Our Top Stock Ideas in Silicon Valley’s Biggest Bet in Healthcare

The first company is a leader in genomic sequencing, providing the machines used for more than 90% of the world's DNA tests and empowering the personalized medicine movement. The second is an undervalued global drugmaker whose big bets on diagnostics are paying off for the development of personalized drugs. And the third is a pure play on liquid biopsies, whose much-hyped recent IPO could be worth the buzz for risk-tolerant investors.

In the following video, Industry Focus: Healthcare host Shannon Jones and Motley Fool contributor Simon Erickson describe the businesses, opportunities, and investor base of their top three stock ideas. Simon also shares his favorite company of the three.

A full transcript follows the video.

This video was recorded on Oct. 22, 2018.

Shannon Jones: 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 (ILMN -4.65%), 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?

Simon 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 (RHHBY -0.03%), 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 (GH -6.57%), 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.