone right now is because cancer is not just uniform in how you approach it. For example, one of the most diagnosed cancers in the United States is lung cancer. There are more than 200,000 conditions that are diagnosed for lung cancer every year in the U.S. alone. It's skewed. Even though the overall survival rate after five years for lung cancer is only 17% -- this is a very serious cancer -- if you catch it at Stage IV, which is the latest stage for a cancer like a lung cancer, that's only a 5% survival rate. But if you can catch it at Stage I, you have greater than a 70% survival rate. So, for oncologists, the goal is not only to understand and correlate these academic purposes that we've looked at the genome for 20 years, but now that it's getting to the scientific community, how can we actually treat these patients in a personalized manner and catch it earlier on so that we can have a much better patient outcome and a higher survival rate for the most serious of conditions?

Jones: Exactly. Even more importantly, you talked about biopsy. For most cancers, biopsy is how you diagnose a cancer. That's extremely invasive. What we have here is this shift. What we're really diving into is, can we actually detect within a blood sample this free-floating DNA? And, can we then use that to tailor or personalize the treatment options? Of course, there's also the aspect of early prevention, early detection, as well. But really, looking at it from a treatments-specific, personalized medicine approach.

There's huge advantages with not only capturing all this data, which was led by the Human Genome Project that started decades ago. Now, we're actually starting to see the fruit of that. Also, as you look further down the line, it's, how can we now take that and use those insights into actionable treatment plans that actually make a difference? And, to your point, Simon to do it early on, because that's where it makes a difference?

Erickson: Absolutely. Liquid biopsies, like you say, so much less invasive than a tissue biopsy. This is a huge step for the medical community. It has its challenges, but that's definitely the direction I think we want to go with this.

Jones: Absolutely. This is a huge market. I was looking at some numbers, Simon. I saw upwards of $150 billion across the entire spectrum. Do you think that's outrageous at all?

Erickson: It's going to take time. It's not outrageous in any form. Like you said, this is a reactive vs. proactive approach that will determine the ultimate addressable market for these screenings. Again, right now, the addressable market is mostly later-stage cancers, patients that are showing symptoms. Maybe you're at Stage III or Stage IV. You just want to identify what cancer it is that's appeared. That might be less than a $10 billion market right now. Not so large. If we can push that back, like you said, with the liquid biopsy, a preventative screen through a blood test, there are estimates that even just in Stage II, that's a $40 billion market right there. Stage I would be more than $100 billion market. You add all those up together.

It depends how good we get at doing these screens. There's still a lot of challenges we have, not only financially, from a reimbursement perspective, of whether or not they're medically necessary for patients or just nice to have, nice to know. At this point, that's still unclear. And then, the other thing is the technical challenges, too. The last thing you want to do is have false positives where you're starting to really worry emotionally about having a cancer that's not actually there in the first place. Anything less than 100% or very near to 100% accuracy is going to cause a lot of issues.

This is a field that's still developing. Still has a lot of work to go, but definitely could be a $150 billion market. No doubt my mind.

Jones: Another thing to watch here is, as these companies start to develop these products, and we actually see them in these large patient populations, is looking to see just how congruent are these tests? Do they represent and show the same thing? There was some research a little bit earlier this year that seemed to put a question mark on that. I think there'll be more to come. But I think that's also another huge area to watch. You mentioned on the reimbursement side. Will payers like Medicare pick these up? Even from a regulatory pathway. I know the FDA has become much more open to innovative, personalized treatments. We'll want to continue to see that, and hopefully will continue to spur the entire ecosystem that's involved, from diagnosis all the way to care.

Simon, before we dive into stocks that our listeners should be watching, as I mentioned, you've been watching this space literally for years now. You've seen it ebb and flow and grow. I want to start with one that you and I have talked about quite a bit. If you're a member of The Motley Fool, you're probably pretty familiar with this first stock. The first one we're going to dive into is the gene sequencing giant Illumina, ticker ILMN. More importantly, we're going to be focusing on its spin-off venture, GRAIL. Simon, what can you tell us about Illumina and GRAIL?

Erickson: Illumina is the 800-pound gorilla in genomic sequencing. They are the largest player by far. They did more than 90% of the world's high throughput genomic sequences. Every year basically since their creation, they built upon this concept of next generation sequencing, doing genomic sequences faster and faster and at lower and lower costs. That's how you've been able to see a whole genome sequence being done for less than $1,000 today in a couple of hours. And they're still saying that they have the architecture in place to get it below $100.

The reason this is so important is because, for any of this to be financially feasible, or even time feasible, we have to get those costs of sequencing lower and lower. It's information that's great for oncologists to have, but it has to be financially available to pay for. Illumina has driven down the cost of sequencing for decades now.

