Schrodinger (SDGR -3.60%) is one of my high-conviction investments -- a class of stocks where my confidence level is as high as it gets. Sort of like Shopify, Square, Roku, or Sea. The difference is that Schrodinger, with its $5 billion market cap, is a lot smaller than those other names.
I can think of at least two small caps -- Silvergate Capital and OptimizeRx -- where my conviction levels are about as high. But I already have large positions in those stocks. Right now Schrodinger is a tiny position in my family's investments, and I want to add more shares. Here's why Schrodinger is so high on my buy list.
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1. It's the key tech company for drug discovery
Healthcare is a huge, $9 trillion worldwide market. About $1.2 trillion of that money is spent on pharmaceuticals. So, obviously, drug discovery is an incredibly important (and profitable) industry. I'm invested in many biotechs that are in the business of finding drugs that work. But perhaps even more profitable are the "picks and shovels" for the biotech industry -- those tech businesses that help drug companies find valuable molecules.
Schrodinger's software is like a supercomputer that runs a lot of math and helps companies find molecules that have higher probabilities of success. If you're digging for healthcare gold, Schrodinger's calculus increases the probability that you will find it. Specifically, its technology helps drug companies find the best target in the human body for a specific disease, and the drug molecule that has the highest affinity for that target.
The company is named for Erwin Schrodinger, the physicist who proposed the famous "Schrodinger's Cat" experiment. Schrodinger's equation is a key basis of quantum mechanics, specifically quantum chemistry. His calculus is way over my head. I couldn't tell you if the company's math is right, or whether it has just hijacked a famous scientist's name and the math doesn't work at all. But what I can tell you is that out of the top 20 pharmaceutical companies, all 20 of them use Schrodinger's software to find drugs. As Watergate reporters Bob Woodward and Carl Bernstein once said, "Follow the money."
2. You don't need absolute assurance to make money in the stock market
Schrodinger's (the physicist) theory requires recognition of and respect for uncertainty. Similarly, we do not know with absolute assurance that the molecules Schrodinger's (the company) software finds will ultimately cure diseases. That's why the U.S. Food and Drug Administration (FDA) still requires human trials before we allow pharmaceutical companies to market their drugs to the public. It doesn't matter how good the math is -- we still have to test the drugs in the real world.
Erwin Schrodinger's theory, as far as I understand it, is about probability. The corporate Schrodinger's software increases the probability that the molecules a drug company uses to treat diseases will work. That's why Big Pharma is paying for the software. Anything that improves your odds of finding a great molecule is valuable, because the cost of having a bad molecule is super-high. On average, a drug company can spend at least $1 billion bringing a drug to market -- one study even put the number at $2.6 billion. So you can imagine how catastrophic it is for a biotech company if the FDA rejects a molecule.
What we know is that Schrodinger's software dramatically improves the identification of molecules that are more likely to bind to target proteins. In one study, 80% of Schrodinger's molecules had improved affinity (stronger binding), versus a 10% result with human approaches. And Schrodinger's software not only finds superior molecules, it speeds up the drug discovery process. The traditional human approach to drug discovery synthesizes 1,000 drug compounds every year. Schrodinger's high-speed computers evaluate billions of molecules in a week.
3. Schrodinger has lots of optionality
Right now, Schrodinger's claim to fame is that it's the tech stock for drug discovery. That's why I'm investing here. But one of the cool things about this company is that the higher math it's working on has applications in many, many fields, not just pharmaceuticals. As the company writes in its annual report, "since the physics underlying the properties of drug molecules and materials is the same, we have been able to extend our computational platform to materials science applications in fields such as aerospace, energy, semiconductors, and electronic displays."
These are huge market verticals, and you can see how significant it would be if Schrodinger's modeling software started to dominate the way these industries work. Physics underlies the whole universe, so software that helps you understand and predict the physical world ultimately saves companies a lot of time and money.
A whole section of the company's website is devoted to this kind of materials science, and its software is used for nanotechnology, organic electronics, energy capture and storage, thin films, polymers and polymer additives, consumer packaged goods, and the creation of metals, alloys, and ceramics. So that's one more way this company can become extremely valuable -- if its software becomes fundamental to more and more industries. I'm not surprised that Bill Gates (with his family's foundation) owns 11% of Schrodinger.
Not only can Schrodinger's software be used in various fields beyond the pharmaceutical, the company is taking a deeper dive into drug discovery, too. Specifically, it's using its software to find its own molecules that it's keeping in-house. These drugs haven't reached clinical trials yet. Nonetheless, Schrodinger's entry into drug discovery shows how much optionality this company has to grow its business and reward investors for years to come.