Jones: It's interesting, another stock we'll get to in a minute, actually, most of their sequencing is done by Illumina's machines. If there was a stock that I think is a favorite among The Fool, Illumina is definitely it. I think what's really interesting with Illumina is this pan-cancer screening approach that they have. They're hoping to diagnose people at a very early stage, even before they have symptoms and regardless of the cancer type.

Looking at Illumina and this GRAIL approach that they're going after, they've got huge backers. They've got some deep pockets to actually pull this off. What can you tell us about that, Simon?

Erickson: Oh, my goodness! Yes, indeed. They've got everybody on board with this. One of the interesting things about this company, a lot of people think it's a race to the bottom. Is Illumina making any money if they keep pushing down the cost of the genomic tests? Yes, they are. They're making two-thirds of their money from consumable materials for each one of those runs. As we see the volume continue to increase, more and more people doing genomic tests, we've seen the consumer DNA databases -- these are the 23andMes and the Ancestry.coms, basically the kits they send to your home -- we've seen the subscriptions of those increase from 12 million people to 25 million people in just the last seven months. We're seeing this exponential increase in volume. That's very good for Illumina's business.

You mentioned the GRAIL side of this. It's actually more of a software, data science play on it. Now that you have all of these genomes, how can you correlate between them to find a specific gene responsible for a specific condition? GRAIL's first CEO was actually an ex-Google executive. You can see, they're trying to make sense of this terabyte of data that comes through in each genomic sequence that's done on those Illumina machines. Of course, the insight, the analytical approach to detect cancer very, very early stage before there's any symptoms, is their goal.

You also mentioned the financial backers. They've got Jeff Bezos on board backing this company, Bill Gates is on board, J&J [Johnson & Johnson], and of course Illumina themselves is on board with GRAIL. They just raised their series C. They brought in $300 million from mostly Chinese companies. There are even rumors that there might be an IPO for GRAIL within the next year, probably listed in Hong Kong. That's something I'm paying a lot of attention to right now.

Jones: I heard that. It'll be really interesting if it happens. Also, another key thing to watch is, GRAIL has started putting out data related to this large-scale multi-center trial. It's basically an observation trial. In order to have a populationwide screening test, GRAIL knows it needs to work on a very large scale with this trail. The aim is to analyze blood samples from 10,000 patients, 7,000 with cancer and 3,000 with no known cancer, and basically build a library. To your point, building out this huge database that they can then access and then continue to scale to hundreds of thousands of patients. The goal is, can we start to detect and identify early signals way beyond symptoms, way before something is actually diagnosed? This trial is huge. It's ongoing right now. I think a key area to watch is, how many are they able to enroll? And then, what kind of data are they able to glean from that? And then more importantly, how can they turn that data into insights that then will actually tailor and customize a treatment plan for someone?

Erickson: Absolutely agree. They've already raised $1.5 billion through three rounds of funding. That's a huge amount of money for a private company. As you mentioned, they need a lot of data points and that doesn't come for free.

Jones: True, very expensive. Of course, our listeners who are healthcare investors, you know even a small-scale trial within the hundreds is literally billions of dollars.

Let's turn our attention over to valuation from Illumina's perspective. Illumina, obviously a huge growth stock, has a market cap right now of $46 billion, trading at $316 a share. Even though it's a growth stock, do you still see opportunity here with the stock over the long-term?

Erickson: Yeah, absolutely. We were talking back in the Million Dollar Portfolio days, our team would talk about how the market was thinking that Illumina was overvalued at a $20 billion valuation. But these things aren't happening linearly. It would be easy for an analyst say, "OK, we did this many genomic tests worldwide this year. We're going to do this many next year and linearly increase the next year." That's definitely not what we're seeing right now, in terms of the total number of sequences that are out there. Up until the year 2014, there were less than 40,000 genomic sequences done worldwide out there for a whole genome sequence for a human being. now, like we just said, there's 25 million just for the consumer DNA side of it. This is something that's happening exponentially, with Illumina capturing the majority of their money from those consumable materials. They've got such a lock, more than 90% of market share on this market. You're starting to see those large precision medicine initiatives in the U.S., like the one you mentioned, but also in the U.K., they're doing one in China, they have their own precision medicine initiative. These are government funded, multibillion dollar projects, and they're all using Illumina's machines. I still personally think there's plenty of room for Illumina to continue to grow, even at this valuation.

Jones: Yeah, I certainly agree there, too. Let's shift gears and talk about the second stock that is extremely relevant in this space. This is a larger name overall, international drug and diagnostic giant. That company is Roche, ticker RHHBY. They've really been beefing up their bets when it comes to personalized medicine. They're doing this in multiple avenues, but the one that has captured the most attention was their bolt-on acquisition of Foundation Medicine. Simon, of course, this sock doesn't get nearly as much attention as an Illumina does, but it sounds like they've got an interesting approach with Foundation Medicine.

Erickson: Huge company. Diagnostic side of the business, the drug-making side of the business, too. They're very integrated. They've got a lot of resources and tools available to not only see what's going on with patients, but also prescribe those personalized drugs. As you mentioned, Foundation Medicine was an investment that Roche had for years because they wanted to build out this database of customers genomes. Foundation Medicine was originally tissue biopsies. They've moved within the last year to doing those liquid biopsies like we mentioned before. The goal is to correlate between, what is the patient looking like at the genetic level; and then personalize the cure for them, as well.

Foundation has been a phenomenal investment for anybody who got in on this company. They IPO-ed in 2013 at $18 a share. Roche bought them out this last summer at $137 a share. By my count, that's better than a seven-bagger in five years. Pretty good return for investors.

Jones: [laughs] That's an excellent return. For our listeners, Todd Campbell was really singing the praises of Foundation Medicine for years. We did certainly have to congratulate him on his early win here. What's extremely interesting with Foundation Medicine, and even with Roche and their approach, very similar in that they're attempting to detect and identify early signs of cancer on the genetic level. But if you actually look back in the history, Roche actually attempted a hostile take-out of Illumina. It was a $6.2 billion takeover bid, which Illumina of course fought back -- and, honestly, can you blame them? But it makes sense when now, you see Roche positioning themselves and being very strategic about Foundation Medicine.

Simon, with Foundation Medicine's approach and their platform, do you see any advantages compared to, let's say, Illumina and GRAIL? Are they doing anything different?

Erickson: This is less of a swing from the fences than GRAIL is. GRAIL is basically trying to go for the whole enchilada. When you look at patients with no symptoms, very, very early stage, there's a ton of work and a ton of money that's going to have to go into that. It will be interesting for me as an investor to see how independently Roche lets Foundation run. Is this simply a diagnostic tool that's available to oncologists who may or may not want to use Roche's personalized drugs that they're creating? Or is it going to be more of a sales tactic to say, "Hey, we're still a drug maker, we're using Foundation to push more of our own drugs." It'll be interesting to see the response between oncologists and Roche, and how independently they run Foundation.

Compared to GRAIL, I would say it's much less independent, it's much less of a swing from the fences. Again, a $5.3 billion valuation that Roche put on Foundation, that's a pretty good premium, even considering last time we saw GRAIL's private foundation, it was at about $3.2 billion. There's still a lot of growth, I think, for both of those companies. In my mind, there's more upside for GRAIL if they can figure out the technical challenges.

Jones: I will say, to Foundation's credit, they actually secured a pretty nice Medicare reimbursement coverage. Right now, Medicare reimburses an initial rate of $3,500 per test. More importantly, Foundation Medicine estimates that only 150,000 of the one million Americans with advanced-stage cancer are currently being screened. It just goes to show, if screening becomes more of a standard for all cancer types early on -- maybe that's a part of, when you go to your physician for regular checkups, there's a regular cancer screening -- you can see the opportunity is huge. I saw some estimates of a $12-15 billion market opportunity just for their FoundationOne platform that they've been using. This will be a really interesting one to watch. To your point, I don't think it'll be as much of a swing from the fences as GRAIL, but certainly a formidable competitor.

Erickson: Yeah, 180,000 patients is nothing to sneeze at. That's a great database they have.

Jones: Their test has been validated with 2,100 clinical samples and 4,200 analytical samples on top of that. Certainly, they're up there. I think when it comes to Roche, Foundation Medicine, certainly keep an eye on them, because GRAIL will not be the only one in this particular market.

Let's talk about the third stock here, Simon. Compared to the other two, this is brand-new to the public markets. This is a company called Guardant Health, ticker GH. They just had their IPO earlier this month. The company sold 12.5 million shares, $19 a share each. On its first day of trading, the stock soared almost 70%. I think they raised about $238 million in their IPO debut. Simon, do you think this stock is worth the hype?

Erickson: I will go out on a limb here, Shannon, and say yes, I do think it is. There is definitely a lot of hype around this. Just in the last couple of days the stock is up, what, 30% since we started talking about this? Not giving us, necessarily, credit for talking about it and that causing the spike. Still, interesting to see, so recently, all the attention on Guardant. They're also doing liquid biopsies. They've identified 73 different cancer-related gene mutations that they're screening for out there. They have 70,000 patients. They're pretty well-established. Both their CEO and their chairman previously founded companies that got bought by Illumina, which is an interesting and very important note, I feel like.

But, unlike GRAIL, they're taking a much more measured approach. Guardant is going after advanced-stage cancer first. They've got their cancer screen. They're building off of that advanced-stage cancer to go earlier and earlier in the diagnostic and detection phases. But, they've already got their screen approved by Medicare for non-small cell lung cancer, which is great, a very important cancer to test for. A lot of private insurers, Blue Cross Blue Shield, have already approved their tests. They're getting a lot of headway out there. If they can do more and more tests and improve this screen that they have, I think there's plenty of room for them to run from their current valuation.

Jones: Yeah, absolutely. I think what makes Guardant so interesting is, not only are they on the early detection and early prevention arena, but they're also looking at it from cancer reoccurrence. This is an area that does not get nearly as much attention. Point of the initial diagnosis, yes. But, for cancer that reoccurs, there's really not a ton of scientific data to back up, when should you start treating? How should you treat the patient population? What's the best treatment to use in those circumstances? You've seen that in various indications, but not on a wide scale. This is in addition to, you mentioned the late-stage liquid biopsies. That in and of itself is about a $6 billion opportunity. The cancer reoccurrence detection market is a bigger opportunity, potentially about $15 billion. So, because they're going in with a slightly narrower approach right now, looking at advanced cancer, but then looking at, how can we apply that to various stages of where a patient is at, I think this makes this company particularly intriguing. Honestly, I have to agree, I think it's kind of worth the hype.

Erickson: And, like you just mentioned, they have that measured approach. They've taken what they've learned from advanced-stage cancer. You've seen them moving earlier and earlier in the diagnostic-stage screening. I think that's the right way to do this, rather than just go all-in and try to fight too much off at the same time.

Jones: I have to ask, Simon. Given that it just debuted on the market, I know this was one stock, when it came to valuation, it was a little bit harder to bite the bullet on. Tell me your hesitations there with how this stock is valued currently.

Erickson: They're really interesting. They've raised more than $500 million in funding, already. Most of that is actually from some heavy hitters that are not in the public markets. The IPO got a lot of attention, but 30% of ownership of this company is SoftBank, who is, to be frank, kind of erratic on how they make investments and where their view is for the future. They've got a very visionary CEO and founder, but it's kind of hard to tell what SoftBank's intentions are sometimes. They own 30% of the company. You've got Khosla Ventures and Sequoia Capital both owning about 10% stakes. Those are very, very well-renowned venture capitalists in Silicon Valley.

But you add all that up, that's 50% ownership of the company. The public owns a decent stake of this, too. Institutions, the Fidelitys and the T Rowe Prices of the world, only own 6% of Guardant health. That's your critical, stable financial base for a company, is these funds that are going to buy and hold for a long, long time. VCs aren't always known for buying and holding for a really long time. They've got their own investors, and they have to have exit plans in place.

That's my hesitation as an equity investor in the public markets. What's going to happen if SoftBank or Sequoia or Khosla Ventures starts unloading a lot of shares? What's going to happen to the share price as of right now? I'm not saying that will happen, but that's definitely a hesitation. It's something we need to pay attention to. There could be a lot of volatility Guardant's future.

Jones: Very well said, Simon. To wrap things up, if you had to choose, of these three, which would be your top pick?

Erickson: My top pick every time when I talk on the show with you guys is going to be Illumina. I think the competitive position, the 800-pound gorilla in the room, is going to be right at the forefront of this trend of personalized healthcare. I love them. I've talked many times about how much I love them, so I won't belabor the point.

I do think, though, the one worth keeping an eye on for investors is still Guardant, just because we had such a recent IPO. I still think a lot of analysts, especially those institutional analysts, haven't quite wrapped their head around this opportunity. I tend to think that, this being the disruptive field that it is, of personalized healthcare, once that starts sinking in, there's going to be a lot more institutional interest in that company. That could be very good for the stock price, too.

Jones: That's awesome, Simon! That means next time you're on the show, we're going to do a follow-up and see where those stocks are at, and which one is your favorite. Thank you so much for taking the time to come and chat with us about cancer diagnostics. Always a pleasure to talk with you, Simon!

Erickson: It was really a pleasure on my side as well! Thanks very much for having me, Shannon!

Jones: Any time. Listeners, thank you so much for tuning in! That's it for this week's Industry Focus: Healthcare show. You can always find us on iTunes, Spotify, and now, we have our own YouTube channel. Go to youtube.com/user/themotleyfool to check us out. As always, people on the program may have interest 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. This show is produced by Austin Morgan. For Simon Erickson, I'm Shannon Jones. Thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Shannon Jones has no position in any of the stocks mentioned. Simon Erickson owns shares of Illumina. The Motley Fool owns shares of and recommends GOOGL, GOOG, and Illumina. The Motley Fool owns shares of JNJ. The Motley Fool has a disclosure policy.